For most traders, strategy development is merely a means to an end—a necessary process to be endured on the path to making profits. Just as spending gold is more enjoyable than panning for it, so it is with trading system development: Actual trading is usually more fun than developing a trading approach.
Unfortunately, this leads traders to take all sorts of shortcuts, and make all kinds of mistakes, as they develop their trading methodology. While this makes the trader’s life easier in the short run, mistakes and shortcuts inevitably come back to roost in real-time trading.
The good news is that most traders make the same mistakes in development, and once identified, they can be overcome and corrected. Eliminating these issues won’t make strategy development any easier, regretfully. Strategy development, performed the right way, becomes much more difficult when the shortcuts are eliminated.
So, what are some of the most common mistakes and shortcuts? Here are three of the more common ones. We explain why they are harmful, how they can be recognized and how they can be corrected. Avoiding these common mistakes will make any trader a better builder of trading systems.
No. 1: Complications & obfuscations
If you have been involved with trading for any length of time, you’ve undoubtedly come across complicated trading approaches. For a discretionary trader, this might look like the chart shown in “Analysis paralysis” (below). Many indicators, many lines, and many support and resistance areas adorn each and every chart. For an algorithmic trader, a complicated approach might be thousands of lines of code, with dozens or even hundreds of variables to optimize and tweak.
Both of these approaches have one thing in common: They are extremely complicated and involved. Many inexperienced traders think this is the way to develop a system. Their thinking is that the more indicators that line up, and the better the fit of their algorithm to past data, the better off the strategy is. Nothing could be further from the truth.
The fallacy in thinking a complicated approach is better is that a superior result with historical data does not equate to real-time success. In fact, constantly tinkering with an approach, adding an indicator, or inserting another rule in the algorithm to make a trading approach more complicated, usually only gives the trader a false sense of confidence. Improving and adding rules to a strategy does not mean it will work better in the future.
As hard as it is for most to believe, the simple approaches are usually the best. For a discretionary trader, a clean chart with only one or two indicators, coupled with a thorough understanding of price action and market dynamics, is always better than a chart clouded with lines and indicators. For algorithmic traders, one simple entry rule is typically better than five or 10 conditions that must be satisfied for a trade to be taken.
A simple example of this is shown in “Clear direction” (below). While far from a perfect system, the strategy is very simple. Such a strategy is unlikely to be overfit to historical data, and therefore is more likely to perform well in the future.