The mid-1990s was a golden era for the trading system business. System vendors such as Keith Fitschen, Randy Stucky and Mike Barna thrived. Most of these systems were either trend-following, index, volatility breakout and variations of pivot points.
Hundreds of copies of a trading system were sold during this time. Some developers traded their own systems and made money. Developers learned that those who purchased their systems often ran from adversity, even en route to greater profits, and would stop trading a system amid its first drawdown. The business model was relatively simple. The systems were sold as software. Clients would buy the system, trade it until that first drawdown and then stop. A typical price for a trading system was $1,000 to $2,000.
Vendors could sell these systems for this knowing that only10% or so of the clients would continue trading after a drawdown. This allowed the vendor to continue trading the system even in small markets without concern of saturation. If 100 systems costing $2,000 each were sold, the vendor made $200,000; but because only 10 people were likely to stick with the system, the inefficiencies it tapped into remained. Even if in the best of times they sold 1,000 copies, grossing $2 million, 100 people trading 200-300 lots would have a minimal impact, if any, on a liquid market such as stock indexes.
Despite that secrets are held dear in the trading industry, most vendors sold fully disclosed systems. This became a key to success. If clients didn’t understand a trading system or have access to its logic, it became very easy to pull the plug the moment the system stopped working. Today, most systems are leased with undisclosed logic. Although this is cheaper for the customer, those trading the systems become the weak hands of the market. Folks are quick to abandon a losing position.
Both drawdown and the largest losing trade—key factors many people use to determine whether or not a system is worth trading—are poor predictors of a system’s reliability. In general, the lower the drawdown or the largest the losing trade, the less likely the system is to work in the future.
When developing a trading strategy, it’s important to focus on the core logic, and not just performance metrics. Simple Harmony, which I developed in 2005, was a basket trend-following system that has been ranked in the top 10 by independent system tracker Futures Truth since release.
A modified version, called Trend Harmony, had about 40% less drawdowns than Simple Harmony because of filters. For example, mechanical logic was employed to filter out trades during the fourth wave of an Elliott Wave impulse sequence. Another version traded on multiple time frames. Both of these systems performed worse, post release, than the original system.
Another classic example is an intermarket trading system for Treasury bonds. The intermarket divergence concept is based on the 30-year T-bonds and the Philadelphia Utility average, as follows:
- If Bonds < Average(TBond,6) and UTY > Average(UTY,20) then buy at open
- If Bonds > Average(TBond,6) and UTY < Average(UTY,20) then sell at open
This system is simple but shockingly effective. From Sept. 22, 1987, though Aug. 7, 2014, including $50 per trade for slippage and commission, the system made $250,768.75 trading a one-lot with 60.3% winning trades and an average winning trade of $1,967.30. The maximum intraday drawdown was $22,131.00. The drawdown is a bit high, but the system has remained robust, working well since originally published in 1998.