What is a Trading System?
September 9, 2004
Knowing When and Where to Jump In Lowers the Risk
Italian Riccardo Russi dives into the Tiber River from the 18-meter high Cavour Bridge in Rome to celebrate the New Year, Wednesday, Jan. 1, 2003. (AP Photo/Gregorio Borgia)
A trading system is just a set of rules that tell you how, without any ambiguity or any subjective elements, to trade stocks or mutual funds.
Every trading system needs to have two parts:
(1) A Market Timing Part: Something to tell you whether to be long the market, short the market, or to be in cash.
(2) A Selection Part: Something to tell you what to buy, when to sell, and when to buy something else.
There are many ways to build a trading system. Lots of people do not like the idea of a trading system at all. They prefer to rely on technical and fundamental data which is always interpreted in subjective ways. This is fine, but I think that if you are going to trade stocks or mutual funds, then you should use methods which can be analyzed with some rigor and backtested effectively.
At this point, it is just about impossible to trade actively managed funds. This leaves ETFs, Rydex, Profunds, and Potomac Funds. If you are going to trade only some of the last three, then it is best to get an account directly with some or all of Rydex, Profunds, or Potomac Funds. Check their minimums. If you are going to trade ETFs or stocks, then you want a brokerage with low fees. I am currently using TDAmeritrade (since around 2006).
Of course, good results cannot be guaranteed. If you optimize a system over a period of several years when the market has done very well, and you get a backtested result of, say, 50% per year, you cannot expect to get 50% every year. What you gain through the development of a system is a way of making decisions that has worked in the past. The next year you might get 60%, or you might even lose money. It all depends on the market conditions. After all, if the best fund in your family only goes up 5%, you can hardly expect to do much better than that.
When Doesn't This Stuff Work?
Everything on this site assumes that the market trends. That means that it will either tend to go up for a while, or down for a while. If the market is not trending, there are two possibilities: (1) It is totally random - that is to say that the chances of it going up tomorrow are the same as the chances of it going down tomorrow, and (2) the market is flat - that is it makes a number of small moves in either direction, but nothing decisive. While there may be some times when the market is not trending, the condition is extremely rare, and does not generally last for long. In a non-trending market, the signals do not work well, and few selection algorithms work well. If you sense that the market is not trending, cash is an excellent option.
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