Mechanical Trading Systems
Hey Joe! What do you have against mechanical trading systems?
I think you might agree that trade management for system traders has become increasingly important as markets have become more volatile. As more money moves into commodity futures, particularly managed futures and system trading, commodity markets are experiencing higher levels of volatility and trending and correction moves (swings) are occurring much faster than in the past, requiring that a trader must constantly monitor his/her position.
A key underlying concept in trading is to limit how much money you are willing to let the market take from your account when you are in a losing trade, and how to keep 50% or more of a profitable move/trend before exiting on a system generated stop. Let’s face it: if you have to get out with only 50% of a move you will have had a much smaller percentage of the swing or trend.
Mechanical systems have strengths and weaknesses. The most notable weaknesses with trend following mechanical systems is their inability to account for a sudden change in market dynamics (such as news) once a position has been entered, and their propensity to give back what were once measurable net open profits.
Most that trade or have traded trend following mechanical systems have experienced this “giving back” and know the psychological effects of this can be quite disappointing. In fact, I believe this is the number one cause for failure with most inexperienced systems traders. Interestingly, this failure due to not having the need for self-control is probably the same thing that lures many back to the idea of trading a mechanical system. There’s no doubt that we have seen valid mechanical systems do a reasonable job of finding winning trades only to return most if not all of those winnings. Even worse they often get stopped out at with a loss. However, when you combine good system logic with proper trade management (the human element) many system weaknesses can be overcome. It is at the point you allow entry of the human factor that a system becomes a method.
Before you begin trading any method:
Know the system and the markets it trades. Start by doing a complete portfolio analysis to determine the average winning, average losing, largest winning and largest losing trades for each individual market. This will familiarize you with the detailed landscape of your territory or “the markets you are trading and their performance marks”. Now I’m not suggesting you abandon the mechanical nature of a method. Doing that makes little sense. In fact, when trading a method, the only time I allow myself to intervene is just before an entry signal has been given and then only after a trade has been entered based on the specific logic (rules, formulas, filters, analysis, etc.) of the method.
Let me give you an example:
I trade a method based on a 40 minute chart of the E-mini S&P 500. The entry signal and the objective are based on a percentage. If the bar from which the percentage is derived is too small, I will stand aside. There is no sense in entering a trade that where the objective is so close to the entry that I would not be able to execute properly. Similarly, I will not enter a position the trading day before a legal holiday, even if the method gives an entry signal.
Once I’ve entered a position will then watch for any sudden movement, regardless of cause, that could negatively or positively impact my open positions. Many times I have been in positions that had large or unusual price action following the effects of news or other market concerns. And many times this had given me an opportunity to cash in on quick profits. If I hadn’t taken them when they were there, I would have lost those profits and in many cases incurred a loss by exactly following the method. When there is a substantial and sudden move in my favor, I take my profits. Doing this locks in profits and ensures that I am paid to trade. I can always consider the same position once the market re-adjusts. Often when markets react to news or irritations they will readjust as quickly as they initially reacted, so you must manage your positions closely.
There are times when trading a method that you will miss part or all of a move. This is because using limit orders result in a no fill situation at either the entry or the objective.