What Is A Trading System?
Trading systems give you clear-cut directives as to when you should be entering or exiting your trades. It should also tell you how much you should be risking on a trade, what quantity you should be entering with, but traders often get hung up on the former, just when to enter or exit and end up in all sorts of trouble...
Trading systems have been a buzzword in the trading world for a long time. Whenever something stirs up interest the SOS show up, by SOS I mean the "snake oils salesmen" not save our souls. But that is precisely the novice traders need at the beginning of their career, someone to guide them properly and exploit their lack of understanding.
Trading Systems - Traditional View
One of the great traders who did a lot of good work for helping beginners, Alexander Elder, popularised this term. People, however, have completely misunderstood the term and some have even gone ahead and abused it. When I read Alexander Elders book, "Come into my trading room...", it was a revelation, but I too ended up focusing on the just the entry and exit part of it, basically completely missing the point.Over the years people have been taken by terms like success ratio, backtesting, reward to risk ratio, and the like and forgot the part where a trading system was supposed to assist a trader to learn more about the markets as well as himself...
This has bred a lot of confusion among the minds of traders, beginners especially. Lets us look at a number of ways people use trading systems and how it should be done...
Types Of Trading Systems
- Mechanical Trading Systems
- Trend Following Trading Systems (buy high - sell higher)
- Consolidation Trading Systems (buy low - sell high)
- High-Frequency Trading System
- Discretionary Trading Systems
- Indicator-based Trading Systems
- Black Box Trading Systems
- Seasonal or Cycle based Trading Systems
- Astrology-based Trading Systems
- Buy and Hold Trading System (investing)
- News and Events based Trading Systems
Let's dive into them one by one...
1. Mechanical Trading Systems
via GIPHY
This is characterised by a fixed set of rules, which a trader must follow without questioning and in all situations. The rationale for the system is based on the set of rules which was backtested (extensively) and have proven to have a statistical edge. In simple word,s if you take enough signals based on the system the winners will overtake the losers and make you money in the long run.
There are two major types within this and a third one which is fast becoming a force to reckon with...
a. Trend Following Systems (buy high - sell higher)
The trend is your friend, this old adage has travelled across generations and is still used today. It is true in some respect too. In this particular system, traders try to buy when a stock starts trending up and hope to ride the trend as long as it continues. When there are signs that the trend is stalling they get out.
But this is easier said than done as the trend shows some characteristics that make it difficult to follow it...
- The trend seldom continues in a straight line, there are often pullbacks and sometimes deep enough to throw out even the most resolute traders. (I have found this problem particularly difficult to handle.)
- The trend is only obvious when it is well underway, and many a time there are false signals of its start. Only to see the trend collapse and end up continuing the consolidation.
- This results in multiple attempts being made by traders to catch one and when they finally catch one, the next most difficult part is to hold on to your trade through the numerous pullbacks and vacillations.
So even though this remains the favourite of most beginners, this type has a big graveyard of its own.
b. Consolidation Trading Systems (buy low - sell high)
This is where the markets spend most of their time, as per some studies even as high as 70% of the time the markets spend consolidating. Now to the beginner consolidations seem like a total waste of time, because she is looking for the trend in the wrong place, for a pro it is a haven or both long and short-term opportunities.
not only do smart traders play the numerous small moves within the consolidation they also accumulate their positions for the inevitable trending move that is to come next.
c. High-Frequency Trading System
This one is catching up to be a rage amongst the aspiring young traders who have strong mathematical and programming background. The philosophy is to entrust the trading into a robot or a program and let them exploit the fleeting discrepancies in the markets prices.
The success depends on the quality of the program, the execution speed and lastly on the edge the program has. If the logic itself is flawed, no matter how powerful your computer is, it won't make any difference.
While the merit in this type of trading system cannot be denied, it is not for all traders. The amount of capital required and the programming skills needed is not everyone's cup of tea.
Pros - Mechanical Trading System
- Eliminates human intervention and emotional biases.
- Easy to backtest.
- parameters can be tested and tweaked to suit the current markets.
Cons - Mechanical Trading System
- Suppressing emotions can lead to second-guessing the system by traders.
- tweaking the parameters can lead to analysis paralysis and curve fitting the system to current data.
- Any amount of backtesting cannot guarantee the system performance in the future.
2. Discretionary Trading System
I personally believe that this type of trading system is best for the retail traders. But they need to understand one thing that as a retail trader they don't have an obligation to trade all the time. They can pick and choose their opportunities well...
There are many tools that can be used for discretionary trading like...
- Technical Indicators (eg: RSI, Stochastics, MACD, etc)
- Traditional Technical Analysis (eg: trend Lines, Channels, Chart Patterns, etc)
- Advanced Analysis Techniques (eg: Elliott Wave Theory, Harmonic Patterns, Price Action and my personal favourite Market Profile and VSA, etc)
Some traders even trade based on the feel they have developed over the years by just watching the screen. Its very hard to put a tab on what tells them what the markets are going to do, but they do make money too.
Pros - Discretionary Trading System
- This is good for beginners as it will let you get in touch with your emotions.
- You have complete control over your trades.
- Some of the great tools do not lend well to rule-based trading hence cannot be adapted to mechanical trading systems, but can be used here.
Cons - Discretionary Trading System
- Even though you have complete control, sometimes pulling the trigger can be extremely hard.
- Losses may colour your judgement and make you take some irrational trading decisions.
- All the human psychological biases will come out and play on your mind while trading.
Despite some serious cons, one thing that discretionary trading is better at is risk control, you are always in control of that, that is a big thing...
3. Indicator Based Trading System
Image Source - https://bit.ly/2GtXAIs
This one is probably the most common way of trading with the novices in technical analysis. part of the reason for their popularity is the ease with which they are available in all technical analysis platforms. Ever wondered why every technical analysis platform has these indicators, because they are easy to program, its just a few simple mathematical formulae applied to price and volume.
Over the years there have been classifications among those indicators, ones that suit trend following better was called trend following indicators and ones that suited sideways consolidations better were called oscillators.
These indicators by definition lag the price, but they do offer some value. For instance, they can be very helpful in assessing the momentum of a move. Specifically when it is decreasing or about to explode.
Some of the common indicators are - RSI, stochastics, MACD, OBV, Williams R, CCI, etc the list is endless. Go through a detailed post on my favourite indicators here...
Pros - Indicator-Based Trading System
- Easy availability.
- Lots of literature, videos, PDFs etc are freely available. (most of it is garbage though)
- Relatively easy to understand.
Cons - Indicator-Based Trading System
- Lagging indicators + misguiding approaches to using them = trading disaster.
- Very limited legitimate sources of information available.
- Prone to confirmation and availability biases...
4. Black Box Trading Systems / Following Tipsters / Listening To News Channels
via GIPHY
What can I say about them, I have just one thing to say - don't do this!
There are no pros for this only CONS! (pun intended)
5. Seasonal or Cycle Based Trading Systems
This type of trading is as old as the markets. We are well aware different cycles, we face them on a day to day basis. Some of the common cycles that come to mind are...
- Weather Cycles.
- Cosmic Cycles (day-night).
- Business / Economic Cycles.
The idea is that some of the phenomena repeat at approximate time intervals on a regular basis. And traders have evolved over the years to take advantage of the same. For instance, in a generally depressed phase of a business cycle, smart traders expand capacities and acquire assets and when the cycle turns and reaches a pinnacle, these smart traders contract capacities and sell out the assets.
The same philosophy can be applied to markets, when the prices are depressed you should be looking to buy and when they are atrociously high you should be looking to sell. A great contribution in this area was made by one of the greatest minds the industry has ever seen, Richard Wyckoff. His work on Market Cycles and his Market Cycle Schematics are timeless. (LO)
Pros - Seasonal or Cycle based Trading Systems
- An age-old technique, supported by ancestral wisdom.
- Some of the cycles are extremely precise.
Cons - Seasonal or Cycle based Trading Systems
- Sometimes the cycles can stray and not repeat as they should.
- Based on observations, often cannot be explained in scientific terms. (but we still have to learn a lot)
6. Astrology-based Trading Systems
via GIPHY
Yes, there is a vast field of interest which applies astrology to predicting market prices and cycles. I have observed the results of some of these systems and they are extremely uncanny sometimes.
Actually, I met one trader during a recent seminar I was speaking at and that gentleman shared his analysis with me. It was spooky because of the markets in the following days followed his analysis exactly.
I have plans to explore this intriguing field, but I am strapped for time and as any field of interest to become a master at anything you need to do justice to it and give it the time it demands.
Pros - Astrology-based Trading Systems
- Well, whatever I have observed so far has been nothing short of amazing.
Cons - Astrology-based Trading Systems
- Once again there are many charlatans in this field spreading incorrect information, so be very particular who you listen to.
7. Buy and Hold Trading System (Investing)
This method was made popularised by the greatest investor of all times, Warren Buffet. But this is one of the most abused rationalisations. When traders get stuck in their stock positions, they say they are holding it for the long term.
Actually, the position which should have been abandoned brutally, they convert into a long-term investment. That was not the approach of Warren Buffet.
Those who are not serious about trading rarely put in the requisite work and the results speak for themselves.
Pros - Buy and Hold Trading System (investing)
- It is a great system if you know what you are doing.
Cons - Buy and Hold Trading System (investing)
- Using it as a rationalisation will only make things worse for you, a bad position needs to be dumped and a bad decision needs to be corrected, sooner the better.
8. News and Events based Trading Systems
There are traders who trade only news and events, but not the way most retail trader approach it. These professional traders put in an inordinate amount of work and study the markets in great detail.
What attracts retail traders to news and events is usually the increased volatility and big moves that often follow these events. They often underestimate the amount of work required for trading these events successfully.
For beginners though I would suggest steering clear of these events and news.
Pros - News and Events based Trading Systems
- Once again, it is a great system if you know what you are doing.
Cons - News and Events based Trading Systems
- The volatility after these events is too hot to handle and beginners are best served to avoid these events.
- Often the markets tip their hand before the event, but it is not so easy to read it in real time.
Conclusion
I have put forward the many different trading systems used by traders and their pros and cons, now it is up to you to select the one that suits you the best. If you need to discuss some of them in greater detail, don't hesitate to put your doubts and queries in the comments section below.
I am sure your friends and colleagues will find this information useful, so go ahead and share it with them because...
No comments:
Post a Comment
...I am thrilled to learn what you think about this piece of content...