In broad terms, trading falls into one of two camps: systematic or discretionary. A discretionary approach welcomes personal judgment in individual trading decisions. Alternatively, a systematic approach involves conceptualizing, defining, writing and testing rules for entering and exiting trades, then consistently trading by those rules going forward.
Discretionary traders argue that past data were molded by unique micro- and macroeconomic forces and rigid rules based on that data ignore the fluidity of the markets. Systematic traders counter that, with care, even new traders can write rules that are robust enough to accommodate unseen market scenarios.
One of the strongest arguments for systematic trading, however, has to do with the trader, not the system — more precisely, the trader’s emotions.
“The buy or sell signal of a trading system follows automatically from the enabling of a set of rules that is independent of the varying discretion and emotion of the trader,” says Rick Thachuk, president of the WLF Futures, Options and Forex Education Network.
Traders, particularly new traders who lack the experience of market moves and reactions, generally perform poorly when emotions come into play.
“[A] mechanical system executes without the immediate emotion that accompanies discretionary trading,” says Michael Gutmann, an independent systems trader. “That is not to say a mechanical system won’t generate lots of emotions from the trader who executes it — losing trades from a mechanical system are also difficult to swallow — but the immediate emotional reactivity of discretionary trading is eliminated.”
Once emotion is controlled, experts say, consistency can follow.
“Trading with discretionary logic is simply another way of saying ‘trading inconsistently,’ and this will produce volatile results,” says Paul King, owner of PMK Trading LLC. “Trading with a system implies one will always take the same actions under the same circumstances.”
Adds Thachuk: “A trading system will also, by construction, follow obediently the established rules for risk management and limiting loss, rules that can be difficult to adhere to when trading by discretion, especially for beginners.”
If you agree and wish to take advantage of the consistency and emotional control that trading systems offer, then you have at least two choices: You can develop your own trading system or you can buy one from a third-party developer.
BENEFITS OF BUILDING
The steps to building a viable trading system are beyond the scope of this article. However, you don’t need to understand the minutiae of systems development to consider the benefits of developing one.
The most important reason to build your own trading system is you will have full knowledge of when, why and how it trades, Thachuk says.
“Also, by developing a system yourself, you have complete control over the parameters of the system, such as the markets traded, time horizon, risk capital required, trading frequency and maximum drawdown to name a few,” he says.
King points to a number of reasons to build your own trading system:
• You can historically test performance under different market conditions.
• You know that there is no vagueness or fuzziness in your trading rules.
• With full knowledge of the system’s rules and trading tendencies, you will have the confidence to trade through the inevitable losing periods.
According to Gutmann, having built your own trading system, you also are more adept at modifying it when market conditions change.
“When a trader builds his own system, he knows why it performs as it does and can make adjustments — and adjustments are always needed,” Gutmann says. “If a system is purchased, then the adjustments may only be available at additional cost.”
Of course, building a trading system has its drawbacks as well. First, it’s not necessarily easy and can be mentally draining, often with little or no payback. Also, if you are going to build your own trading system, you do need some knowledge of how the markets work, and that takes time to learn as well.
“[A trading system you build] will be limited to your own trading knowledge,” Thachuk says. “For beginners, this could be a significant, binding constraint. [A] successful trading system will likely need to have an edge over other, competing systems. If you don’t believe that you can provide any edge, then it may be better to consider purchasing a trading system.”
Other arguments against building your own system are the cost of development software and data, as well as your own personal time and energy. Even simple systems can appear complex to the uninitiated (see “Inside systems,” right).
“Systems development can be very time consuming,” Gutmann says. “Making use of the latest software and systems can take a level of technical background that the average trader does not have.”
PAYING FOR PERFORMANCE
In general, there are two types of pre-packaged, commercially available trading systems: open systems and so-called “black-box” trading systems.
When a trader buys an open-trading system, they can see the logic behind entry and exit orders. That is, once you purchase the system, you can examine why it trades. In black-box systems, the logic is locked. These systems — or, more precisely, the developers of these systems — don’t reveal their trade-entry logic to the buyer. A black-box system will simply read current market data and report buy and sell orders as they happen.
“I would never recommend that anyone buy a black-box system,” says Murray A. Ruggiero Jr., vice president of research and development for TradersStudio and a contributing editor to Futures. “You want the logic fully discussed, so you can learn to understand it, even modify it and make it your own so you can feel good about trading it.”
However, the same experts who wouldn’t recommend a black-box system say that there are times an open-logic commercial system may make sense.
John Hill, president of Futures Truth Inc. in Hendersonville, N.C., has been independently testing and developing trading systems for decades. His company is best known for periodically publishing a table of independently tested third-party commercial trading systems (see “Futures Truth’s Top 10” ).
While Hill says there are caveats to buying a third-party trading system — he says he’s seen his share of suspect approaches — occasionally a viable commercial system does become available. He also says the question to buy or build doesn’t have to be an either/or decision.
“There’s nothing wrong with trying both approaches,” Hill says. “But if you’re going to buy one, you’ve got to be extremely careful that you deal with reputable vendors. There’s a lot of trash out there.
“We had a couple of those come through here last week,” he adds. “One was a guy who based the success of his system on the results of trading crude during the Gulf war (a one-off scenario that has little relevance going forward). And I had a guy present what we call the Will Rogers system: only buy stocks that go up. If they don’t go up, don’t buy them. What this cat was doing was looking at the close of the market, and if the stock went up, he had the system buy earlier in the day.”
However, there are lot of reputable vendors, Hill says. And many of them have developed solid trading systems that can form the core logic of a viable program.
“Some of these guys know what they’re doing,” Hill says. “If somebody has already invented the wheel, why reinvent it?”
One reason, some traders say, is because that wheel may not stand up to the road ahead, and if you don’t understand what you’ve gotten yourself into, then you can’t hope to fix it.
“What does the user do when the purchased system generates losing trades right out of the box?” Gutmann says. “Often, the new user gives up quickly, disgusted that they spent hard-earned money on something so opaque as an automated system whose inner workings they took for granted.”
Others see no value whatsoever in purchasing a third-party system, open or closed.
“There is no benefit that I can see,” King says. “If you have the skills to evaluate a ready-made system, then you have the skills to develop your own. Alternatively, just give your money to someone who already knows what they’re doing to manage.”
IF THIS IS SO GOOD…
One of the most common arguments against commercial trading systems questions the rationale of the seller.
“It is difficult to understand why a developer would sell a system that generates profit rather than use it personally and exclusively,” Thachuck says.
Hill says that one reason to sell a trading system is something all traders should understand: to make money. It’s extremely unlikely that a commercially sold trading system could become so popular and widespread that it would invalidate the logic used in the system.
“If a small vendor sells his system, it’s not going to affect his trading one iota,” Hill says. “First of all, the effect on the market will be irrelevant. Second, most buyers will follow it for three months then get distracted and quit. Also, a lot of vendors simply don’t trade. There’s a tremendous knowledge gap between the ability to build a good trading system and make money in the market. Even the best developers can’t follow a system because of the emotions of fear and greed involved.”
Whether you have the discipline to stick to a defined set of rules is an important consideration if you are going to trade systematically, whether you buy or build. Trading systems require following all rules religiously. Successful system traders avoid the temptation of bypassing the rules, whether that comes in the form of holding a loser too long or being too quick to take profits. The beauty of trading systematically is that you have made those exit decisions beforehand based on strong research and statistical evidence, not in the heat of a fast market.
Some argue that the most important factor in how, or if, you trade systematically is you.
“If a person is going to build a system,” Hill says, “That person needs to be mathematically strong. They should be an entrepreneur type [who has] built their own business. A type-A personality [but also] patient.”
In addition, some market expertise is necessary, and that takes time to acquire. “The system developer should have good experience actually trading his or her target markets,” Gutmann says. “I don’t believe in development of trading systems by smart but inexperienced traders. The developer needs to have a good background in technical analysis, and this includes knowing what technical methods have been tried in the past so that previous systems are not simply recreated.”
King agrees: “If you just make it up as you go along, then you’re going to lose money competing against traders who have a complete, tested, and positive expectation trading method. If you can’t or don’t want to put the effort in to design, develop, and test your own trading system, then you can’t expect to be successful.”
James T. Holter works as technical editor and contributor at Futures.