Trading System Goals

Throughout this site, I make the point that you need a trading system so that you don’t become futures market roadkill. But what should a good trading system do?

Firstly, let’s talk about what it can’t do. A trading system can’t predict the future. Given the findings of chaos theory, it is unlikely that such a thing is possible. The best systems that I have seen get it right around 70% of the time, and that comes from following existing trends (that is observing the past) rather than from forecasting.

Ultimately a trading system can’t tell you how much you should trade or how much risk you should take on - these factors will always depend on you (unless you are happy to put a system on autopilot and are prepared for the consequences).

Instead a good trading system needs to tell you when to enter the market, when to exit with a profit, and when to exit with a loss.

Inexperienced traders focus purely on entry points. This is only part of the picture. Selection of exit points is more critical to your profitability.

A good trading system must have a positive expectancy. This means that on average profits exceed profits. That is how a casino makes money- it doesn’t attempt to predict every turn of the roulette wheel. The casino has positive expectancy (the house advantage), and over time winning becomes inevitable, despite occasional losses. Your system needs to do the same thing.

This is different from accuracy. If you had a system that got 80% of trades correct, but each losing trade was 10 times the size of each winning trade, you would soon lose your money. Your trading system is ideally accurate, but must have positive expectancy. Most millionaire traders are right about 40-50% of the time, but their profits far exceed losses so have positive expectancy.

A good trading system works predictably across different market conditions. A system that trades gold should not totally fall over when it is given data for wheat.

A good trading system is ultimately a noise filter. The problem is to evaluate every price change and determine whether it is random noise or a change in trend which will result in a trade. This depends on the level of noise (or volatility) in the market at a point in time.

I’ll discuss some of these ideas further in future postings.