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October 1996
How do you measure successful trading or investing? Obviously, the simple answer is the bottom line. Everyone's stated goal is to increase that bottom line. But there's a harsh reality attached because it is, simply, a number; there isn't any qualifying, no perhaps or maybes permitted. It is, after all, the bottom line. We all want to increase our own bottom line, but most traders, including me, have to go through a process to do so; we climb a set of stairs built upon pillars of hindsight to reach a certain level of knowledge. Why is this? Why do we have to make mistakes before we learn? Our real problem is our own nature. People tend to make a few observations, then generalize to the extreme, only to discover the hard way that our mindset doesn't hold up under the bright light of reality.Similar circumstances befall every field of endeavor. An idea evolves over time, beginning with an observable event, before generalized conclusions are drawn based on, at best, logic, or at worst, subjective experience. Fortunately, someone at some point subjects the concept to the application of analysis referred to in the academic world as the scientific method.
The concept of the scientific method can be attributed to 17th-century English statesman and philosopher Sir Francis Bacon, who argued that knowledge was gained only through research, empirical testing and drawing conclusion on the facts. Of course, it's a little more complicated than that, but for the moment, let us borrow from the philosophy and form arguments for traders. The steps to applying the scientific method to trading are: You observe some aspect of the markets; devise a theory or model consistent with what you have observed; use the theory to make predictions; test those predictions by back-testing or further observations in real time; modify the theory based on your results; then repeat the steps until you are satisfied.
This approach can be brought to bear on any technically based trading method, whether it's the simplest chart pattern or the most complex model. We have two articles in this month's STOCKS & COMMODITIES that will aid you in understanding this process. First, our interview is with Nelson Freeburg, editor and publisher of the Formula Research newsletter. Freeburg explains the steps to researching and developing trading models, and he shares with us the results from some of his favorite research. Second, our feature article, "The siren call of optimized trading systems," written by Contributing Editor Dennis Meyers, highlights some of the mistakes to avoid when developing a trading model. Both articles will aid you in designing and testing your own models.
Developing trading models will give you a set of powerful tools to aid you in your own money management, whether you're a professional or an individual who wants to take your skill level to that of the professional trader. You'll have a plan and a set of guidelines to follow, which should make the difference in that all-important bottom line.
