When it comes to trading systems, there are three distinct camps. One subscribes to the belief that the more investors who follow a system, the more likely it is to be successful. Another faction is convinced that the only route to investment riches is to keep a trading strategy a well-protected secret. Still another group of investors begins trading without any system at all.
What's common to all of these investors is that many of them will encounter failure. When they do, they are faced with a decision: to continue searching for the right trading system, or to abandon the effort entirely. It's no small decision - choosing the right path can quite literally make or break your fortune. Read on to learn how to assess a system and determine its worth.
Tried and Tested Trading Systems
Many investors do not feel confident about designing a trading system that will successfully squeeze profit out of an unpredictable market. Often, people look for a system that is "tried and tested", in the belief that a system that has proved profitable for others will be profitable for them too. This can be the case, and sometimes a very popular system can generate its own momentum and produce profit for its devotees. However, investors must be aware that not all systems are successful in all market conditions, making "tried an tested" an unreliable measure of a trading system's value. (For more, see Trading Systems: Introduction.)
Many systems can only be profitable under the market conditions for which they were designed; in fact, most are designed to be used in either a ranging market or a trending market. In light of this, some active traders use two different systems, depending on the prevailing market.
System Vs. Method
A prevalent view is that the vast majority of traders cannot or choose not to follow a system properly. Therefore, this view suggests that it really doesn't matter how many traders know about a particular system or attempt to follow it. Famously successful trader Richard Dennis, in his "turtle" experiment, took a group of people (turtles) who had never traded before and taught them his system. The results were compelling: although the turtles became skilled traders and made many millions, the success of the group varied dramatically. Eventually, the system was made public, free of charge, with the reasoning that even with what turned out to be rather simple system rules, most traders who tried could not or would not adhere to the system. This experiment illustrates that faithful implementation of a system may be more important than system selection; therefore, investors must be realistic and choose one they are willing to rigidly follow. (For related reading, see Master Your Trading Mindtraps.)
The Lemming Effect
An equally somber analysis that draws a different conclusion suggests that an investor should not follow any system that is publicly available specifically because other traders fail to follow the same system correctly. The reasoning behind this notion is that the lack of complete adherence to the rules and the novice nature of public system traders causes them to make bad trading decisions - such as entering a trade too late and exiting too early. This, they believe, reduces the profit potential for those who do trade exactly as the system demands, as the early exiting causes the price to stall or even reverse direction.
There is a persistent belief that the more widely publicized and used a system is, the less likely it is to be profitable. It is fair to say that this effect is unlikely unless the system is highly popular or there is very little liquidity in the market. Logic also dictates that if this lemming effect did happen, the more followers the system had the greater the effect would be. Therefore, an investor looking to follow a system should "paper trade" the system in a demo account for some time, exactly according to the trade rules, keeping an eye out for signs of early exiting. The best indicator of this is to test trades that consistently collapse before reaching their potential. It would be unwise to attempt to time the exit from these trades before the collapse because, traditionally, collapses come sooner and sooner until the trade has insufficient profit to justify making it at all. This is because the other proponents all try to beat the collapse themselves. Just as with the manufacturing of physical products, competition drives down profit margins to the lowest acceptable point.
(For related reading, see How Investors Often Cause The Market's Problems.)
In the world of physical products, the market rewards the best quality, best price, best value and most efficient. In the investment and financial trading world, the measure of that market reward is called alpha. This is often used as an indicator of a trader of investment manager's skill; alpha attempts to measure investing success over and above the returns generated by the market on its own. To beat the market, an investor has to be better than the average trader. In other words, he or she needs to extract alpha from the market. (For more insight, read Adding Alpha Without Adding Risk.)
There is a growing belief that alpha is finite; David S. Hsieh, a professor of finance at the Fuqua School of Business at Duke University, in a speech at the CFA Institute's hedge fund conference in 2006, reckoned the amount of alpha in the hedge fund industry was $30 billion. However, if Alpha is finite, this would suggest that anyone who is successfully extracting it from the market would be unable to make their system public and continue turning a profit. As such, prudent investors should always view any system with a healthy amount of skepticism, particularly those that are for sale.
Thin the Herd
Investors profit from the disparity between a stock's inherent value and the market's perceived value or market price. If an investor is convinced that a stock pick has greater value than the market has currently placed on it, he or she can gain big when the market realizes its mistake and moves to correct the price.
The trade window, or time to buy, an undervalued stock is naturally limited by the market correction. However, this disparity's lifespan is limited and, as a consequence, so is profit potential. If the goal of most trading systems is to identify either the disparity itself or the market's move to correct it, then it is logical to assume that a popular trading system - with many devotees chasing the same instance of disparity - would result in diluted profits. Traders who subscribe to this belief give no credence to any system used by anyone else. A system made public, they reason, could not have been very good; after all, why would a trader release a profitable system when it would certainly diminish their own success? These investors believe that successful traders must develop their own unique systems and never make them public. Designing a proprietary system gives the trader flexibility to tweak it and adapt it to the various market conditions. It may seem a daunting task, but to design a trading system is easier than one would think.
If in any doubt as to which approach to take, logic suggests erring on the side of caution. Why risk a public system if you can design your own? Creating a trading system from the ground up gives the trader the skills and confidence required to deal with changing market conditions. However, if an investor decides to use an existing, publicly available trading system, he or she should not only backtest, but forward-test too. Regardless of what you choose, deploy the system in a live-test environment before risking any investment capital, and keep your eyes open for signs of an over-used strategy.