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 signals, sizing, record-keeping, risk management. The whole enchillada.
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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