We often discuss the importance of a good disciplined system when trading options. Note that most every effective professional has a system(s) which pays him or her very well. Today, we are going into the details of creating an effective system. As a side note, nearly every recommendation service we have at BigTrends.com operates on a unique system that is well defined.
Having a clear defined strategy allows the trader to focus on execution, having already developed the necessary trading rules in advance. We recommend you do the same. This article will be focusing on indicators and optimization when developing systems. Another important factor is combining of various indicators and criteria to making a winning system. This article deals with the foundation of a good system - the indicators used and optimizing them properly.
Start With Indicators
Just like execution, the process used in the formulation of a new trading system, should be standardized. This way, traders don't find themselves wanting a system or indicator to work and letting that skew their conclusions. For the purposes of this discussion, we are assuming you are using software to conduct your tests such as TradeStation or MetaStock.
Your first step is to decide which indicators you will use for your system (example: MACD, or Moving Averages). How do you know what indicators to use? For beginners, and even experienced traders, I recommended testing individual indicators by themselves. Beginners should test indicators for obvious reasons (because they don't know what works and what doesn't). Experienced traders should test basic indicators because they need to make sure that the indicators they were using 5 years ago still work. You cannot simply say that you think an indicator works well, you have prove to yourself via testing and the use of logic.
Once a good trader tests his indicators, he/she will get a feel for what a good indicator is. A good rule of thumb is this: when you test an indicator over a stock list multiply the average win/loss ratio (size of winners vs. size of losers) by the average percentage of winners. If the product is 1 or greater, this is a good sign. Compared to a coin flip, an indicator or strategy with a 1 reading is twice as effective a stock-picking tool.
Optimizing
Optimizing is crucial when it comes to developing a trading strategy. For those of you not familiar with optimizing, it is the process by which the computer tests various settings for an indicator to find the best setting. Let's use an example. Let's say you are testing, for a bullish system and you are looking at stocks crossing over a moving average. The optimizing tool can look over the last 20 years (or more) and figure out what length moving average is the most effective for a specific security over specific time frame. What a useful feature! With optimization, one needn't wonder what length moving average to use. One can simply test it. But just because optimizing suggests that a 10-day moving average was the best length to use for the SPYders in the 1990s doesn't mean that it will work well for agricultural stocks in the 2000s or gold commodity in this decade.
Here is one good way to optimize: Assemble a random list of at least 9 stocks. Again, let's use moving averages for our example. For the 9 stocks you might get these optimal lengths for the moving average line (20, 19, 18, 17, 17, 16, 15, 13, 12,). The best optimal length is typically the middle value, which is the median, 17. So now you have an optimal length for your new moving average crossover system! Test this system across at least 30 stocks (different from the 9 stocks) to figure out how effective the system is. Remember, we are looking for at least one in the ratio we mentioned earlier.
The System Itself
Your next step is developing a trading system. It might be comprised of one indicator or a combination of many more. We recommend using whatever yields the highest ratio and one that you feel is repeatable amongst the universe of all stocks/ETFs, etc. The key here is to ask yourself this question as you decide on which system to use: "What criteria must be satisfied for me to adopt a new system?".
The reason why we say that we are looking for the ratio to be above 1, is because we want our system's decision to be objective. As a comparison, many companies do not define the characteristics of a CFO when they decide to hire one. Instead, they usually fall in love with someone, hire him or her and find out later that the person they hired is great, but doesn't meet any of the necessary criteria. The point is, the decision should be made in advance to keep you from falling in love with just any system. It has to have the numbers you are looking for. For example:
* What is the minimum "percentage profitable" that you are looking for?
* What is the minimum win to loss average you are willing to accept?
Once you develop a system that fits your criteria and not the other way around, you are ready to trade and make money. Follow these steps, and you'll be on your way to profitability.
Trade Smarter!
Price Headley, CFA, CMT - Founder, BigTrends.com