Common Sense and Mechanical Systems

March 28, 2003

There is the belief in some quarters that mechanical systems are superior because they have been backtested and because they take the emotion out of trading. The trades that the system tells you to make have worked out in the past; therefore they should work out in the future. To deviate from what the system tells you is to allow your emotions to take control. Then you become like those funny animals in the commercials who do not make good Cybertraders.

There is a lot to be said for this approach. However, consider the following two examples.

(1) I developed a bond trading system that included PCRIX. This is not entirely a bond fund, since it uses a base of bonds to trade commodities. Nevertheless, I included it in the system, since it had been trading relatively well. What I did not know is that the manager is the kind of total jerk who just takes a position and holds it no matter what happens. It appears that the fund was long commodities such as gold and oil. These did relatively well, but then they sold off as the war progressed. Did the manager sell his losing positions? Did he go short? No way. Hence the chart of the fund looks like somebody who was on viagra for a while, but was then cut off from his supply. This is pathetic. The fund can be traded, but not in a slow-reaction time system like my bond fund system. In fact, I think that the manager is too unreliable for anybody to take other than short-term positions in the fund. Maybe PIMCO will dump him and the fund will look better.

(2) April 2, 2003. One of my systems recently said to sell one fund and buy another. This just did not look right to me, and I decided to wait until I got the end-of-month distribution. It turned out that there was a problem with the Fasttrack database, and that the distribution was not credited in the database. When it was, the trade went away. The moral is that one should do an On Line Integrity Check of the Fasttrack database before actually taking the trade, and in addition if a distribution is not credited in the database, you should call Fasttrack and hold up the trade until the distribution appears. This is particularly important in the case of bond systems, where distributions are frequent.

(3) All of the equity signals I follow are currently in buy status except for the seasonality signals, of course. The initial euphoria of the war caused some very nice gains. It was clear to anybody with a little common sense, however, that any perceived setback would have a disastrous effect on the equity market. Everybody was waiting for the war trade that worked out so well in 1991. This was is different, and so is the market reaction. I did not buy equities when the signals flashed because I felt that the risk in such an emotional situation outweighed the possible reward. Profitable short term trades were possible, but I have never been good at that. Tine will tell if these buy signals will be profitable.

Some people claim that the technical indicators are measures of the emotion in the market. For example, if MACD of a fund is positive, it means that the fund is accellerating as its holdings increase, for example. So the emotion behind the buying of its holdings is strong and increasing. There are other interpretations of other indicators, I suppose.

Under this view, we have unemotional measures of the emotion in the market. The strength of technical systems may be based on that fact, since it allows an unemotional play based on others emotions. I rather like that.

Anyway, the bottom line is that it is always important to be able to stand back and take a common sense approach to what is going on. When I was recruiting people for work at the MITRE Corporation, I always said that what we did was just applied common sense. Yes, some of the stuff we did was highly technical, but the success of most projects in which I was involved was based on our ability to look up from the highly technical stuff and apply common sense to the big picture in which the technical stuff was being done.

Applied common sense works in the market, and should not be confused with emotion.

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