From the July/August 2014 issue of Futures Magazine • Subscribe!

Building a trading strategy involves more than testing and optimization

It happens to every trader: the sudden serendipitous rush of a brilliant trading idea. Maybe it occurs on the drive home after a long day at work, or possibly an idea suddenly manifests during a morning shower, and sometimes before falling off to sleep. Wherever it takes place, the normal instinct of the trader is to rush to a computer to test the idea, quickly analyze the results, and if the idea seems successful, begin trading it.

Unfortunately, that is the absolute worst approach to take. Even though trading software (with simple strategy development and optimization features) cuts the time from creating a trading strategy to seeing the historical results to mere minutes, it does not mean it is the right approach. In fact, a quick test and superficial evaluation is usually the completely wrong way. 

To be successful in the long term, the trader must treat strategy creation like building a house. No home builder starts building as soon as he finds a lot and gets some supplies. There are many steps to go through before even starting construction, and the same concept holds true for developing a trading strategy. Creating a plan and building a foundation are two of the first steps a homebuilder, and a trader, must address before testing and analysis.
 

Blueprint for profit

Ask any builder, and he’ll tell you building a house starts with a plan, or blueprint. The blueprint shows what the final product will look like. The same holds true for building a trading strategy; it has to start with a plan, one that shows the end result. Sadly, many people think a plan means “find a trading system that makes a lot of money.” That is too general—how much is “a lot of money?” Being specific, not vague, is the key here.

To be successful in creating trading strategies, a trader first needs to have a detailed plan, goal or vision for the expected performance of the strategy. This way, as the trader develops the strategy, there will be clear ways to measure progress. Thus, good strategy development starts with a solid goal. Personal development coaches frequently talk about SMART goals, and that is a good approach to follow. SMART, as shown below, is an acronym to help one remember the important features of an outstanding goal: Specific, Measurable, Achievable, Relevant and Time bound. So what is an example of a SMART goal for developing a trading system?

The “S” in SMART means the goal has to be specific. “Developing a trading system that makes a lot of money” is not at all specific. A trader with a non-specific goal will never know when the goal is reached. Instead, a goal like “this trading system needs to average $12,000 net profit per year per contract over at least seven years of walk-forward testing” is certainly specific enough. Being specific, then, achieves two goals: It helps the trader determine when the target is reached, and it helps filter out systems that do not meet the plan, before too much time is wasted on an under performing strategy.

Measurable is the “M” in SMART. Simply put, it means having objective numbers and performance metrics in the plan that the strategy has to meet. It is fairly easy to create a strategy that “minimizes drawdown,” but it is far more difficult to create one with a “30% maximum drawdown, measured on a trade close-to-close basis.”

“A” stands for Achievable, and this is where a lot of traders go astray. Developing a trading system that “earns at least 20 points per day per contract in the E-mini S&P 500 futures” is certainly specific and measurable, but it is far from achievable (at least for most traders). Setting an unrealistic goal only leads to frustration, and inevitably causes developers to shortcut the development process. The point is to aim high, but also to aim for something reasonable.

The “R” in SMART stands for Relevant. For trading system design, the trader has to make sure details in the plan help lead to creating a solid system. If a plan includes “no more than three consecutive losing trades,” ask “is this criteria truly relevant to developing a trading strategy?” While it may be a nice feature of a trading approach—who would not like a system that never had more than three losses in a row?—it really takes away from the primary focus. Remember that a trading plan has to be relevant to creating a long-term profitable trading strategy, first and foremost. Other, non-critical items can be put on a wish list, but should not be the primary focus during strategy development.

The final letter in SMART, the “T,” stands for Time bound. Just as no home builder wants to spend 10 years building a house, no trader wants to spend years developing a trading strategy. So good developers put time limits on strategy creation. This is appropriate for two reasons. First, setting a time limit prevents the developer from continuously tweaking and altering a strategy to improve it. That type of approach almost always leads to over fitting. Second, time limits keep the developer engaged. Instead of focusing on just one strategy, the developer knows dozens of potential strategies are waiting to be evaluated, so the focus is then on evaluating ideas, not perfecting one system.

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