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.

081104_1.gif
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."

081104_2.gif
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.

081104_3.gif
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. Mutual Funds & ETFs

    ETF Analysis: Guggenheim Enhanced Short Dur

    Find out about the Guggenheim Enhanced Short Duration ETF, and learn detailed information about this fund that focuses on fixed-income securities.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  3. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI KLD 400 Social

    Find out about the iShares MSCI KLD 400 Social exchange-traded fund, and learn detailed information about its characteristics, suitability and recommendations.
  4. Mutual Funds & ETFs

    ETF Analysis: iShares Agency Bond

    Find out about the iShares Agency Bond exchange-traded fund, and explore detailed analysis of the ETF that tracks U.S. government agency securities.
  5. Mutual Funds & ETFs

    ETF Analysis: PowerShares DWA SmallCap Momentum

    Find out about the PowerShares DWA SmallCap Momentum Portfolio ETF, and explore detailed analysis the fund's characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  7. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  8. Trading Strategies

    How To Buy Penny Stocks (While Avoiding Scammers)

    Penny stocks are risky business. If want to trade in them, here's how to preserve your trading capital and even score the occasional winner.
  9. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Low Volatility

    Find out about the PowerShares S&P 500 Low Volatility ETF, and learn detailed information about this fund that provides exposure to low-volatility stocks.
  10. Chart Advisor

    Stocks to Short...When the Dust Settles

    Four short trades to consider, but not quite yet. Let the dust settle and wait for a pullback to resistance for a higher probability trade.
RELATED TERMS
  1. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
  2. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  3. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  4. Systematic Manager

    A manager who adjusts a portfolio’s long and short-term positions ...
  5. Unconstrained Investing

    An investment style that does not require a fund or portfolio ...
  6. Head-Fake Trade

    A trade where a stock or market appears to be making a move in ...
RELATED FAQS
  1. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  2. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>
  3. What is the difference between passive and active asset management?

    Asset management utilizes two main investment strategies that can be used to generate returns: active asset management and ... Read Full Answer >>
  4. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  5. What percentage of a diversified portfolio should large cap stocks comprise?

    The percentage of a diversified investment portfolio that should consist of large-cap stocks depends on an individual investor's ... Read Full Answer >>
  6. How do you know where on the oscillator you should make a purchase or sale?

    Common oscillator readings to consider making a buy or sale are below 20 or above 80, respectively. More aggressive investors ... Read Full Answer >>

You May Also Like

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!