Trading System Definition

Trading System refers to the whole set of rules, practices, and habits that make up the process of trading.    This includes market selection, portfolio selection, when to trade, which trading strategies to use when, entry signals, exit signalssizing, record-keeping, risk management.   The whole enchillada.

Extra Insight:

Even though I often use the terms interchangably, I think Trading System is bigger than Trading Strategy.

A Trading System is said to be either mechanical, discretionary, or a mixture of the two. 

Most mechanical systems are run by a computer, but they need not be.  A person could conceivably make manual calculations and monitor trades according to rigid rules.   Even in a fully automated mechanical system, the human element is present — someone must decide which system, when to turn it on, how to keep the computers running, etc.   However, backtesting is an obvious step in the development of a mechanical trading system. 

For discretionary traders, modern trading also relies on computers acting according to fixed rules.  For example, many people, wheither they consider themselves traders or investors, fundamental or technical, consult stock charts populated with their favorite analysis techniques and indicators.   Backtesting can inform the judgement of a discretionary trader by outlining the potential performance of various strategies and indicators.

Ed Seykota often says that a trader’s system is really the set of emotions he/she is unwilling to feel.  (See Sat, 17 July 2004 in his Trading Tribe FAQ).   I feel like dodging by saying the emotional side is beyond the scope of this blog.  

Now that I think about it, its not so hard to backtest a general example with software.    For example, the Rational Choice book cites a few studies that prove our human tendency for loss aversion.  To codify that, write a system with: 

  • no stops in order to avoid the pain of taking a known loss,
  • close targets to avoid the pain of giving profits back, and
  • quick file deletion to avoid the pain of knowing its unprofitable. 

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Updated 11/13/08.

Win Rate Definition

The Win Rate (% Win) of a trading strategy is the percentage of profitable trades for a given backtesting run.  I calculate this as:

%Wins = Number of wins divided by total number of trades 

Extra Insight:

  • Win rate is about the only metric to compare entry strategies before you’ve selected an exit strategy.
  • Win rate is also a good metric to gauge if you can stick to the system or get too demoralized by low win rates.
  • You can’t exactly determine the loss rate from the win rate because a trade may break even which is, technically speaking, not a loss.  For comparison purposes however, it is enough to know the win rate, the expectancy, and the standard deviation.
  • For a trading system, the win rate is the probability of a winning trade.  It is NOT the probability of profitability.   For that, calculate expectancy because the size of the wins vs losses matters.  A lot.   For example, a profitable trading system may win less than 50% of the time if the wins are bigger than losses.    Likewise, its certainly possible to lose money on a system with an extremely high win rate when that one big monster loss comes along to wipe out all previous gains.

Last updated 11/10/08.

Backtesting and Blog Goals

I start this blog while immersed in the early phases of my fourth major US stock market backtesting effort. 

The purpose of the blog is to record my key decisions and tactics for backtesting.   I intend it to be a resource for traders and active investors . I hope that others will learn from my efforts and we all learn from each others’ comments and discussion.

My goals for backtesting are:

1. Design trading strategies for my own use.   Specifically, 

  • US Stock Market
  • both buying long and short selling 
  • investigate both trend following and band trading  
  • swing trading: end-of-day (EOD) or daily charts and trades that last several weeks  

2. Provide information that other traders can use to develop their own systems.    That includes the areas above, and in addition, I want to illustrate for new traders such key concepts as:

  • stop loss orders 
  • market orders vs limit orders vs stop entry orders
  • trailing stops
  • price targets
  • indicators like moving average, RSI, MACDH, Stochastic

3. Do this with a scope and scale that goes beyond the resources typically available to private traders, including:

  • delisted stocks
  • over 15 years of historical data
  • clean database
  • multiple time periods to avoid curve fitting
  • crude and robust strategies only…limited fussing with parameters
  • statistically sound methodologies
  • monte carlo simulations to generalize beyond the given data

 Let’s dive in!

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