Why Trade Systems?

I am often amazed at the unbelievable amount of worthless investment advice offered. The reason I say that is because the vast majority of advice offered seems to be nothing more than opinions based on little to no real scientific research. Its similar to the countless “cures” that you can find in health food stores. Nothing more than untested and unsubstantiated claims.

My opinion on this continues to get stronger and stronger over the years. I have tested countless methods that the authors purported to be “money makers” only to see the vast majority of these ideas being nearly worthless. Many of these authors are very respected and have well established followings. In some cases they have near celebrity status!

A good example of this is Chart Patterns. There is an entire industry built on chart patterns. Things such as triangles, pennants, rising wedges, trend lines etc etc. Unfortunately, if you ever try to code these patterns you will first find that patterns are extremely subjective. A hundred people looking at the same chart will see 100 different patterns. In addition, most “obvious” patterns are only obvious after they have confirmed themselves. This is nothing more than hindsight bias. When you put the rubber to the road and actually test many of these “chart patterns” they don’t hold up at all. I find the same true for things such as Gann Lines, Fibonacci numbers, Elliot wave, the list goes on and on.

Think about this, you wouldn’t put a powerful drug in your body that was not first rigorously tested in a scientific manner would you? Why would you expose your financial health to ideas that were not also rigorously tested in a scientific manner? It’s amazing the financial advice and "tips" people will take based on the flimsiest of evidence! This was hammered home recently with all the multimillion-dollar salaried Wall Street analysts who lost their investors billions. In some cases this was disingenuous advice, in other cases it was just stupid predictions based on untested theories about what “should” happen. "Looks like a cup and handle base"????

What I am suggesting is that the ideas you use should be ones that have gone through rigorous scientific analysis. Ideas that have been broken apart in hundreds if not thousands of different ways and then tested across thousands of different examples to see how they would have performed. Furthermore, trading good systems can help to reduce the psychological sabotage so prevalent when trading without a mechanized method. The demons of fear and greed and panic and euphoria can be kept in check better.

The following text was taken from a popular trading book, Decision Traps, by J. Edward Russo and Paul J.H. Schoemaker. In this book, nine different types of decisions were tested using three different decision methods. The accuracy of the decisions was then compared and analyzed for effectiveness in predicting final outcomes. The investigator looked at different types of decisions, predicting grades, predicting recovery from cancer, performance of life insurance salesmen, as well as predicting changes in stock prices. He used three different decision making processes: an Intuitive Prediction Model, a Subjective Linear Model, and an Objective Linear Model.

Decision Models

• Intuitive Model = Discretionary Trader
• Subjective Model = Technical Trader
• Objective Model = Systems Trader

Intuitive Prediction Model (Discretionary Trader)

Intuitive prediction is defined as making a decision without the use of any objective or quantifiable data. For instance, in trying to predict the academic performance of graduate students, the researches asked their advisors to do so without seeing their grades and just by talking to them. The decision-makers had to rely on their intuitive impressions and any other factors they thought relevant (how the student dressed, their language skills, grooming habits, etc.). This is the same way discretionary traders make trading decisions - using intuition and gut instinct. In predicting the stock prices, it is highly likely that the researcher engaged a discretionary trader to predict the future prices of stocks.

Subjective Linear Model (Technical Trader)

A Subjective Linear Model is a much more complex decision making process. It starts with the interviewing experts in a field and learning how they make decisions. The researcher literally asks the expert how he or she makes decisions and they respond by explaining how they make their predictions. Although these experts are not using quantifiable data, they have enough experience and knowledge in their field to be successful. This decision making process is then outlined by the researcher.

For instance, a physician, highly experienced in treating cancer, has probably become fairly adept at predicting the life expectancy of his patients, even without using any objective data.

The researcher interviewed the physician and attempted to determine exactly how the physician made this assessment. Then the researcher put this newly quantified data into a regression model and attempted to predict the life expectancy of cancer patients.

This is very similar to how a technical trader makes decisions. He goes to seminars and reads books to learn how the experts make decisions using technical indicators. He then takes what he learns and attempts to trade like he experts. In a sense, he does his own regression model of the expert's process to make trading decisions.

Objective Linear Model (System Trader)

For the Objective Linear Model, the researcher developed an objective model based on historical tests and observations to predict results. This is defining and using quantifiable data, running historical tests, and then using the results of the tests to predict future outcomes.

For instance, the researcher would look at reams of physical data from terminal ill patients, and correlate the data with how long the patient lived. After running the historical tests, the researcher would then obtain the physical data form cancer patient, and using the historical test data, attempt to predict how long that cancer patient will live.

This is exactly what a system trader does. He runs historical tests and then uses that data to take a position in the market. He uses objective quantifiable data tested historically to make his trading decisions. The following table shows the results of tests.

In every case, the Subjective Linear Model outperformed the Intuitive Prediction Model bit only by a small margin. If you look at predicting the changes in stock prices, the Subjective Linear Model only slightly outperformed the Intuitive Prediction Model.

The real insight from this study comes when we look at the results of the Objective Linear Model. In every case, the Objective Linear Model outperformed both the Intuitive Prediction model and the Subjective Linear Model. In some cases, the improvement was minor, and in others it was substantial. It is interesting to observe that the greatest improvement came when using the Objective Linear Model in predicting the changes in stock prices!

Hopefully I have caused you to think a little bit about using thoroughly researched systematic methods in your trading (if your not already). My nearly 12 years of computerized research has given me the opinion that roughly 90% of the methods in the public domain (books, seminars etc.) has little to no real value.

Unfortunately, many charlatans and snake oil salesmen have used the guise of computerized research to sell equally worthless creations. The real key is learning how to use the power of computerized research to develop robust trading systems without falling into the many possible traps including optimization.

All of our systems have been rigorously tested and researched in a manner that we feel would meet the standards of the most knowledgeable and successful system traders.

Feel free to email or contact us with any questions or comments on this subject. dhoffman@traderstech.net

A study by Harvard Business School professor John E. Lintner found that including futures in an investment portfolio "reduces volatility while enhancing return". And that such portfolios "have substantially less risk at every possible level of return than portfolios of only stocks or only stocks and bonds".


Source: www.traderstech.net