What is a Trading System?
“Trading Systems” are technical analysis based computer models which generate specific buy and sell signals in one or more stock or futures markets by analysing historical and real time movements in price, fundamental and other types of data to gain an insight into the most likely direction the market will take in the future. If the model detects that the most likely direction will be up, the system generates a buy signal and vice versa. Systems guarantee your trading decisions are consistent and disciplined by making them for you automatically.
Example: A simple example of a trading rule could be as follows:
1. If the current market price is higher than the 200 day Moving Average of prices then Buy at market.
2. If the position is losing more than $500, Sell at market.
Technical Analysis: The grand majority of trading systems are based upon technical analysis rules, strategies and indicators which aren’t fully disclosed to the investor. This type of system, in which the code is not disclosed is called a Black Box system – as no one knows what’s inside. The technical analysis inside of the system can be as basic as moving averages, oscillators, and relative strength indicators; or very complex intermarket data, seasonality or sentiment.
System Assist Brokers: Most systems are developed by third party scientists or market specialists, however at SCM we develop our own systems. While they used to sell the system to investors in the old days, the norm now is for the developer to simply lease the use of the system to clients on a monthly basis through a system assist broker such as SCM. We have taken this to the next level by both developing the trading system in-house, trading it with our own money and making it available for clients to trade as well. The system assist broker runs the system software on its machines on behalf of the client and monitors the system signals minute by minute throughout the trading day, entering any buy and sell signals issued by the system into client accounts, while a monthly fee for the system comes out of the client account.
Types of Systems: There are hundreds of different futures trading systems which operate on everything from Crude Oil to stock market futures like the e-Mini S&P. Systems generally operate on one of three time frames:
Day Trading: The most popular type of systems (but not necessarily the best), these usually operate on highly liquid markets like stock index futures such as the S&P 500 and e-mini S&P futures. A day trading system’s defining characteristic is it will NOT hold a position overnight. All positions for day trading systems are exited by the end of the day. One common misperception about day trading systems is that they trade very frequently. This is not necessarily the case, as many wait for the optimal market “set up”, and therefore do not trade on several days each month. We offer ‘Around the World’ portfolios where you can run a day trading system in each of the three major timezones, Asia, Europe and the USA giving additional diversification than simply trading in one time zone on it’s own.
Swing Trading: These types of systems hold positions for several days to weeks, and again operate mainly on highly liquid markets like the stock index futures, bond futures, and more recently energy futures. There general approach is to ride market “swings” for a few days, then exit or reverse the position and ride the swing the other way.
Trend Following: The “old man” of trading systems, trend following is the classic approach employed by some commodity indexes, billion dollar hedge funds, and the infamous “Turtles”. Trend following systems generally operate on a portfolio of commodity markets across the grains, energies, metals, softs, interest rates, and currencies. They continuously monitor each market, waiting for each one to “break out” of its normal trading range and begin a long term trend. The system attempts to ride these trends as long as possible. With huge, multi-year trends like Crude Oil going from $20 to $70 and Euro Currency futures moving from .85 all the way to 1.35 – the allure of trend following systems is easy to see.
Transparency & Liquidity. Two big advantages a trading system investment has over alternative investments in vehicles such as hedge funds or real estate is full transparency and nearly instant liquidity. Investors can see all of their positions at all times marked to the market, and per the limited letter of direction will not see any surprises. Should an investor need cash for any reason, wires can be processed the same day if received by 11AM.
Why trade mechanical systems?
Most experts tell us that discipline is vital to success as a trader. We must not only have a market edge through a trading system that delivers a positive expectancy over time (ie, makes money), we must follow this system with great discipline. This means that we must always place our predetermined stops in the market to protect us from large losses and we must allow them to be hit and not move them away from the market. It also means that we must not take our profits early (this was my own worst failing as a trader) nor should we stay in the trade longer than planned.
It is exceptionally difficult for most traders even with a winning system to follow strict trading rules with discipline. This is because as human beings our egos tend to make us believe too much in our trades and we all suffer to a greater or lesser extent from emotions such as fear and greed which lead us to modify a winning system when we are in the market.
Ego, fear and greed are the real enemies that prevent most of us from becoming successful traders.
It is my view that the most highly successful discretionary traders follow strict rules and rarely make changes on the fly. They are in effect trading mechanically. There will be exceptions but I believe they will be quite rare.
My thesis is, therefore, that almost all successful trading is essentially mechanical in nature.
What fully mechanical systems do is program the trading system using readily available programs such a Trade Navigator, Tradestation etc, so that it can be automated to a greater or lesser extent. When you use fully mechanical systems and particularly when these systems are either automated or traded on your behalf by a broker you are removed as much as possible from the day-to-day emotions that ruin traders.
At Strategic Capital Management we believe that having a broker trade proven mechanical systems on your behalf provides the highest probability for most individuals of becoming profitable. Strategic Capital Management provides a unique broking service through specializing in trading its own in-house developed and proven futures trading systems on behalf of clients.
Diversification
Research shows that including a trading system within a broad portfolio can actually increase returns and reduce risk as they are typically non-correlated to traditional asset classes such as porperty and a buy and hold share portfolio.
Potential for High Returns
Because a trading system is designed to take advantage of market volatility and leverage, returns can potentially be larger (they can be lower as well if the system gets it wrong) on average than simply buying and holding a basket of shares. In addition trading the short side of the market, as well as the long side means investors have the opportunity to profit in both bull and bear market conditions. The other advantage is that becasue risk is managed the downside or volatility of returns can be less than that of a buy and hold portfolio and thus these types of investments are suitable for leveraging. You may also like to think of the following example: What is better 1 return of 20% or 20 returns of 1% in the same time period. Clearly with the compounding effect with 20 returns of 1% can be compounded to a total return of over 22%. We follow this mantra whenever possible.
FOR MORE INFORMATION PLEASE PHONE ANDREW GIBBS ON (09) 525 6511 OR EMAIL andrew.gibbs@strategiccapitalmanagement.co.nz
