Trading Systems: Designing Your System - Part 1

Trading Systems: Designing Your System - Part 1

http://www.investopedia.com/university/tradingsystems/tradingsytems2.asp

The preceding section of this tutorial looked at the elements that make up a trading system and discussed the advantages and disadvantages of using such a system in a live trading environment. In this section, we build on that knowledge by examining which markets are especially well-suited to system trading. We will then take a more in-depth look at the different genres of trading systems.

Trading in Different Markets

Equity Markets
The equity market is probably the most common market to trade in, especially among novices. In this arena, big players such as Warren Buffett and Merrill Lynch dominate, and traditional value and growth investing strategies are by far the most common. Nevertheless, many institutions have invested significantly in the design, development and implementation of trading systems. Individual investors are joining this trend, though slowly.

Here are some key factors to keep in mind when using trading systems in equity markets:

• The large amount of equities available allows traders to test systems on many different types of equities - everything from extremely volatile over-the-counter (OTC) stocks to non-volatile blue chips.
  
• The effectiveness of trading systems can be limited by the low liquidity of some equities, especially OTC and pink sheet issues.
  
• Commissions can eat into profits generated by successful trades, and can increase losses. OTC and pink sheet equities often incur additional commission fees.
  
• The main trading systems used are those that look for value - that is, systems that use different parameters to determine whether a security is undervalued compared to its past performance, its peers, or the market in general.

Foreign Exchange Markets
The foreign exchange market, or forex, is the largest and most liquid market in the world. The world's governments, banks and other large institutions trade trillions of dollars on the forex market every day. The majority of institutional traders on the forex rely on trading systems. The same goes for individuals on the forex, but some trade based on economic reports or interest payouts.

Here are some key factors to keep in mind when using trading systems in the forex market:

• The liquidity in this market - due to the huge volume - makes trading systems more accurate and effective.
  
• There are no commissions in this market, only spreads. Therefore, it's much easier to make many transactions without increasing costs.
  
• Compared to the amount of equities or commodities available, the number of currencies to trade is limited. But because of the availability of 'exotic currency pairs' - that is, currencies from smaller countries - the range in terms of volatility is not necessarily limited.
  
• The main trading systems used in forex are those that follow trends (a popular saying in the market is "the trend is your friend"), or systems that buy or sell on breakouts. This is because economic indicators often cause large price movements at one time.

Futures
Equity, forex, and commodity markets all offer futures trading. This is a popular vehicle for system trading because of the higher amount of leverage available and the increased liquidity and volatility. However, these factors can cut both ways: they can either amplify your gains or amplify your losses. For this reason, the use of futures is usually reserved for advanced individual and institutional system traders. This is because trading systems capable of capitalizing on the futures market require much greater customization, use more advanced indicators and take much longer to develop.

So, Which is Best?
It's up to the individual investor to decide which market is best suited to system trading - each has its own advantages and disadvantages. Most people are more familiar with the equity markets, and this familiarity makes developing a trading system easier. However, forex is commonly thought to be the superior platform to run trading systems - especially among more experienced traders. Moreover, if a trader decides to capitalize on increased leverage and volatility, the futures alternative is always open. Ultimately, the choice lies in the hands of the system developer.

Types of Trading Systems

Trend-Following Systems
The most common method of system trading is the trend-following system. In its most fundamental form, this system simply waits for a significant price movement, then buys or sells in that direction. This type of system banks on the hope that these price movements will maintain the trend.

Moving Average Systems Frequently used in technical analysis, a moving average is an indicator that simply shows the average price of a stock over a period of time. The essence of trends is derived from this measurement. The most common way of determining entry and exit is a crossover. The logic behind this is simple: a new trend is established when price falls above or below its historic price average (trend). Here is a chart that plots both the price (blue line) and the 20-day MA (red line) of IBM: Breakout Systems The fundamental concept behind this type of system is similar to that of a moving average system. The idea is that when a new high or low is established, the price movement is most likely to continue in the direction of the breakout. One indicator that can be used in determining breakouts is a simple Bollinger band overlay. Bollinger bands show averages of high and low prices, and breakouts occur when price meets the edges of the bands. Here is a chart that plots price (blue line) and Bollinger bands (gray lines) of Microsoft: Disadvantages of Trend-Following Systems: Empirical Decision-Making Required - When determining trends, there is always an empirical element to consider: the duration of the historic trend. For example, the moving average could be for the past 20 days or for the past five years, so the developer must determine which one is best for the system. Other factors to be determined are the average highs and lows in breakout systems. Lagging Nature - Moving averages and breakout systems will always be lagging. In other words, they can never hit the exact top or bottom of a trend. This inevitably results in a forfeiture of potential profits, which can sometimes be significant. Whipsaw Effect - Among the market forces that are harmful to the success of trend-following systems, this is one of the most common. The whipsaw effect occurs when the moving average generates a false signal - that is, when the average drops just into range, then suddenly reverses direction. This can lead to massive losses unless effective stop-losses and risk management techniques are employed. Sideways Markets - Trend-following systems are, by nature, capable of making money only in markets that actually do trend. However, markets also move sideways, staying within a certain range for an extended period of time. Extreme Volatility May Occur - Occasionally, trend-following systems may experience some extreme volatility, but the trader must stick with his or her system. The inability to do so will result in assured failure.

Countertrend Systems
Basically, the goal with the countertrend system is to buy at the lowest low and sell at the highest high. The main difference between this and the trend-following system is that the countertrend system is not self-correcting. In other words, there is no set time to exit positions, and this results in an unlimited downside potential.

Types of Countertrend Systems
Many different types of systems are considered countertrend systems. The idea here is to buy whenmomentum in one direction starts fading. This is most often calculated using oscillators. For example, a signal can be generated when stochastics or other relative strength indicators fall below certain points. There are other types of countertrend trading systems, but all of them share the same fundamental goal - to buy low and sell high.

Disadvantages of Countertrend Following Systems:

• Empirical Decision-Making Required - For example, one of the factors the system developer must decide on is the points at which the relative strength indicators fade.
  
• Extreme Volatility May Occur - These systems may also experience some extreme volatility, and an inability to stick with the system despite this volatility will result in assured failure.
  
• Unlimited Downside - As previously mentioned, there is unlimited downside potential because the system is not self-correcting (there is no set time to exit positions).

Conclusion
The main markets for which trading systems are suitable are the equity, forex and futures markets. Each of these markets has its advantages and disadvantages. The two main genres of trading systems are the trend-following and the countertrend systems. Despite their differences, both types of systems, in their developmental stages, require empirical decision making on the part of the developer. Also, these systems are subject to extreme volatility and this may demand some stamina - it is essential that the system trader stick with his or her system during these times. In the following installment, we'll take a closer look at how to design a trading system and discuss some of the software that system traders use to make their lives easier.

Next: Trading Systems: Designing Your System - Part 2