Trading Systems and Money Management

 Trading Systems and Money Management

“This is Wall Street, no act of kindness will pass unpunished.”

— Unknown

As an editor, writer, and technical analysis expert first for Futures magazine and

later Active Trader magazine, I realized that although there are plenty of technical

analysis books in general and on rule-based trading in particular, they were all say-

ing the same thing and not bringing any new thinking into the subject. This is espe-

cially true when it comes to the intricate topic of how to build and evaluate a trading

system so that it remains as robust and reliable when traded together with a profes-

sional money management regimen in the real world, as it seemed to be when test-

ed on historical data.

In an effort to do something about this, I first wrote Trading Systems That

Work (McGraw-Hill, 2000), which focused on longer-term systems on the futures

markets, and now Trading Systems and Money Management, which focuses on

short-term systems in the stock market. Both books combine featured systems with

a fixed fractional money management regimen to maximize each system’s profit

potential, given the trader’s tolerance for risk.

To combine a mechanical trading system (the rules for where and when to buy

and sell a stock or commodity) with any money management strategy (the rules for

how many to buy and sell, given the trader’s risk–reward preferences and the behav-

ior of the markets), is not as easy as taking any system, applying it to any market

or group of markets, and deciding on not risking a larger amount per trade than

what your wallet can tolerate.

Instead it’s a complex web of intertwining relationships, where any change

between two variables will alter the relationship between all the other variables.

And, as if that’s not enough, the strategy should be dynamic enough to mechani-

cally self-adjust to the ever-changing market environment in such a way that the

Copyright 2003 by The McGraw-Hill Companies, Inc. Click Here for Terms of Use.

risk–reward potential remains approximately the same for all markets and time

periods.

This book is for those traders who haven’t been able to pinpoint what is miss-

ing to make the complete strategy larger than the sum of its parts. If you allow me

to take a guess, I’d guess that what you feel is keeping you from succeeding as a

trader is the overall understanding for how it all ties together and what really con-

stitutes a more “sophisticated” strategy with a higher likelihood for success than

the ones you’re currently using. The way I see it, to simplify things, the develop-

ment process could be divided into a few building blocks:

First, we need to learn what we need to measure to achieve robustness and

reliability. Second, we need to learn to formulate and test the logic for the entry

(and possibly also some sort of filtering technique). Third, we must understand and

test different types of exits. The last point of actual research is to apply and test the

money management according to our risk preferences.

The first part of the book will show you how to measure a system’s per-

formance to make it as forward-looking as possible. By forward-looking we mean

that the likelihood for the future results resembling the historical results should be

as high as possible. To do this, you will need to know the difference between a

good working system and a profitable system and which evaluation parameters to

use to distinguish between the two.

The emphasis will lie on making the system work, on average, equally as

well on a large number of markets and time periods. We also will look at other

common system-testing pitfalls, such as working with bad data and not normaliz-

ing the results. Another important consideration is to understand what constitutes

realistic results and what types of results to strive for. A lot of the analysis work

will be done in TradeStation and MS Excel.

In the second part, we will take a closer look at the systems we will work

with throughout the rest of the book. All eight systems have previously been fea-

tured in Active Trader magazine’s Systems Trading lab pages. The systems are

selected only as good learning experiences, not for their profitability or trading

results. We will look at the systems one at a time and determine how we can mod-

ify them to make them more robust and forward-looking.

All changes will be based on logic and reasoning, rather than optimization

and curve fitting, and are aimed to improve the system’s average performance over

a large number of markets and time periods, rather than optimizing the profits for

a few select markets. The working premise will be, the better we understand the

logic behind the system and the less complex the system, the more we trust it will

function as well in the future as it has in the past. For this, we will do most of the

work in MS Excel, which means we need to learn how to export the data from our

analysis software of choice.

Usually when I build a system, I don’t count the stop-loss and exit rules to

the core system logic. In Part 3 we therefore substitute all the old exit rules for all

systems with a set of new rules, optimized to work on average equally as well on

all markets at all times. To do this, we need to understand what types of exits are

available, how to evaluate them, and how to avoid falling into any of the problems

that adhere explicitly to the evaluation of exits. However, even though the larger

part of Part 3 deals explicitly with stops and exits, the methods used (such as ana-

lyzing the results with a surface chart in MS Excel) also are applicable to other

parts of the system-building process.

At the end of this part, we also will take a look at how to increase perform-

ance by adding a relative-strength or trend filter. Decreasing the number of trades

might decrease the performance for any individual market, but by making room

for more trades in more markets, we can increase performance thanks to a higher

degree of diversification.

The last part of the book will tie it all together by applying a dynamic ratio

money management (DRMM) regimen on top of all the trading rules. With

DRMM, all markets traded will share the same account, so that the result for one

market is dependent on the results from all other markets and how much we decide

to risk in each trade. Also, the number of possible markets to be traded simultane-

ously and the amount risked per share in relation to the total amount risked of

account equity will vary with the conditions of the markets.

Using DRMM, we also can tailor the amount risked per trade to fit our exact

tolerance for risk given the system’s statistical characteristics and expected market

conditions. In this case, instead of optimizing the equity growth, we will optimize

the smoothness of the equity curve. Even with this modest goal, we will achieve

results far higher and better than comparable buy-and-hold strategies. But before

we set out to test the systems using DRMM, in our custom-made Excel spread-

sheet, we will learn exactly how DRMM works with all its mathematical formulas

and why it is the supreme money management method.

However, when moving back and forth between the different steps in the

development process we have to understand that any little change under any of

these categories also will alter the characteristics produced by the others. Therefore,

building a trading system is a never-ending task of complex intertwining dynamics

that constantly alter the work process. This really creates a fifth element that runs

through the entire process as a foundation for the other elements to rest on.

The fifth element is the philosophic understanding of how all the other parts

fit together in the never-ending work process already mentioned. If anything, I

hope that what makes this book unique is the overall understanding for the entire

process and the way it will force you to think outside of the conventional box.

Developing a trading strategy is like creating a “process machine,” in which

each decision automatically and immediately leads to the next one, and next one,

and next one ... producing a long string of interacting decisions forming a process

with no beginning or end. I further believe it is paramount to look at both the

development and the execution of the strategy in the same way.

The purpose of this book is not to give you the best ready-made systems, but

to show you how to go about developing your own systems—a development process

that eventually and hopefully will allow you to put together a trading strategy that is

a long-term work process as opposed to a series of single, isolated decisions.

The advantage of the concept of a work process, in comparison with decision,

is that rule-based trading can be understood as a form of problem solving, using the

four P’s of speculation: philosophy, principles, procedures, and performance.

The emphasis in this book seems to be on the principles, procedures, and per-

formance, but while reading we also need to at least try to understand the philos-

ophy behind it all, because it is the philosophy that ties it all together and explains

the value of the suggested principles and procedures in the rest of the book. That

is what this book really is about. Good luck with your studying and trading.