Refining Your Trading System

06/15/00 05:30:39 PM

by Jim Patterson

You spent a tremendous effort and energy devising trading strategies. Everthing was working fine unitl March, 2000 but then...

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To devise a trading system requires a lot of time and effort. You and your computers will be working for hours trying to find the magical combination that yields a profit. Then when you are confronted by a sudden reversal, such as the one experienced by the Nasdaq Composite after reaching its all-time high in March, 2000, suddenly your profit-yielding system is producing losses. What went wrong? Although answers to this question will vary and your situation is probably unique, there are a few common threads in all possible answers. I will touch on a few of them, which I hope will help you prepare for similar scenarios in the future.

First, does your system have an exit strategy to protect capital when the market gets tough? A really good system provides more than just entry points, it also has an exit strategy designed to protect trading capital. It will keep gains from becoming losses, and it won't let incredible gains become ho-hum gains. Is your system strong enough to handle the market conditions? If you put a solid effort into the design then it probably is. That brings on the next question: Did you follow your system? This is such a simple question but difficult for some traders to answer. If the answer is anything other than an unequivocal YES, then you are at fault. The good news is that you can readjust your trading habits and don't need to completely overhaul your system.

In a typical situation Trader X builds a short-term trading system. The system gives a buy signal on a stock and Trader X acts. Widgets R Us is looking good. As the hours and days pass, Trader X starts doing research on the company. The next thing you know Trader X is patting him or herself on the back. Not only for the profitable trade, but also for building a system that was able to find such a great company to trade. Months pass and everything is fine. There was one rough week when the system gave a sell signal, but the next day the signal reversed back to a buy. When the sell signal showed up Trader X took no action, just a couple of Rolaids. The market looked strong, and if the stock had closed a fraction of a point higher there would have been no sell signal. Then March and April come along. Widgets R Us gets crushed. After running from $30 to $145 in six months, the stock fell like a rock. Another sell signal is given by the system. A couple of Rolaids was all it took last time, but now the stock has fallen $10 below the exit price. More Rolaids and hang in there until the stock rallies back to the exit price. That never happens for Trader X.

The system did not fail. Instead, Trader X broke the system by making the mistake of not selling when the first sell signal emerged. The discipline of adhering strictly to a system is the most difficult aspect of trading. Keep in mind though, that when you design and test a system, there is no variable that takes into account random trades made outside of those generated by the system. So when a system is not strictly followed, you are the weak link in the whole process. This has nothing to do with you being a good or bad trader, but more to do with the fact that you have an opinion and independent mind. Unfortunately, I have seen too many individuals continually modify their system to suit their opinion.

I can't emphasize the importance of discipline often enough. The best way to teach yourself discipline is to think of your system as a commanding officer barking orders at you. When a certain price is reached, take the action that is alerted, no ifs, ands or buts. If it screams SELL, do it. If you don't, you will feel the pain.

The goal in trading is to avoid big losses. If you are using a sound strategy, the gains will come, they always do. We like to think that we are in this to make money, but the key to long-term success is protecting capital when markets move against you. Users of our system, Reggie on Wall Street, fared well during this period, except for those who failed to follow the system! If you stick with a sound system then you will survive.

Jim Patterson

Jim Patterson has been in the securities business for over 11 years. He has been publishing "Reggie on Wall Street", a daily short-term trading newsletter, for over two years. Jim also hosts a weekly internet radio show on www.voiceamerica.com, tune in Friday's at 11:00 AM EST

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