Innumeracy

John Allen Paulos is his book Innumeracy writes:

Some would-be advisor puts a logo on some fancy stationery and sends out 32,000 letters to potential investors in a stock letter. The letters tell of his company's elaborate computer model, his financial expertise and inside contacts. In 16,000 of these letters he predicts the index will rise, and in the other 16,000 he predicts a decline. No matter whether the index rises or falls, a follow-up letter is sent, but only to the 16,000 people who initially received the correct "prediction." To 8,000 of them, a rise is predicted for the next week; to the other 8,000, a decline. Whatever happens now, 8,000 people will have received two correct predictions. Again, to those 8,000 people only, letters are sent concerning the index's performance the following week: 4,000 predicting a rise; 4,000 a decline. Whatever the outcome, 4,000 people have now received three straight correct predictions. This is iterated a few more times, until 500 people have received six straight correct "predictions." These 500 people are now reminded of this and told that in order to continue to receive this valuable information for the seventh week they must each contribute $500. If they all pay, that's $250,000 for our advisor. If this is done knowingly and with intent to defraud, this is an illegal con game. Yet it's considered acceptable if it's done unknowingly by earnest but ignorant publishers of stock newsletters, or by practitioners of quack medicine, or by television evangelists. There's always enough random success to justify almost anything to someone who wants to believe.

This is a great example showing how unsuspecting (& hopeful) people can be swayed into believing that a guru has magical predictive powers. It happens all the time.

Read Bestselling Book Trend Following and visit the Trend Following Blog at Michael Covel

Is Trading Style Hard-Wired?

Perhaps the most common assumption made by traders and trading psychologists alike is that people are capable of adapting to any market or trading methodology.

An increasing body of knowledge, however, suggests that many of the personality factors that affect decision-making under conditions of risk and uncertainty are hard-wired. Brain scans, for instance, predict who will be risk takers in gambling situations and who will be risk-averse. As one researcher bluntly puts it, "Brain activity predicts behavior."

A key element in decision-making is the brain's reactivity to loss vs. gain in decision-making. When the brain responds much more to loss than gain, individuals are far more likely to be averse to gambling. When the brain's "reward centers" respond to winning about as much as losing, the result is risk-seeking behavior. Interestingly, the brain areas that respond to winning money are the same as those that respond to cocaine or chocolate. This helps to account for the frequency of addictive behavior among gamblers--and traders.

Such individuals are not only risk-seeking, but stimulation-seeking. They have a low tolerance for boredom and use risky behavior to generate interest in their environment. Research suggests that easily bored individuals are more prone to depression and addiction than other people. Easily bored people also tend to have lower attention spans than others, increasing the odds of impulsive behavior. Such individuals would have particular difficulty adhering to trading plans and discipline.

Different brain mechanisms have been found to mediate risk-taking and risk-aversion in financial situations. A particularly interesting finding is that the dopamine reward center kicks in about two seconds prior to making a risky decision. Conversely, a brain center that is responsible for emotions of anxiety and repulsion is activated prior to suboptimal, risk-averse decisions.

We have no problem with the notion that some individuals are born with physiques that enable them to be successful in athletic contests. It is more controversial, however, to assert that some of us may be born with greater ability to make rational financial decisions than others. And there may be people with brain processes and psychological makeups who should avoid trading as assiduously as they might avoid cocaine.

It's nice to think that any trader can trade any market or methodology. The reality, however, is that we seem to be hard-wired to prefer certain levels of risk and stimulation. It may be more effective to fit trading methods to individuals than to hope to overcome hard wiring and teach a particular style to all traders.

Mechanical Trading Systems

Before we define a mechanical trading system it's best to understand fully the concept of a trading system:

What is a Trading System?

Trading systems are defined by a common set of rules which encapsulate all buy and sell (entry and exit) trading decisions. All trades executed following these common rules belong to the trading system.

This is easy to follow with the help of an example.

John has a share portfolio which consists of some Blue Chip shares and some smaller Speculative Shares. Even with this classification John has two distinct Trading Systems,“Blue Chip Shares” and “Speculative Shares”. Imagine the flexibility and analysis capabilities obtained by managing each trading system independent of the other!

In the example above, John could split his share portfolio into as many trading systems as he likes. Remember, you can create as many trading systems as you like, defined by an unlimited number of rules.

For example, John uses a rule that he will buy shares in all companies which have a PE ratio below 10 and volume turnover of more than $15,000,000 per day. John creates a trading system called “LowPEHighTurnover” to manage all his investments.

All future trades that John makes based upon his rules will belong to the "LowPEHighTurnover" Trading System. To extend this concept even further you can get creative and set up numerous trading systems which are independent of each another.

The benefit of creating trading systems is the high level of control and analysis capabilities which it provides. Having numerous Trading Systems is only beneficial when you have the right tools to help you with the analysis process.

What is a Mechanical Trading System?

A more advanced concept of trading systems is that of mechanical trading systems. Mechanical trading systems are designed to be totally mechanical in nature. A mechanical trading system executed correctly will exclude the undue influences of emotion, which can hinder the performance of many traders.

Human emotion is one of the most complex and hard to control areas of trading. No trader or investor has been able to conquer the market without first controlling their emotions.

Mechanical trading systems are defined by a distinct set of rules which instruct the trader what should be done and when to do it (entry timing and exit timing). It provides a signal when the trader should enter a trade and when the trader should exit a trade.

As the rules of a mechanical trading system are clearly defined, we can backtest the mechanical trading system over historical data. Backtesting is important to provide confidence that your mechanical trading system will be profitable. Backtesting is required before you undertake to commit any capital to a mechanical trading system. The results obtained from backtesting will provide an indication of the system's profitability, sustainability and highlight the characteristics of the system to illustrate how it will behave in a real life trading situation.

When performed correctly, backtesing is the closest we can get to determining the sustainability of a mechanical trading system without actually risking any money. Backtesting provides an easy way to gain confidence regarding the profitability of the system before you make the decision to commit your hard earned money to trading it.

Mechanical trading systems can be defined as a method of generating trading signals and quantifying risk independent of a trader's discretion. Although the advantages of utilising a mechanical trading system are many, most market participants agree that their greatest benefit is the tempering of destructive emotions, considered the enemy of all successful traders, from the decision making process.

Types of Mechanical Trading Systems

Mechanical trading systems which primarily use price data (high, open, low, close and volume) to derive trading signals can be classed as being either trend following or reversal based.

Trend following and reversal based trading systems have distinctly different characteristics.

Their characteristics will influence which type of trading system you decide to trade or design. The frequency and duration of trades signaled by either system are amongst the common differences between these two trading system types.

Trend following trading systems:

Trend following trading systems try to capitalise upon an established trend in the price of the security. For this reason, trend following systems tend to be traded over a longer time horizon than a reversal system.

When compared directly to a reversal system, the duration of the trades in a trend following system are distinctly longer and the number of trades taken by the system is less.

Trend following systems are most suited to be traded for long term gains as the capital and time requirement for this type of system is less than a reversal system.

Reversal systems:

Reversal systems on the other hand try to identify a change in the direction of a security and capitalise upon this change in direction.

Reversal systems anticipate a change in direction of a security and as a result will signal more trades on average than a trend following system. The increased number of trades is compensated by a shorter trade duration.

Reversal systems are most suited to traders who wish to be more active in the market. The potential for short term gains is high however reversal systems require more discipline and time to trade correctly.

Backtesting your trading system

What is going to give you the confidence to start trading your hard earned money on your trading system idea?

Any wise investor will do as much testing as possible before starting to trade a system with real money.The best option is to backtest the idea over historical data to determine how well it would have performed over that set of data.

Interpreting these results will provide you with sufficient information to assess the potential of the trading system.

When backtesting, your aim should be to replicate real life as close as possible. This means a proper backtest will need to effectively go back in time and start trading your mechanical trading system moving forward to the end of the data set.

So, how do we go about doing this?

In today's technological world, you can use the power of computers to complete the backtesting for you, to do this you will need:

1. A computer.
2. Backtesting software.
3. Historical data.

The only other alternative is to perform a manual backtest. This is not only time consuming but very hard to replicate and test variations of your mechanical system.

In other words, you should automate the backtesting process.

So long as your mechanical trading system works with just price data (open, high, low, close, volume) you will be able to utilise backtesting software to perform the test.

It will be no use backtesting, if your historical data does not enable you to test your idea. For example, you create a mechanical trading system with the following buy rule:

Purchase the share when the 10 day moving average of the close crosses above the 50 day moving average of the close.

The rule above can be tested quite comfortably over historical data which contains only price data. If, on the other hand your buy signal rule was a little more complex as detailed below:

Purchase the share when the 10 day moving average of the close crosses above the 50 day moving average of the close and the price to earnings ratio was 80% or lower than its value 4 months prior.

This rule is very complex as it introduces data which is not often supplied or maintained in a database of price information.

To successfully backtest this would involve obtaining historical data of the close as well as the price to earnings ratio (PE ratio). Obtaining historical information on a group of equities would normally consist of only the open, high, low, close and volume for each period.

Because of this limitation many mechanical trading systems are designed around purely technical indicators and rules based around only the open, high, low, close and volume information (price information).

Any mechanical trading system designed around fundamental data is really beyond the scope of retail investors due to the lack of historical data available to conduct a complete backtest.

With this in mind, remember that backtesting is not compulsory. You can start trading your own mechanical trading system without completing backtesting, it is a high risk strategy which is not advised.

Read on to learn more about the backtesting process.

With advances in technology, a wide range of trading system backtesting software is available. The benefits obtained from backtesting software cannot be underestimated. It will save you time and provide an endless opportunity to fine tune and test variations of your ideas.

A small outlay in capital to purchase good backtesting software will potentially save you thousands in the market if you have not backtested your ideas properly, it's a very wise investment if you are considering designing a mechanical trading system.

This is a quick guide to highlight some of the items which you should keep in mind when searching for backtesting software.

What backtesting methodology does it employ?

Sounds like a really complicated question, but it's not. Always remember that backtesting software should represent real life as closely as possible when it performs the test.

This way, you will have more confidence in the results. Never forget it will be your hard earned money on the line when you start trading for real!

“Real life” simply means that as we trade in our everyday lives we can make trades as much as our capital will allow.

For example, suppose you have two backtesting software applications, one of them performed the backtest by going back in time and starting from the start of the data moving forward one day at a time. The other started from today and worked its way backwards.

Which one of these represents real life the closest? Of course the first one is the obvious choice.

You should always ask the following questions about the backtesting methodology which the software employs:

1. Does the test move forward from the start of the data and step through each period of that data?
2. Does the backtest software monitor my money available for each trade and not trade if there is no money?
3. Does the software stop the test when I run out of money? In other terms does the test continue after you experienced negative equity. Remember in real life you cannot continue to trade if you have no money left.

Is the backtest software dependant upon any other software?

You need to find out if the backtesting software is dependent upon you owning another piece of software in order for it to run.

This is not necessarily a bad thing as the software may be utilising functionality from another piece of software which is superior in the industry. It is not necessarily a bad thing for the backtesting software to rely upon another piece of software, in fact, it may make the backtesting software better as the programmers and designers have had more time to concentrate on the backtesting functionality of their program with minimal time needed to be spent on the functions which the other software performs.

If you are required to own another piece of software you will be best advised to investigate that software application first.

What kind of data does it accept?

All backtesting software will require the use of data in order for it to perform its backtest.

Even when the data only consists of open, high, low, close and volume information, the software application may rely upon a certain format. Make sure the data you have or are wishing to obtain is fully compatible with the backtesting software.

Will it backtest leveraged instruments?

People will design and create mechanical trading systems for all types of instruments. The most common will be a normal share.

What if you designed a mechanical trading system for a leveraged instrument? You will need to backtest your idea using the correct leverage settings for the instrument.

If you think you will be in a position to design a trading system for leveraged instruments then you need to make sure the backtesting software caters for those instruments.

Is there a limit to the number of instruments that can be backtested?

If you design a trading system for a universe of 1,000 stocks you will need to make sure the backtesting software can cater for the large number of stocks (items) required for the backtest.

We have known some backtesting software to be limited to a maximum number of items, this is an area for concern as it puts a caveat on the backtest results and on the design of the mechanical trading system.

Make sure you can run the backtest on a limitless number of items.

Backtest results, what should I expect?

Once you have performed a backtest you will begin to analyse the results. The results you obtain from the backtesting software should be comprehensive enough to give you a clear indication of the potential of your system.

Expect nothing more than an absolute abundance of statistics and graphs to illustrate the results of your trading system.

When it comes to trading system performance data, the more the better. The more statistics and graphs you can analyse will enable you to tune and tweak you trading system enabling you to create a more powerful system which you can have confidence trading in real life.

In addition to backtesting results you will need to have the same level of detail and sophistication when you start trading your system in real life, this is where Stator - Advanced Finance Management takes over.

Remember, the more statistics the better.

Make sure the backtest recognises your account capital as it moves forward in time.

In real life you start trading with a set amount of money (capital).

If you trade this amount of capital and run out of money after one year, you can't continue. It's a simple equation, running out of money means you can't continue trading.

Make sure the backtest follows this same real life scenario, as it will be no use having ten years worth of results when your account capital reached negative figures after only one year.

In real life this event would have forced you to stop trading.

Make sure the backtest allows the use of money management.

Make sure you can play around with various money management (position sizing) models when performing the backtest.

Money management can dramatically change the results of any trading system. Having the ability to adjust your position size based upon risk is a very powerful concept which can dramatically improve the results of any trading system.

We highly recommend being able to adjust position sizing when performing a backtest.

For more information about various money management models and position sizing click here.

Understand what language the backtesting software speaks.

Computers do only what humans instruct them to do.

When you design a trading system, you want to have no limitations on the ideas which you can test. Any good backtesting software will be controlled by some programming language, make sure this language is as flexible as possible.

You will find some backtesting software uses established programming languages and others have their own programming language, either way make sure this language offers a wide range of options and flexibility.

The more flexible the programming language, the more creative your trading system can be.

Some points to bear in mind when backtesting

We previously made mention that backtesting should be designed to mimic real life as close as possible.

The following points are issues which you need to be aware of when performing any trading system backtest.

Ensure you have clean historical data.

When preparing to perform a backtest you need to ensure you have clean data. Make sure the data is correct (adjusted for splits etc) and contains the exact universe of stocks you wish to backtest.

For example, if you have designed a mechanical trading system which you wish to backtest on the Australian S&P ASX 200, your data will have to comprise of stocks which make up the S&P ASX 200 index.

Good, clean data is crucial to a proper backtest. Make sure you obtain good quality data for your backtest.

Setup is everything.

These days, running a backtest simulation will not take long at all. Be careful however that you check all the settings before you run the backtest.

It's also advisable that when the backtest is complete you re-check the settings.

If the results are too good to be true then they probably are.

You won't be the first person to backtest various trading system ideas. Many beginners fall into the trap of running a backtest and getting carried away with results which are too good to be true.

Whenever you get results which just seem too good, take the time to check and re-check your code.

Make sure you have programmed the system to represent real life and some common areas to check may be:

1 . Your entry is looking into the future. (can't do this in real life)
2 . You enter a position on the open however part of your entry criteria is the close of this same day. (can't do this in real life)
3 . You use an indicator which uses future periods to determine its value (zig zag indicator is a perfect example)

The real motto with this tip is to check and re-check your code to validate that it's representative of real life.

Searching for the Holy Grail is pointless.

Sooner or later you will find yourself testing ideas in the hope of stumbling across that magic secret which will unlock the market and all its profits.

This won't be the case, you will never create a trading system which has a 100% success rate. Many have tried and many have failed.

The Holy Grail does not exist.

You should be looking for a good trading system with minimal draw-down (the maximum equity during the trading systems life) and a good reward risk ratio.

Many trading systems have more losing trades than they do winning and the system still makes money. A perfect example are trend-trading systems made famous by the Turtle Traders, this system only had ~40% winning trades.

Successful Traders are Goal-Oriented, Disciplined, and Ambitious People

by Adrienne Toghraie, Trader’s Coach

“What brings you joy?" The answer should just pop out. After all, successful investors and traders are highly goal-oriented, disciplined, and ambitious people. How can you have such qualities in abundance and not know what makes you happy? Yet, strangely enough, a fair number of people cannot answer.

“Okay Adrienne" you say. “Suppose I’m one of those people who doesn’t know what brings them joy…What does that have to do with making money in the markets?" If you do not know what brings you joy, you are very likely not going to be able to sustain a long and successful career.

#The things that bring you joy can sustain you when things go badly.

When you are having a bad day, when you have experienced a serious trading loss, when you are feeling sad because a close friend has died, when your son wrecks your car, or when you begin to question what life is all about, you need to have things in your life that bring you joy. And you need to know immediately what they are so that you can call upon them to remind you that life is still good even when some things about it are going badly.

#The things that bring you joy can give you a reason to succeed.

I know a number of people who gave up successful careers in the markets because they had no reason to be successful. There was nothing in their lives that they wanted to support, to nurture, and to see to completion.

#The things that bring you joy give you the energy, enthusiasm and perseverance to keep going.

Joy is the juice in your veins, the lift in your step, and the air under your wings. It’s what keeps you working on that system and finding the answer to that nagging problem.

#The things that bring you joy combat depression and pessimism.

Negative emotional states can cause a trader to miss trading signals and lose opportunities. Pessimism can result in depression, or deepen and extend a depression. Depression can put a rapid end to a trading career.

#The things that bring you joy make you a joy to be around.

A spouse who sees you only when you are feeling joyless can begin to feel that you are a liability in life. He or she may need to fill life with the company of those who make life happy and pleasant. After all, don’t you want to be around people who are happy and can make you smile and laugh? A good and supportive marriage is one of the most important assets a trader can possibly have.

#The things that bring you joy help you to think more creatively and more clearly.

Imagination works much better when the mind is at peace than it does when it is filled with miserable and obsessive thoughts. Great ideas and insights are more likely to come in moments of joy than when the mind is in turmoil. Opportunities seem to abound when you are happy and positive. The same opportunities will be difficult to see when you are mired in pessimism. The most successful investors and traders are able to use their intuition in making decisions. Intuition is available only when your mind is at peace.

#The things that bring you joy allow you to feel more joy in the things that normally do not bring you joy.

When you are able to feel joy in one area, there is a spillover effect into other areas of your life, just as there is a spillover effect when you are feeling angry, pessimistic and upset.

Recently I worked with a client who began our session together with a long series of sad stories and laments. Clearly, Charles’ life had not been going well for a long time. His wife had left him, children avoided him and he had given up his trading career as a successful money manager. Charles was living with close friends who tried to encourage him to get on with his life and who recommended he call me.

When I talked with him, Charles sounded hopeless. I asked him what brought him joy in his life; he hesitated and barked at me, “What relevance does joy have in this conversation?" Did I not understand that there was no joy left in his life? But I was undeterred. Yes, joy was the central issue for Charles. If he had nothing that brought him joy, it was unlikely that he would have an anchor to keep him from drifting further away from a successful life. Without something that brought him joy, I would have a hard time giving him a reason to succeed. Without a font of joy, I could not squeeze out any excitement, energy or enthusiasm for the rigours of putting his life back together.

When Charles and I got together for private work I pressed him to go back to times in his life when he was doing things that made him happy. It turned out that he had loved to play the saxophone when he was at school. He had also loved to read historical novels, especially ones about submariners in World War II. In his childhood he had lived in Connecticut and had loved camping in the woods. As we progressed, he began to discover that there were many, many things that had once brought him joy that he had slowly abandoned or forgotten. I convinced Charles to spend time walking through the beautiful North Carolina forests near his home, dusting off his old saxophone and starting to play it again, and going to the library to find some of the newer historical novels and accounts from World War II.

Without any conscious thought, Charles began to find a new energy and passion for getting back into the trading game. When they saw his new sense of his own worthiness, associates who knew his ability as a money manager were eager to invest their capital with him. He is now earning money for his clients and has made positive steps to change his whole life. When I saw him several days ago, he had a bounce in his step, he was dressed like a winner, and he was filled with a sense of optimism. Charles is well on the way to recovering success and happiness. The lesson for him was that if he had allowed himself to do the things that created joy in his life, he would not have reached the bottom.

If, like Charles, you cannot say what brings you joy in life, then you too can look back to the days when you were carefree and spent time doing the things that made you happy. As you begin to list them, you will discover that the list will expand rapidly. Choose three simple things you would like to add back into your life, and then go for it. You will be amazed at the spillover effect on your work in the markets.

If you can figure out what brings you joy, then you can focus your thoughts and energy on those things in your life. The resulting positive energy will, in turn, seep into the rest of your life, including your investing and trading, and will open up new opportunities for success.

The mine field

The second set of circumstances that creates an environment for ‘heart and mastery’ comes from those who overcome tremendous adversity. Having what it takes to conquer exceptionally difficult circumstances gives you the endurance to conquer yourself and to achieve mastery.

Enter Sea Biscuit

The movie, Sea Biscuit, is a true story about how several people and one horse combined their efforts to create a champion. To make this happen they had to be in the right place at the right time, experience wonderful triumphs, face great difficulties and make unusually risky choices. All of them faced great adversity and each of them developed the ‘heart’ of a winner.

They also had the gift of being able to recognise the ‘heart’ in each other. The horse’s owner lost his son in an accident that he blamed himself for. He also lost his wife because she blamed him, too. He needed an opportunity to overcome his sadness and guilt. The trainer, who was living from hand to mouth, needed someone to recognise his special talent for connecting with animals. He was presented with an opportunity to train a horse of his choice.

As a teen, the jockey had to leave his family because they could no longer afford to support him. He longed for the opportunity to prove that he was the special person that his father wanted him to be. Of course, there was Sea Biscuit. The horse needed an environment of nurturing to show his breeding, talent and ability to be a winner. Sea Biscuit was the ultimate of what ‘heart’ can do for the soul of man. His triumph brought a nation together after the bitter days of the Great Depression by giving people hope for the future.

There are many people throughout history who have overcome great odds and adversity in their quest for greatness. Some people with ‘heart’ are:

• Dr. Milton Erickson, who in spite of polio became the greatest hypnotherapist of all time.
• Tiger Woods, who in spite of the race barrier became one of the greatest golfers of all time.
• Lance Armstrong, who in spite of cancer in his lungs and brain won the Tour de France five times in a row Thomas Edison, who was sent home from school because the teachers said he was too stupid to learn anything, but became one of the greatest inventors in history.
• Benjamin Franklin was the fifteenth of seventeen children of a poor candle maker. His first obstacle was that he had only one year of schooling. He went on to teach himself philosophy, four languages, the classics, writing for publication, science, finance, politics, diplomacy – to become one of the best educated and greatest Americans.
• Annette Kellerman was a sickly and lame woman who became the World Diving Champion and was judged the world’s most perfectly formed woman.

In the ‘rags to riches’ stories that I have collected over the years, there are a few that I think about when I go through a challenging time in my own life. One that stands out is the story of a trader named Roger. He was born into a family that had a difficult time keeping food on the table and a roof over their heads. His father was in a wheelchair and took care of the three children at home. His mother, who had very little education, worked in a candy factory production line. Roger did what he could as the oldest son to help support the family by becoming a paperboy and doing other odd jobs. Since he was unable to finish high school, he thought that he was destined to do blue collar work for the rest of his days. Until the day that changed his life.

Roger was in the habit of doing good deeds for people because he saw his father and mother help others despite their difficulties. He learned from a very young age that good deeds gave you good feelings. With all of the sad moments in his life, he longed for good feelings. So he looked for opportunities to help others.

Roger was working as a maintenance man in an office building in Chicago. One day he found a briefcase filled with important and valuable items, such as contracts and certificates, in the restroom. An executive at the Chicago Board Options Exchange had hurriedly left it there. Roger returned it intact and the man wanted to reward him for his honesty. The man was impressed with Roger and asked about his life. He wanted to know how a good-looking, honourable young man was cleaning buildings for a living.

After Roger told him about his life the man offered him a job as a runner at the CBOE. Runner led to trader, trader led to super trader and super trader was able to send his brothers and sister to school and give his parents a more comfortable life.

While Roger seemed to have been given his break when he became a runner, his training for becoming a trader started from overcoming his difficult life and recognising the value of good deeds.

True grit

Yes, there is opportunity for creating ‘heart’ beyond adversity and being born into it. This third set of circumstances is for those who:

• set their sights on a goal for mastery with tasks that are developed out of a good plan
• seek out good models and mentors.
• develop the discipline necessary to follow good rules consistently.
• create a nurturing supportive environment.
• become a constant student of the markets.
• balance all areas of life to support mastery.
• handle psychological issues that create sabotage.
• work with a success coach.
• become a mentor to others.

Suzy was a woman who sought out what she wanted and did whatever it took to be the best she could be. She was a high achiever in school and in the corporate world. Then she became a top multi-level marketing consultant while creating a nurturing home for her family. Suzy’s husband was looking for a new career after retirement and in the process, he and Suzy both became interested in trading. She transferred the experience of her multi-marketing skills into becoming successful as a trader. Working side by side with her husband and using the same formula for success, Suzy blossomed into becoming a master trader while her husband developed into a good trader.

The fact is that with the right formula those with the ‘heart of a trader’ will blossom while others will only be ‘good’.

Stray bullet of greatness

There is another form of greatness. There are those people who, in the process of seeking out one form of success, achieve another.

One of the most talented people that I know in the financial field has written several best selling financial books. He is an exceptional trading teacher and has developed several profitable trading systems. He is one of the best in the world at analysing markets. The only problem is that his target was to become a great trader and that success has eluded him. He has solved the problem by having someone else pull the trigger on trades for him. While he has experienced the rewards of greatness, there is a part of him that would give it all up to become a great trader.

Conclusion

I believe that the ‘Heart of a Trader’ can be developed. Yes, it is easier for some because of their experiences and resources, but even the best of traders may not reach their top performance if they do not follow a good model. The fortunate thing about working on becoming a great trader is that there is always more than one winner. Even if you only become a ‘good’ trader, in trading “Good ain’t bad."

Adrienne Toghraie, Trader’s Coach, has lectured and coached some of the most successful people around the world, and has published eight books on the psychology of trading

Back testing

From Traderpedia

Definition: Testing a strategy on historical data in order to see if it would have been profitable.

Contents [hide] 1 What is a backtest? 2 The data mining problem 2.1 How to combat the data mining problem 3 Results of a backtest

What is a backtest?

A backtest is a simulation of how a trader with a mechanical trading system would have responded to market data, i.e by buying, selling, or forgoing any transaction at all. Backtesting is a way of testing the signals given by a trading system in order to see whether it would have been profitable in the past.

As with any simulation, the more realistic the backtest, the more useful it is. Obviously, the goal of any trader is to maximize return after slippage and transaction costs (while avoiding unnecessary risk) and these costs should of course be included in the test.

The data mining problem

Just because a strategy would have worked in the past had a traderstumbled upon it does not necessarily mean it is reasonable to think it will continue to work in the future. The Super Bowl Indicator (NFC team wins, market goes up) and the hemline indicator (skirts long, sell short) are obvious examples, but don't be lulled into thinking that any strategy based on more sensible criteria is sure to work. Backtesters must be careful to avoid hyping results based on a limited set of data. There may be something special about the data the backtester used (e.g., it's all January data) that causes anomalous results. Or the results may simply have been caused by chance.

Data mining is even more of a hazard as backtesters use new programming techniques and greater computer horsepower. "Genetic algorithms" sometimes spit out eye-popping numbers when using historical data. It remains to be seen whether these algorithms actually help predict anything. As O'Shaugnessy said in What Works on Wall Street, "Torture the data enough and it will confess to anything."

How to combat the data mining problem

There are three primary ways to combat data mining.

The most obvious is to view with suspicion results that contradict common sense or other well-designed studies.

The second way to avoid data mining is to divide the available historical data into a "play" set and a "confirmation" set. Use the play set to experiment with, and then see if the confirmation set confirms your hypothesis. For example, if you had 5 years of data at your disposal to test an intra-day system, you might have a play set of 24 randomly selected months and a confirmation set of 24 different months. This method is almost sure to tell you whether you are really eliminating problem children or just trying too hard. If you do not have fairly large set of data to start with, you cannot use this technique. Be very cautious in interpreting your results.

The third way is to avoid over-optimising or "curve fitting" your system. By this I mean continually tweaking and adding parameters in ordre to increase the overall profitability. Do this to excess and you are likely to end up with a brilliant system for the period of time under scrutiny, but one that fails miserably as market conditions change. The best systems tend to be fairly simple.

Results of a backtest

Here are the questions most traders want a backtest to answer before putting money into a trading system:

• Does the system provide returns that are significantly better than an appropriate benchmark?
• What is the maximum drawdown of the system?
• Is the system realistic in terms of slippage costs?
• How many trades per year are necessary for the system?
• How long is the typical position kept open in the system?
• What is the ratio of the average winner to the average loser (the profit/loss ratio)?
• What is the ratio of winning to losing trades (the win/loss ratio)?
• What is the maximum adverse excursion?
• What is the system's expected value?
• What are the characteristics of the system's equity curve?
• Is it realistic to assume an entry and exit could always be made when indicated?