The Trading Digest

In this post I am going to try and convey to you a concept that is so critical to system traders but so thoroughly misunderstood by many active traders. The problem that I continually face when I engage in conversation with other traders is that what they call a system is invariably an entry mechanism. Many of these are when some moving average, Fibonacci, overbought or oversold condition has been reached. These are obviously only a few of the many many more conditions that that this “trader” has seen on his charts that look so obviously profitable.

But are they profitable? As a backtester I can test concepts and see what in very general terms seems to “work”. But what of those people that don’t test? Do they know what “works”? Trust me I get emails from and this week met in my chatroom people that are doing things that I know do not work. As a matter of fact virtually all of the commonly held axioms of trading are dead wrong. How do I know? I’ve tested it. John who also writes for this blog has amazing programming skill which have allowed us to test more complex theory’s then I would have ever thought imaginable. So I know when I hear a “system” that does not work. But again they almost invariably mention the entry. Which leaves me shaking my head because having tested hundreds of thousands of concepts across millions of bars of data, entry is of no value when testing a system without exit logic.

When creating a system I need exit rules that will be applied across all of the data - entirely mechanical. I can give you a good example of something that happened in the chatroom of Thursday afternoon. The chatroom is mine and I have made it my goal to destroy the illusions of what works and try to reprogram people to look at the market in ways that do work. In a systematic type fashion. The reason most active traders under-perform the major indexes is because they are invariably doing things that don’t work. Anyway this visitor walked into the chatroom on Friday and said “watch this number on the qqqq 49.64″. The rest of the conversation between myself and Al went like this:

Me (dayvejohnson) : why?

12:20 Al just watch what happens when it hits and then short

12:21 dayvejohnson al silly comments like that sound stupid

12:21 Al why

12:21 dayvejohnson of course it could but whats the logic

12:21 dayvejohnson whats the trade

12:21 Al fib numbers

12:21 dayvejohnson well then its definitely nonsense

12:21 Al extentions

12:22 dayvejohnson because obviously you’ve never tested that

12:22 dayvejohnson when was the last signal?

12:23 dayvejohnson i’m trying to get people in this room to get rid of all the silly nonsense- and yet it still follows us

12:23 dayvejohnson in

12:24 Al sorry dave i don’t mean to be nonsense

12:24 dayvejohnson give me the rules for the fib system…i’ll test it for you

12:24 dayvejohnson guarantee it a loser……

12:24 dayvejohnson i’m just trying to keep things straight here

12:24 dayvejohnson ok?

12:25 Al I will see what happens when it hits the number then we will discuss it means anything

12:25 dayvejohnson it means nothing

12:25 Al what make so sure

12:25 dayvejohnson if the previous 100 occurances showed no edge and this one works how does that leave the people in the room?

12:26 Al i think its all about probabilities

12:27 dayvejohnson uhh ok

12:27 dayvejohnson so there is a probabilty of the trade working?

12:27 Al sure

12:27 dayvejohnson lol

12:27 Al nothing for sure

12:27 dayvejohnson what has your data shown

12:28 Al the data has proven to be good the last a few years

12:29 dayvejohnson what was the largest loser?

12:29 dayvejohnson so i can adjust my position size?

12:29 dayvejohnson avg holding period

12:29 dayvejohnson mae (max adverse excursion)

12:29 dayvejohnson mfe (max favorable excursion)

12:30 Al the beauty of it: loses are so small

12:30 dayvejohnson so whats the exit criteria?

12:31 Al i think we will hit the number today

12:31 dayvejohnson whats the exit again?

12:33 Al You can set your own exit plan according to your risk tolerance - (my interjection here - this is usually when things start to get fuzzy)

12:33 dayvejohnson so you have not really tested it

12:35 Al I sure did

12:36 Al nothing a 100%

12:36 dayvejohnson i know that i am a system designer

12:37 dayvejohnson what i am trying to get you to do is give me the parameters

12:37 dayvejohnson you see to say a number above us is a fib number means nothing

12:37 dayvejohnson whats the trade?

12:37 dayvejohnson your stop?

12:37 dayvejohnson your exit?

12:37 Al wow getting close

12:37 dayvejohnson the whole ball of wax

12:38 dayvejohnson because thats how you test a system

12:39 dayvejohnson do you see what i mean

12:39 dayvejohnson it has no more significance than me saying watch that 49.75 area

yellow area denotes Al’s magic area

So basically thats the conversation. Can you guys understand how useless what he stated was? It was not really “tested” because there is absolutely no exit logic. So what happened? Well we hit 49.68 late in the day on Friday. Now what? Is the trade closed end of day Friday? Is it stopped out because he said the beauty of the system is that it takes “small losses”? Did it already take a few cent profit? It could possibly be a fantastic system. But what is the system? What I am trying to convey here is I hear this baloney all the time. It is of zero value to me - ZERO. This sort of nonsense is rampant on message boards, chatrooms, and blogs.

I have challenged people in the room this week based on a variety of criteria they believe make a viable system. I can prove they are not. I am going to continue to do that. My lesson here is a system is not entry logic alone. Start to test those exits not based on when you think you would get out of the trade but based on a solid consistent set of rules. While in the trade whole bouquets of emotions can and do affect trading decisions

On my old blog I posted the signals for a swing trade system that I had tested in various market conditions over a variety of years. I posted these before the market opened with simple at the open market orders. In the year that I posted these we made 40%. Not bad. But the beauty of this is that before the test was started I posted what the average winner, average loser, and average holding period would be. At the end of the year those numbers were right on the nose. Amazing? How did I know? Because I had seen in backtesting over 250,000 trades and what they looked like through all trade conditions. Nothing magical but just basic standard deviation in price of the holding period I would be holding based on historical precedence. This is powerful stuff.

After dispelling many of these hokey “systems” I usually get asked “So what does work?” For now I will keep that part simple. The goal of this blog is to start covering the varying concepts that do work in very basic form. But what works is the opposite of conventional wisdom. I know thats so hard to grasp because it hits the core of many active traders belief systems. But it is without question why the vast majority of active traders underperform the major equity indexes.

So please feel free to stop in my chatroom. I have been posting my intraday trades for a particular system that is making major reversal calls. This system generally triggers about 2 signals per day. I trade this on both the SP futures as well as the Dow futures. This system is somewhat different than in the live videos I post but uses similar techniques as those. We had a great week trading and in the end I think many that were there have learned a bit having been there. So feel free to stop in but please leave your market myths at home. (the permanent link is the upper left hand part of the page)

Have a Great Night!

Dave Johnson

4 Responses to “Why Can’t People Grasp this Critical Component of a “System”?”

1. No B.S. Chat -- Move the Markets Says:
   July 16th, 2007 at 12:48 am

   [...] reading this post, I like where he is going with it. He is also posting calls for a futures system that he uses, and [...]

2. jkw Says:
   July 16th, 2007 at 2:58 pm

   I have a question related to backtesting. How do you model slippage? I’m trying to develop an intraday system for trading e-minis. My slippage model is to use the worst price for the 15 seconds after the order decision is made. This results in an average slippage of about 4-5 ticks per trade (2-3 per order). I have managed to develop lots of systems with about 2-4 ticks of profit average per trade, but with my slippage model I can’t manage to make anything consistently profitable. It seems likely that I am overestimating slippage, but I would rather overestimate it and throw out marginally profitable systems than underestimate it and start trading a marginally losing system.

3. Dave Says:
   July 18th, 2007 at 7:40 pm

   JKW:
   As I could write a book on this subject alone and delves into some rather technical parameters I will email you directly. You should here from me soon. So so busy….

4. George Says:
   July 18th, 2007 at 10:25 pm

   Hi Dave,
   May I ask what platform you use for back testing? TradeStation, eSignal, or something fancier?

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