Trading Systems – Build or Buy?
Winning traders have one thing in common – they have a good system and stick with it. But should you buy an off the shelf system (there are many available on the Internet) or build your own system? What will you need to look for? Both approaches have advantages and drawbacks, but this article discusses the pros and cons and comes to a conclusion.
What does a trading system do?
A trading system needs to identify what to buy or sell, the entry point (when to buy or sell), the direction (buy or sell), the amount of capital that should be allocated to the trade, the stop loss (if the market moves against the trade) and the profit target (if the market moves in the direction of the trade). Notice that stop losses are integral to a system – there is no such thing as being right all the time.
A good trading system should have a positive expectancy. That means that on average, profits should exceed losses. This is how professional traders make money.
If a system is right 90% of the time (unlikely!), but it loses $20 ever time it is wrong, but wins $1 every time it is right, it has negative expectancy. Despite being right most of the time, you will lose money with this system. Conversely, if your system is right 50% of the time, but wins $3 for each time it is right and loses $1 each time it is wrong, it has positive expectancy and you will make money over time.
Positive expectancy is a function of stop losses, taking profits at the right point and managing capital. Look for positive expectancy in any system you use. This is more important than accuracy.
Buying a system
It is not hard to find a range of supposedly fantastic systems for sale. There are two types: black box and white box systems. Black box systems used undisclosed “secret” algorithms. I would strongly suggest avoiding a system that doesn’t disclose the algorithm – don’t buy black boxes. You need to have a lot of faith in it, and the backtesting of it to trade such a system.
The majority of professional traders don’t use off the shelf systems. That is because many of the systems are optimised to provide a high return over the test data for advertising, but don’t perform well in real life. If they use a system, it will be one that is developed internally that is suited for the risk profile of the trading house. If you had a winning system that would make millions, would you sell it for $200?
You might also find an approach that uses charting. The course may identify certain patterns in charts. I am very skeptical of this because it is often difficult to identify the patterns in the course of trading, although of course some patterns can be found in hindsight. Often the pattern can be interpreted in several ways.
The benefit of an off the shelf system is that it has been developed for you. The drawbacks are many – you don’t know how it will perform in real life, you can’t be confident with it, it is unlikely to perform well and it may overtrade and take on huge risks, well outside of what you are comfortable with.
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Tags: Building systems, Trading Systems