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Developing Trading Systems - Part 1Cho Sing Kum This is the first of a 3-part series which I wrote in a financial forum on 1st April 2001. Lightly edited.
In writing this article there is one important assumption I made - that you are a technical trader. The reason being that this whole article is about Developing Trading Systems using technical analysis indicators. Let us first define what is trading, system and technical analysis so that we have a common understanding.
What is Trading?Much has been
discussed or assumptions have been made as to what is trading and what
is investing. The dictionary has these meanings: Trading:
To engage in buying and selling for profit. So, what is the difference? I really can't tell. Some explain trading as short-term while investing as long-term. This may be consistent with the dictionary which seems to imply that trading involves more buy and sell while investing is buy and hold. But when it comes to developing trading systems, there is actually no difference between the two. Why? I will leave this to you to figure out.
What is a Trading System?Trading system here does not mean computer software. It means a trading approach or methodology; a trade plan. This trade plan contains all the rules of when to buy and when to sell, how much of capital to risk etc. It can be managed manually but of course it will be more efficient to run this on a computer. There are computer softwares that will do this, subject to some inputs from you. So don't worry that you are not a C/C++ or Visual Basic programmer.
What is Technical Analysis? Technical analysis
studies the activity of market price. When working with technical
analysis indicators, it is believed that the various factors that affect
a market - fundamentals, political, economics, etc. - are reflected in
the price of that market. By monitoring the price, market action (or
trends) responding to supply and demand can be determined. Technical analysis
is generally not concerned with the reasons for a particular price
movement, but only with the price movement itself and the developing
patterns that can assist in determining which way the market might move.
This type of analysis can be defined as an approach to market
forecasting involving the evaluation of current and historical market
prices, volume, and in the case of futures, open interest. The
"trend" concept, essential in technical analysis, is built
around the premise that a trend moving in a particular direction has
more probability of continuing in that direction than reversing; but
does eventually reverse. Technical analysis can help you identify trends
early in development in order to trade successfully in the direction of
those trends. It can also help identify signs of trend reversals. Technical analysis
techniques are tools used to study market action. They are applied to
charts to help you visually see market price action. As to why
fundamentals, political, economic factors are reflected in technical
price action, this is how Richard W. Schabacker explained it. Note that
Edwards and Magee acknowledged in their book, Technical Analysis of
Stock Trends, that their works were based on research done by Schabacker.
"In the
record of such trading all these many and varied fundamental factors are
brought to bear, are evaluated and automatically weighted and recorded
in the net balance on the stock chart. The trading in any stock is largely the result of the influence these fundamental factors have had on each buyer and seller of each share of stock. The stock chart is a pictorial record of such trading, so that it, in itself, is a reflection of all those other factors and, from a purely technical standpoint, need therefore concern itself no further with such fundamental considerations."
Two Important Concepts Now that we have
agreed on this definition, we shall go on to the article proper -
Developing Trading Systems. When you are developing trading systems,
there are two concepts you have to understand. More Than One Type Of Market The first concept
is that there is not just one type of market. I am not talking about the
different stock, commodities, financial futures or foreign exchange
markets. But that within a particular stock market in a particular
country, there is more than just one type of market - trending, sideway
and choppy. This is what I mean. Now this is very important because no
one system can work well in all three types of market. The key is to
develop one that works well in one and limit your losses in the other
two. This is a basic but very important concept that will save you a lot
of headache later on. So whether you are trading stocks, commodities,
interest rate or foreign exchange, within each of this arena there are
still the three types of market. Trading Systems are Made Up Of Parts The second concept is that you need not approach system development as a whole in the beginning. In other words, you may have an idea for an entry signal only and have no idea as yet how you would want to exit. Although your idea for a system is incomplete, that does not mean you can't go ahead to develop your system. You can start developing your entries until they work really well. Throughout this, you could be using any exit signal just for the purpose of testing and working on your entries. When you are satisfied with your entries, you can then proceed to work on your exit signal. Or you can also start with exits if your experience suggests that an exit signal can be worked on and improved. Then go on to develop your entry. Or you may have a different entry signals that you would like to test out with different exit signals. It really doesn't matter which way. Remember that trading systems are made up of parts that can be stripped out and examined individually.
Selecting Your Market Type Different traders
have different psychological and emotional make-up. They come from
different background, brought up in different countries, societies and
families. Even twins brought up in the same family will develop
different behavior. No two persons are alike. Therefore, you must decide
the market type you want to trade because this will determine the type
of systems you will be developing. Once you understand this important
point, you will understand why people have to trade differently. You
will not fall into the often mistaken thinking that when you are buying
and someone else is selling at the same time and/or price, that one will
be right and the other wrong. You will very clearly understand there is
no such thing in the market place and any such misconception is a result
of obscuration caused by the deluded mind. Get rid of this delusion and
you will acquire much wisdom to know yourself and avoid being
slaughtered in the market place as you travel on this life-long journey
to be a better trader. You will then have
trust and faith in the systems you develop, and be confident to follow
through your trades when others are talking opposite to your positions.
Such talks will not agitate you. You will avoid the mistake of asking
others for their opinions about your positions. You make your trades
based on your entry signals and these are the only valid opinions,
nothing else matter. How many times have you been shaken out of your
positions only to find the market went your way? You will also learn not
to comment on other's positions because you know for sure you don't know
their reasons for the trades and you don't want to rudely affect their
decisions. To help you decide
for yourself what type of market you want to trade, let's take a look at
a sample of each. If you have looked at enough price charts, you would
have already notice the three types of market - trending, sideway and
choppy. Let's look at each
of them and the systems that are appropriate.
Trending Market This is one where the moves are made up of sustained increase or decrease in price. Fig.1 is an example.
Figure 1. Trending market This market has
been in an uptrend for about nine months since June 2000. The price
trend is characterized by sustained up moves with small corrections that
are short-lived. This is a trend trader's dream come true. Trending system Trending systems
are designed to profit from big trending moves. They are the most
popular type of systems because it is every trader's dream to catch the
trend, to let profit run. But, alas, these are also the most difficult
systems to trade. How many traders can resist taking a profit? With
catch phrases like 'It's never wrong to take your profit', 'A small
profit is better than a loss' etc, how are traders ever going to let
their profit run? And when you are grilled that you need to know your
risk/reward ratio, which means you must have a price objective, how are
you ever going to let your profit run beyond the price objective? No
way. If you really want to let your profit run, you cannot have a price
objective, you are not going to know your risk/reward ratio. You will
have your risk pre-set but not your reward. The market will determine
the reward for you and this is taken care of by your exit signals. You must let your
profit run; it is wrong to take your profit if your system did not flag
you the exit signal; a small profit is not better than a loss because
there is no sure guarantee that a small profit will turn into a loss, it
is only your fear telling you so! A small profit can grow into a big
profit only when given the chance. Your system will take care of this.
There is no greed involved. However, it is
observed that markets trend only about 15% to 20 % of the time. If you
are not psychologically and emotionally strong to let your profit run,
then you are not going to generate enough profits from trends to offset
all the losses you will suffer 80% to 85% of the time when you get
whip-sawed, to turn in net profits. So not only must you let your profit
run, you must also have strict money management techniques in place as
an important component of your system to limit losses. Your priority is
to maximize your profits when the markets go into trends and to minimize
the losses during those times when the markets go sideway or become
choppy. If you can overcome these obstacles then you can think of trading trend systems. Trend systems can be very profitable overall. This explains why many people want to trade them.
Sideway Market A sideway market is one where price moves with small up and down movements within a general sideway direction. These up and down moves are insignificant to be considered as trends. See Figure 2.
Figure 2. Sideway market In this chart,
price moved sideway for about nine months from May to early Nov 2000.
This is the type of market where trend systems will fail but where
Support and Resistance type of systems will perform. Support and Resistance Systems Based on the
observation that markets tend to move without trends about 80% to 85% of
the time, the aim of Support and Resistance systems is to catch the
small up and down price moves. Such systems attempt to buy low sell high
and are therefore basically trading against price moves. The biggest
problem with this type of systems is that you will be picking tops and
bottoms. Therefore be prepared for prices to go against you. You buy low
sell high but the market keeps going against you. You buy low and the
market keeps going lower. You take small losses until the market turns
upwards in your favor and gives you a profitable trade. Vice versa when
you sell high. Since market becomes quickly overbought or oversold, you
will miss big trend moves because your system will take you out early,
cutting your profit when there are trends and then making you trade
against the trend. Because of the
design to buy low sell high, this type of systems will keep shorting the
market when there is an uptrend and keep buying the market when there is
a downtrend. So they usually produce small profits but big losses. Since most people like to buy low sell high, picking tops and bottoms, this type of systems tend to be psychologically and emotionally easier to trade though not necessarily the most profitable. Also commission and slippage can eat into profits because of the increased frequency of trades.
Choppy Market A choppy market is also sometimes referred as a volatile market. Like the name implies, it chops about in sharp price jumps usually characterized by gaps. Figure 3 is an example of one such market.
Figure 3. Choppy market Volatility Breakout System This type of
system take advantage of sharp price jumps in a choppy or volatile
market. It measures recent volatility and then attempt to trade on
breakouts as volatility increases due to price expansion. Trades
generated by Volatility systems tend to be short-term with the exit
either based on a certain measure of price move or on a certain number
of days in the trade. Profits per trade are usually small. Since most of
your time will be spent waiting for price breakouts, such systems keep
you out of the market most of the time. Some method of trading for this
type of market may include, but not limited to, gap opening or sudden
increase in daily range. One of the setback
of this system is if there is no, or limited, follow-through in the
direction of the price breakout, this system would fail. So you really
need to identify a very volatile market to properly trade this system to
have consistent profits. Traders in the US
characterize the US stock index futures as a volatile type of market. I
have not done such research into the Singapore stock index futures. Do
you think it may be characterize as one too?
Questions I will conclude
Part 1 here but before I do, I would like to leave you with 2 charts of
US$ agst Japan ¥, see Figure 4, and ask you two more questions in
addition to the two questions that I asked earlier: Why do think that
Trader A and Trader B have differing views when both are JPY traders? Would you agree that both are right in their views and both can still be profitable trading in opposite direction of each other, one buying while the other selling?
Figure 4. Same market, two traders with two different and
yet correct views
In Summary In Part 1 today,
we have covered:
In Part 2 In Part 2, we will go on to design and test out a trending system. We will also study the System Performance Report of the system.
The answers to the four questions are in the article Supplement to Developing Trading Systems - Part 1.
Back to Let's Learn Technical Analysis Index page for more articles...
Important: These charts and commentaries are provided as an education on how technical analysis can be used. Technical Analysis & Research is not an Investment Advisor and we do not claim to be one. These charts and commentaries are not to be construed as investment advice or any other investment service other than the originally intended purpose as stated here.
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