Taking for granted that it is impossible to predict future in any way, to professionally work in the financial markets it becomes necessary for a trader to have a valid trading system which generates buy and short signals, a trading strategy which allows to develop an operative protocol. Thanks to the traditional technical analysis, many things can be learned about graphical formations, trendlines, supports, resistances and so on. Then everything is put together and the trader buys, for example, when a certain resistance is broken or he sells when a support collapses. In other words, he follows a strategy, a trading plan.
An automated trading system is nothing but a set of operative rules that we insert in a technical analysis program. These rules convert the conditions recognized as true into signals with which to enter and exit positions on a particular financial instrument, thus cutting out the emotional component of a trader’s personality and managing risk an automatic way. A trader, when developing a trading system, must choose those mathematical micro-models that he considers to be the most adequate for a specific market, defining the necessary conditions in order to enter and get out of a position.
And here it comes the first difficulty: while a chartist can well be unaware of all the issues regarding a trading system, a trader who wants to program an efficient and profitable system must have a great and detailed knowledge both of markets and trading techniques. Inputs and condition settings cannot be casual but they have to match with the aims we intend to pursue. Because of this fact, trading systems are the arrival point for many expert traders who feel the need to manage risk in a professional way, so they represent the natural evolution of a trader’s technical approach to the market.
The main advantages in using a trading system are:
- The decision making process is autonomous, every psychological component made of prejudice and emotions is cut off, since the system process is superimposed on any subjective evaluation or analysis.
- A trading system allows a trader to test any trading ideas or complex protocols in a short period of time, gaining results that are much more regular compared to those which can be obtained by subjective and not methodologically verified decisions.
- A quite sophisticated mechanical system allows the trader to participate to every relevant market movement, with a limited amount of risk since risk is always systematically controlled. Profits, whenever a strong trend develops, will be let free to run while losses will be cut automatically without hesitation.
- Nothing is left to the trader’s discretion. Most of trading losses come when the decision making process develops in a chaotic, lacking of structure form. Conversely, adopting an automated system only requires discipline and effort in following the indications that the system provides us.
The main disadvantages in using a trading system are:
- In order to maintain the statistical validity of the results generated by a trading system it is strictly necessary to enter all the trades that the system provides. Unfortunately since the trader often lacks of knowledge on the underlying rationale of the system, it often happens that he loses his trust in the system, especially when the system is locked in the so-called “black box”, a box which cannot be opened preventing the trader to know the logic construction behind the trading system.
- There will also be some long periods of time during which the system won’t gain any good results, due to the substantial difficulty in fitting to all circumstances. The market’s structure, meant in terms of volatility and directionality, often changes so it is fundamental to have at our disposal a sufficiently great amount of data including many different market phases when testing and optimizing a strategy.
- Since it is possible to test every strategy on different parameters, the various tests conducted on historical data in order to obtain the best possible results, often end to become some exasperated optimizations which don’t grant an actual better efficiency in the future. Parameters optimizations must be accurately planned as well.
- In conclusion, it must be noticed that following a trading system, especially for an expert trader, causes a constant frustration since even when the market generates clear trading signals, the trader must wait for the system to provide its indications. Thus the emotive tension gets really strong.
Two different ways of using a system
It has to be noticed that trading systems can be used in two different ways: as a decisional help for the trader, thus acting in a sense like an underlying filter, or as a system for the immediate action on any given signal, following the conviction that a well designed system should be profitable on a long term perspective.
Discriminating the trading decisions generated by a trading system exposes the trader to the risk of acting depending on emotions, thus eliminating the main advantage of an automated system which is that of cutting out the emotional component and the stress of discretional trading. Therefore, trading system must be distinguished from decision support systems, that are a set of formulas and indications which the trader can use to take his own choices in complete autonomy; no long or short signals are generated: these systems only provide information that the trader is free to use for entering new positions according to his judgment.
The danger is deceitful and well hidden to a trader’s eyes. Just take a look at the application of a trading system on the following chart: we are clearly in a downtrend on the 5 minutes chart, but the first short order was closed due to temporal limits (red area). In facts, the strategy works exclusively on an intraday basis and closes all the positions at 5:30 p.m.
On the next morning, the future opens with a gap down performing a –0.56%, then it bounces up to -0.35% and then it proceeds in its downward run. But the system doesn’t allow to trade during the first 40 minutes after the opening, so we must see without any power to the fall of prices until, at 9:45 a.m. a short signal is finally generated.
In a discretional trading activity, we would have entered the short position well before the system, after the price’s failed attempt to close the gap. This forced waiting time generates frustration and constantly tempts the trader to anticipate the signals. In this specific case, the risk was high and the position could be closed earlier or not entered at all.
However, trading in a discretional way and not in a systematical one hides some insidious dangers: sometimes it happens to filter correctly even 8 of 10 trades but to lose with 2 simple bad positions all the operative advantage previously created. A losing position is not necessarily a wrong position, a concept that will be perfectly clear to you with time.