Many traders these days want to manage their speculative accounts with fully automated trading systems. The basic goal is to find one or more reliable systems to employ. Accomplishing that simple task, however, is not so simple. Reliability is hard to define, particularly when profits are part of the equation. Even if you knew for certain a particular trading system would provide 25% compound growth over the next five years, success would not be guaranteed.
There are several factors that can contribute to unexpected failure. First, circumstances could require you to take money out in too short a time frame, robbing the system of its ability to profit. Another reason is your personal risk tolerance (or drive for reward) may not mesh with the system’s ups and downs. Finally, the system itself may not have been robust from the beginning, and it may fail quickly when faced with changing market environments.
Here, we will examine all three factors and use them to construct a framework for better analyzing trading systems for real-world trading.
Time and reliability
One of the biggest issues with successful trading is knowing your time frame. You must plan both when you will need your money and how much you will need. The time frame and required system growth date are critical.
Another issue is loss penalty. To demonstrate this, we’ll use a simple triple moving average system. It trades a small basket of futures: Cotton, mini natural gas, euro, copper, Treasury bonds, mini crude oil. We will use $100 for slippage and commissions, trading one-lots exclusively. We will test from Jan. 4, 1991, to April 16, 2013. We are using 12, 60 and 70 as our three moving average lengths.
The system wins only 38% of its trades. The average winning trade lasts 153 days, whereas the average loser lasts only 55 days. If we look at monthly returns, however, six out of 10 months make money. Our winning months average $7,028, and our average losing month is –$5,805. At first glance, this may seem like a paradox—how can only 38% of the trades make money, while 60% of the months are winners? The answer lies in the role of time. This is a trend-following system; as such, a large percentage of trades shows an interim profit at some point even though (per the rules of the system) only 38% are closed out as winners.
Because the average winning trade lasts 153 days, we can assume we must trade for at least 600 days before we make money. That would be just four winning trade periods. Even though it may seem like a long time (almost two years), it is still a short period measured in terms of trade time frame.