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SYSTEM DESIGN
On System Development Part 1
by Mark Vakkur, M.D.
Here's one for the first-time developer of a trading system, or someone who's thinking about developing a system. Here are the basic steps this author took to develop a system for the stock market.
Successful trading is nothing more than systematically putting the odds in your favor. Our only guide to the future is the past; the trader must hunt down historical associations and hope they continue to hold true. These associations can be as simple as the idea that a close above a rising moving average tends to be followed by higher prices or as complex as a DeMark countdown. Moving from an observation to a viable trading system, however, requires a rigorous process of system development.
I will illustrate the development of a simple system for the stock market based on a combination of three variables that have been shown to be highly profitable when used alone -- seasonality; the Presidential election year cycle; and the relationship between the yield on the 30-year Treasury bond and its six-month moving average.
OVERVIEW
Every day, we discover or encounter ideas, concepts or associations that could form the basis of a profitable trading system. However, one indicator or association is often noted apart from all others. Although we could trade several systems simultaneously based on different indicators, would it not be simpler, more efficient, and profitable to combine the indicators or variables into a single system? There are as many answers to this question as there are permutations and combinations of various indicators and variables, but certain generalizations can be made about the process used to develop, backtest and refine such a system.
My purpose here is not to promote a particular system, but to discourage the blind acceptance of someone else's system by demonstrating how easy it is to develop your own. Is this effort worth it? After all, for a few hundred or thousand dollars, you could purchase a black-box system developed by some computer whiz. Although some systems are good, if you don't go through the rigorous process of developing and testing the system yourself, you will probably lack the confidence to trade it. This is especially true after a period of underperformance. You might lose your confidence (and your money) in the system just before it starts to perform as advertised! Doing your own research is essential to successful trading.
TO START WITH
I use the term system here as a comprehensive set of mechanical, strict buy and sell rules based on the values of certain predefined indicators or values. A complete system should also have provisions for money management (such as stop-loss criteria, strategies for scaling back or pyramiding position size, and overall risk management), but for simplicity's sake, I will illustrate a system that is historically safer than buy and hold (based on backtested, historical data) so that no additional stops or checks should be required (although they could be used if so desired).
By mechanical, I mean that the ideal system should offer black and white buy or sell recommendations. Fuzzy systems exist, but they will not be considered here. Successful discretionary traders also exist, but most of us will do far better with a mechanical system. My objective is to keep things simple and never to allow my gut feelings to dictate my actions. An ideal system would generate orders such as: "Buy 100 shares of Best Buy at 30-1/8 stop good until canceled. If filled, place a sell stop at 27-7/8." No fudging, no hesitation, no qualitative assessment.
Mark Vakkur is a psychiatrist and a stock trader. He can be reached at 1751 Vickers Circle, Decatur, GA 30030, or via E-mail at vakkur.mark@atlanta.va.gov.Excerpted from an article originally published in the June 1998 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1998, Technical Analysis, Inc.