In the complex world of trading systems, there are two types of people: programmers and traders. Designing a trading system is a challenge, requiring complex programming experience and skill. But designing a system that actually makes money requires an excellent understanding of the markets, technical indicators, investor sentiment and a whole array of complex data interrelationships.

So where does the programmer without trading experience get instructions? From a trader, but the success of the system depends on how well the trader can communicate to the programmer what the system should do, and then on how skilled the programmer is at translating the desired actions into programming code.

The programmer/trader hybrid is a breed apart. This is someone who, having traded with real money, knows what is needed to develop a winning trading system and also has the programming skills to put the strategy into code. Such a person suffers no misunderstandings or translation challenges. Robert James Deadman, president of Trading Systems Analysis Group (TSAGroup), is such an individual.

As a trader who designs systems, Deadman, who has 12 years of trading experience, takes a different approach to trading than most who play the markets. Not only does he have to create strategies that work in the trading arena, but he must also be able to translate them into program code so that his clients can trade them. This means he must test his strategies exhaustively to ensure they work.

Trader's Advice
What is the most important criterion in a trading system, according to Deadman?

"Most traders consider profitability to be top priority; but to professional traders and money managers, capital preservation or limiting losses is penultimate," he says.

Candidates must exhibit a number of conditions before they are considered.

Deadman continues, "In finding robust systems, we use a parameter called trade efficiency. How does the system perform when it is in the market against a buy and hold strategy? For this we need trading systems that outperform the buy and hold strategy. Then we look for trades that preserve capital. What is the trade's stop-loss? Lastly, we look at profitability."

"Many newer traders make the mistake of being completely preoccupied with profitability while ignoring the maximum draw-down and system losses. Of greater importance to the pro is how much is the stop-loss? A system might have a maximum profitable trade of 30%, but do you want to trade it if the stop-loss is 20%? I don't. I would much rather trade a more modest system with an average 15% profit and 5% stop-loss."

"The major difference between the professional and non-professional is that the latter is looking to hit the home run while ignoring the cumulative effects of losses. What good is having a system that makes 50% but then loses 15 to 20% per trade in the next five trades? If the pro did this he or she would be out of business in short order," says Deadman.

Trading Examples
Here is an example of what he means. When TSA's latest product, called Trade Oracle™, was used to scan a group of stocks, Zix Corporation (ZIXI), a secure e-mailing message service, came up in the search. It showed an impressive four-year return of 900% in a total of 26 trades, 21 of which were winners, a historical success rate of more than 80% and a risk/reward, measured by maximum wins to losses, of 102 to 19 or more than 5:1. It certainly had all the markings of a winner.

Figure 1 – Daily chart of Zix Corp. (ZIXI) showing green buy and red sell arrows. The equity curve in percent in the upper window also looks impressive. Chart by Metastock. Trading system plug-in for Metastock by TSA Group\'s Trade OracleTM™.

But this was not a trade that Deadman would consider and the reason is simple: An examination of the trading history (see figure 2) showed a projected stop-loss of 63%.

"Even though the system has made a ton of money hypothetically in the past, I am not going to consider a trade in which the stop-loss or risk represents 10%, let alone 63%," he says. "Two bad trades, my money is gone and it's back to square one."

Figure 2 – Expert commentary printout from ZIXI trades using the MACD histogram; Trade Oracle system 45 showing complete trade results.

What sort of trades does Deadman like? Here is a trade he actually took around the same time. Medco Health (MHS) came up in a scan of more than 7,000 stocks that he performs daily using end-of-day data and then scanning for candidates using Trade Oracle. The system that found the stock was the 10-day breakout. The historical success rate was 58% with a total of 34 trades, 14 of which were losers and a risk/reward of 7.4 to 2.7 or slightly less than 3:1. This looked anemic compared to ZIXI, but Deadman's most important parameter was met: the maximum stop-loss was just 1.6%.

Emotional Rescue
"I use Reuters end-of-day and I want a system that I don't have to watch all the time while I'm in a trade, since I'm not a day trader. If I lose 1.6%, it's no big deal; I exit the following day and then look for my next trade," Deadman says.

"The biggest problem facing most traders is their emotions. Once I know my maximum downside, I can forget about it and just follow the signals. I'm not tempted to watch every dip and jump intraday, since that only causes unnecessary stress. The odds are in my favor and if it goes against me, my money is protected and I will still have money to trade another day."

For Deadman, it's a strategy that takes all the "unnecessary emotion" out of the equation.

Figure 3 – Daily chart of MHS showing equity curve in percent in the upper window and buy, sell and exit signals in main window. Chart provided by Metastock and trading system signals by Trade OracleTM.

"Don't get me wrong, I like to cash in on the big winners as much as anyone else," says Deadman. "But unlike most retail traders, profitability is not first but third on my list of priorities. What good is a home run if by the time it comes along I'm not in the game? By choosing trades that preserve capital, if a big win comes along it's a bonus, not essential to making money in the markets."

Stay Alive by Preserving Capital
Deadman says that designing systems has forced him not only to be more disciplined in his own trading, but also to incorporate his money management philosophies into his programs. If his systems work for him in trading real money in the markets, he knows they will work for his clients.

However, he stresses that it is important to find a system that suits each individual's risk tolerance and personality. Any good system should have the flexibility to work regardless of the trader's goals, and it is important to not lose sight of your priorities.

If preservation of capital is not the most important consideration in your system, chances are you will end up a casualty of a high-stakes market roller coaster.

Related Articles
  1. Retirement

    How Robo-Advisors Can Help You and Your Portfolio

    Robo-advisors can add a layer of affordable help and insight to most people's portfolio management efforts, especially as the market continues to mature.
  2. Mutual Funds & ETFs

    Top 3 Muni California Mutual Funds

    Discover analyses of the top three California municipal bond mutual funds, and learn about their characteristics, historical performance and suitability.
  3. Chart Advisor

    4 European Stocks to Consider Buying

    European companies, listed on US exchanges, that are providing buying opportunities right now.
  4. Investing Basics

    3 Key Signs Of A Market Top

    When stocks rise or fall, the financial fate of investors change, as well. There are certain signs that can reveal a stock’s course, and investors don’t need to be experts to spot them.
  5. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  6. Chart Advisor

    ChartAdvisor for October 2 2015

    Weekly technical summary of the major U.S. indexes.
  7. Professionals

    Fund and ETF Strategies for Volatile Markets

    Looking for short-term fixes in reaction to market volatility? Here are a few strategies — and their downsides.
  8. Investing Basics

    Tops Tips for Trading ETFs

    A look at two different trading strategies for ETFs - one for investors and the other for active traders.
  9. Investing

    How Diversifying Can Help You Manage Market Mayhem

    The recent market volatility, while not unexpected, has certainly been hard for any investor to digest.
  10. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  1. What licenses does a hedge fund manager need to have?

    A hedge fund manager does not necessarily need any specific license to operate a fund, but depending on the type of investments ... Read Full Answer >>
  2. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  3. When are mutual funds considered a bad investment?

    Mutual funds are considered a bad investment when investors consider certain negative factors to be important, such as high ... Read Full Answer >>
  4. What fees do financial advisors charge?

    Financial advisors who operate as fee-only planners charge a percentage, usually 1 to 2%, of a client's net assets. For a ... Read Full Answer >>
  5. How do mutual funds split?

    Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >>
  6. Is Colombia an emerging market economy?

    Colombia meets the criteria of an emerging market economy. The South American country has a much lower gross domestic product, ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!