Philosophy of the Researching of Trading Systems

The site uses satire with the title, The Holy Grail Research Lab, because the truth is, it doesn’t exist.  In reality, one has to be realistic when designing and testing a system.  Systems advertised in the financial publications are shrouded in secrecy, and those used by hedge funds and quants are very hard or impossible to understand, and understanding is key.  Only by understanding the methodology of the system can one be able to effectively implement it.    

Mission: Research and test a simple set of clearly defined rules-based trading systems commonly mentioned in the financial media and measure their performance over a period of 3, 5, and 10-years.  

But what exactly is a system?  

A trading system is a set of rules that formulate buy and sell signals without any ambiguity or any subjective elements.  These signals are mostly generated by technical indicators or combinations of technical indicators and other variables.  The primary goal of a trading system is to manage risk and to increase the probability of higher returns over the general market indexes in any economic environment.  The research conducted on these systems seek to identify optimal levels of risk and reward, and document any modifications to the different parameters within each rule of the system for future research.

At the onset of researching each system, no system is perceived as better than another, but this could change over time.  Real money should never be used to research and test a system until it has proven its worth in real-time testing over time. 

All of the systems being research here can be categorized as trend following systems.  As the name suggests, trend following systems aims to enter a trend and profit from a continued price movement in the same direction.  According to Newtonian physics, an object in motion tends to stay in motion – this is also one of the principles of the Dow Theory.  Therefore, if a certain currency pair has developed a powerful trend, that trend is likely to continue until something fundamentally changes.  The challenge with trend following is that the trend is an objective process, and the decision to enter the market can be discretionary or mechanical.  

Trend following systems came to prominence when Richard Dennis started his own experiment with the Turtles.  Dennis was a famous commodities trader that believed that trading abilities could be broken down into a quantifiable system of rules that can be taught.  His friend and business partner Eckhardt felt the ability was something innate.  In 1983 Dennis proposed to recruit and train some traders and give them actual accounts to trade in order to see who was right in this ongoing debate.  Ten inexperienced students were selected, invited to Chicago and trained for two weeks.  The trading methodology that was taught to them was a trend following system and the group was nicknamed The Turtles.  Over the next four years, the Turtles earned an average annual compound rate of return of 80% and Dennis won the bet.

Components of a System

Step 1 – Market Observation

If you intend to capitalize on the market behavior, first of all, you need a belief system on how the markets operate. A belief system is a series of ideas you have gathered after observing the market for a while.

Once you are able to explain how the market works from a personal perspective, then you can elaborate hypothesis to capitalize on those ideas.  Market observations are thus the building blocks of every system and trading method.  This is an extremely important aspect most researchers neglect: you can’t just copy a trading system or method – if it doesn’t emerge out of your belief system or if it doesn’t fit into it, it will be very difficult to follow it in tough market conditions.  All of the systems being tested here are deeply rooted in what fits my belief system, otherwise, they are discarded.

Preparing the hypothesis requires one to actually see on the charts if there is enough evidence that a specific action-reaction pattern regularly happens.  For example, you may be a regular reader of the Investors Business Daily, and observe that the market direction system appears to be more right than it is wrong.  Once you have enough evidence that the recurring action-reaction event takes place on a regular basis, then you can formulate the hypothesis.  

Step 2 – Developing the Hypothesis

Part of developing the hypothesis is to take historical data and see if the proposed research case seems logical and feasible.  If the results look promising, then further development can proceed.  However, not a lot of stock is placed on historical data because of the biases it can create, and the natural human tendency to try and manipulate the system to “fit the data.”  Some of the things that must be nailed down are time frames (daily, weekly, or monthly technical analysis triggers), and potential variables that need to be included as factors that influence a trade.    

Step 3 – Selecting a Time Frame

When developing a trading system, it is critical that one analyzes various different time frames because the hypothesis may work on one time frame, and not another.  In many cases, the system will use different time frames but ensure the technical factors are adjusted to give a similar view.  For instance, if a system uses the 50-day simple moving average on the daily chart, the researcher could also view this same system through the lens of a weekly chart, but use a 10-week simple moving average.  Doing so provides the same view, but on a different time-frame, which dramatically changes the view of the data.

The choice of time frame will vary by system, but a lot of it hinges on how frequently you want the system to make a move.  All time frames depict the same patterns, but for different time scales dramatically impact the frequency of trades.  Smaller time frames will produce more buy or sell signals when analyzed with technical indicators than larger time frames.  Once a move is made, a larger time frame will result in staying in or out of an equity for a longer period of time.  Shorter time frames will move into and out of a position sooner than larger time frames.  Lastly, while several time frames can be referenced to gauge market conditions, the system being researched should rely on only one time frame to trigger a trade.     

Step 4 – Research System Development

The next step is system development.  This entails fully articulating the strategy and includes an explanation about the tools to be used and what events provide the conditions to get into and out of positions.  Entry and exit signals must be clearly defined.    

Other issues that should be considered are:

  • Define how a trend is identified (buy signal)
  • Define how the system will identify the direction of the trend or movement (up, down, or sideways trend)
  • How to identify the current state of the market
  • How stop loss levels are identified, tracked, and adjusted (because the will move higher with the trade)
  • Define how a change in trend is identified (sell signal)

Remember, neither technical nor fundamental analyses are exact sciences, and the interpretation of indicators and price patterns can vary from researcher to researcher, especially when emotions can distort perception.  This is why one wants to limit the amount of emotion gut instinct used to make decisions. 

Entry and Exit Signals

Signals are events that trigger market entries, market exits, or some forms of adjustments during the life of the trade.  They are usually based on technical indicators, and provide researchers with a precise, explicit script for the system being researched.  When developing a system, indicators should be identified that will provide an informed choice, and stick with it for the duration of the research.  The parameters that trigger a trade must be specific and with clearly defined market conditions that cause the trigger.  Lastly, every strategy has some kind of protective stop-loss rules.  These should be identified before the trade is made,  

If during the research another favorable signal is identified, then it should only be tested as part of a new research project to preserve the integrity of the current research.

Step 5 – Money and Risk Management

Money management principles serve to determine your position size, and risk management the proportion of your trading account that is risked per trade.  Proper money and risk management are vital to producing consistent and lasting returns. 

While there are various ways to handle both aspects, but in general terms most money managers would agree that a sound strategy would look something like this:

  • Identify the entry level price for an equity
  • Identify the area where the stop loss will initially be placed
  • Subtract the entry level price from the initial stop loss level price, and that is the amount at risk per share for the initial trade
  • Then take the value of the entire trading account and multiply it by 1 or 2 percent.  That is maximum you can risk on each trade
  • Divide amount at risk per share into the total account value, and that is the number of shares to purchase for the initial trade
  • After you enter a position, the stop loss will move higher with the equity.  Once the stop loss is above the entry level, you have no risk on the table and can seek another place to add another position to the trade
  • Lastly, you should never have more than 20 percent of the entire account at risk at any given time across all of your trades

A good trading strategy with no risk and money management principles in place will not produce consistent or lasting returns. This is a key element of every trading system.

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IMPORTANT!!!!  Notice & Disclaimer about any and all content I create, send, or share with anyone, in any form regarding this research:  

This is research.  This is not investment advice.  I cannot be any clearer about this.  I am researching these systems to document their performance in real-time over a period of years for further research.  Be aware that while these systems are commonly referred to in the media, the strategies involved may not be suitable for your situation or risk tolerance.  I am not offering YOU investment advice.  I am merely conducting research on the viability of these strategies and documenting them for future research.

I will not be liable for any loss or damage whatsoever (including human or computer error, negligent or otherwise, or incidental or consequential loss or damage) arising out of or in connection with any use or reliance on the information derived from this research.  The previous statement is here not only because the lawyers insisted, but because it is true.  Consider that I have no idea what your financial goals may be, I am unfamiliar with your risk tolerances, I do not know your personal income, age, savings, financial circumstances, dependents, net worth, what tax bracket you are in.  Heck, I do not even know where you live in.  There are some people who would find these things quite relevant.

I am merely researching alternative options for viewing the markets and documenting it for further research.