In my “System Trader’s Advantage” article we discussed what trading systems are,  how systematic trading helps traders and how backtesting gives systematic traders an edge over other traders.

In this issue I want to discuss what actually makes a trading system profitable. Profitable trading systems are typically simple. Complex ideas just don’t hold up in the long term. So, what actually makes a simple trading system profitable?

What Makes a Trading System Profitable

For a trading system to be profitable it must have a positive expectancy. There are a few ways to calculate expectancy but for ease you can think of it like this:

Expectancy = average win x % winning trades – average loss x % losing trades

But where do these positive expectancy  edges actually come from? For an edge to be real and lasting, it needs to come from some sort of real, observable, recurring behaviour in the market. For example:

• Trends persist: Market participants take a while to observe and act on fundamental shifts, so trends unfold gradually as more and more traders / investors drive the price up.
• Prices revert to the mean: Fear leads to panic selling which drives prices down causing more panic selling.   Traders / investors capitulate and sell when fear is at its peak, then with no one left to sell buyers drive the price up.
• Prices move in ranges or channels: When prices reach a high and then retrace, this leaves some traders feeling regret that they didn’t sell at the high, so when prices approach that high next time they sell. This puts pressure on the price and keeps it from moving higher. The same happens in a price decline. When prices make a low and rally some traders miss out and regret not buying near the low. When prices approach the low again they are eager to avoid the same mistake and rush to buy. This behaviour leads to prices trading in ranges or channels.
• Structural bias: Some instruments have a structural bias built into them. For example, leveraged ETFs rebalance daily which creates inherent decay in their prices. If you look at a long term chart of a leveraged ETF you will see this decay in action.
  In a similar way, over the very long term the stock market rises because the economy grows, technology advances, management reduces costs and becomes more efficient and therefore profitable. This the sharemarket goes up over the long term.

For a trading system to be profitable long term, it must have an edge that comes from something real like this. Combining random indicators and finding something that made money over the last 6 months is just statistical randomness.

Good trading systems are based on a real edge, driven by underlying market behaviour and dynamics… not random statistical anomalies.

So before you adopt a trading system, make sure you understand where it’s edge is actually coming from. If you can’t easily identify what recurring behaviour the system is profiting from, the system is probably not going to be profitable in real time trading.

If It Was That Easy…

One of the most common challenges I hear about trading systematically is “If it was that easy everyone would do it”.

Note that I actually said profitable trading systems are ‘simple’, I didn’t say they are ‘easy’. The sources of systematic edge mentioned above are actually psychologically difficult to act on, so most participants are not willing or able to consistently act on them.

For example, a trend following approach requires you to buy when prices are high relative to the past (the instrument is trending). But this generates fear because the price might fall, so most traders don’t like to buy a strongly trending stock.

The trend then tends to persist, but there is volatility (it doesn’t go up in a straight line), so to catch a lot of the trend you need to patiently sit through all the rallies and retracements that happen during the trend and not sell until the trend is obviously over. Most traders don’t want to do that because there is too much emotion attached to every upswing and dip.

Most traders just want to snatch a quick profit and get out. That is why most traders don’t get big profits and their accounts shrink under the weight of their losses which are larger than their wins.

A good trading system will harvest an edge in the market by giving you the signals that tell you when to get in and out. The critical issue here though is that the trader must follow the system, even if the signals (or the waiting between signals) is psychologically hard.

What gives one trader the ability to take these psychologically hard signals while most traders remain shackled by their emotions?

One word… Confidence.

You must have absolute confidence in your trading system to follow it consistently despite the signals being psychologically hard. This confidence comes from backtesting.

Backtesting To Build Confidence

The great advantage of backtesting your trading system using trading software like Amibroker is you can get far more data on how your system performs.

Let’s take the example trend following system we looked at last issue.

Entry Rules: Buy tomorrow at the open if  the average turnover for the last 20 bars is over $500k the close is the highest close for the last 500 bars.

Exit: Sell tomorrow at the open if the stock closes below the 200 bar moving average.

Initial Stop: 6 times the average true range below your entry price.

Risk Management: Risk 0.5% of your account on each trade, don’t use leverage. Give highest priority to new trades which have moved by the greatest percentage over the past 200 trading days.

When you look at these system rules you may have some emotional reactions, doubts or uncertainties that come to mind (we are all human after all).

Here are some common emotional reactions that many traders may have to a trading system like this:

1. Variation 1: “That entry is too slow, so I want to buy at a 50 bar high to get in earlier”
2. Variation 2: “I don’t want to trade small caps so I only want to take signals on stocks with $5m daily turnover”
3. Variation 3: “The exit is too slow and gives back a lot of profit so I want to get out using the 50 bar moving average”
4. Variation 4: “That stop is really wide, I want to use a tight stop to reduce my risk, I prefer a 2 ATR stop”
5. Variation 5: “I want to take profits off the table so I want to use a 20% profit target”

Let’s backtest these ideas one at a time and see what happens. The charts below are produced using Amibroker, backtesting all listed stocks on the ASX from 1990 – present.

Equity Curve

Here is a summary or the compound annual return and max drawdown:

Every one of the typical psychological responses to the original trading system rules reduced the trading system’s annual return and increased the maximum drawdown.

So much for human intuition!

This certainly builds the confidence needed to follow the original system and ignore the psychological resistances and reactions that happen.

Conclusion

One of my favorite ways to build confidence in my trading systems is to observe the emotional reactions I have to the system rules and the trades they generate, then convert these emotional reactions into rules and backtest them just like we did above.

The vast majority of the time you will find your psychological reactions make the system worse, proving this through backtesting builds your confidence that it is a good system and you are safe to follow it. After doing this a few dozen times most traders find they have eliminated their resistance to following the system.

Now you can trade profitably with the confidence to follow your system consistently!

This article was written by Adrian Reid, Founder of Enlightened Stock Trading and was first published in Your Trading Edge Magazine