WHY TRADING SYSTEMS FAIL
There are a number of reasons why successfully daytrading stocks/currencies/futures is so difficult. The vast majority of daytraders lose money. That’s the Bad news. However, the Good News is that studying and practicing pays off. Since there are far less winning traders than losing ones, by being in the winning minority, you will be in a position to receive good returns on your investment because of the leverages involved with trading stocks, currencies and futures.
The trading system promise:
What is the promise of a trading system? Quite simply it’s the promise of automating your trading. The promise that a computer can do the trading for your while you are sipping tropical drinks on some island. What’s wrong with that? Everything. The belief in this promise makes traders shell out hundreds (thousands in some cases) on day trading courses or daytrading systems or daytrading recommendations from some websites. A trader chasing this dream of automating the daytrading ends up losing first losing money on these courses/systems and later in the actual trading itself.
The truth behind trading system developers and ‘daytrading teachers’:
The trading system peddlers stop short of saying you can relax on a tropical island while the trading system trades and makes profit for you. Many many traders fall for this nonsense since the allure of automated daytrading is too good to pass. They forget to ask a simple question: If you have such a tool why are you selling it for $30? If such a tool were to exist, you can be sure that nobody will be selling it for $30 (or even $2500). Most of these ‘day-trading teachers’ peddling trading systems, day-trading workshops, or trade recommendation websites give out a lame excuse that they are doing it for the love of teaching or that they are philanthropists out there to change peoples lives.
Trading systems and curve fitting:
Typically a trading system peddler may claim 60%, 70%, 80%, or even 90% of winning trades. The fact they typically won’t reveal is that these numbers based on the on 20-20 hindsight. Eventually most trading systems boil down to some form of curve fitting. The system developer takes a look at the past data and then comes out with an equation or a set of rules (trading system) that shows profit in large % of trades.
Flaws in trading system testing:
Quite a few system developers develop a system by using say 10 yrs of data. Then they back test it over the next 10 years of historic data. They adjust their rules/system till it makes a high percentage of profitable trades over all of the 20 years. What’s wrong with this? Well, this is nothing but a curve fitting over 20 years instead of 10. Still no guarantees that this will work over next 1, 2 , 5 or 10 years.
A frequently ignored aspect of trading systems: Drawdowns
What is a drawdown? Let’s say you are investing $10,000 in currency trading. You trade for say1 year and at the end of the year let’s say your account balance is $30,000. Now before reaching the $30,000 figure at some point during the year you made some losing trades and your account balance was down to $8000. In this case you drawdown was 20%. Why this is important? It is extremely important since excessive draw downs can throw you out of the market and you may not be able to get in and trade at the same level till you add some more money to your account. So trading systems that claim success over 10 or 20 years might be hiding large draw downs that would have kicked out of market in the first place.
Types of trading systems:
Generally the trading systems can be divided into two types. Rule based trading systems and trading systems based on cycles (time/Elliott).
Rule based trading systems:
These trading systems are typically of the type, ‘if you see this do that’. For example such a trading system can be as simple as “buy an instrument at market open and sell at market close”. When tried over last 20 years and it produced 70% of winning trades.
Problem with this approach is that the draw downs may not be accounted for. Your account might reach 0 or –ve (throwing you out of market) before the system turns around and starts making profit. Or quite simply the system may not just work in the long or short term.
Trading systems based on rules and divergences:
Some systems are based on a divergences between price and a Stochastics or price and RSI. Problems is these divergence is very difficult to recognize in real-time trading, but easy to see with 20-20 hindsight looking at an old chart. For these reasons these systems that look very smart on paper may be difficult to use in practice.
Trading systems based on pivots/turning points:
Another popular approach for trading system development is to watch for turning points at certain times, also known as time-windows. This approach might appear to give entry/exit signals after an obvious pivot-low or pivot-high occurs, provided it occurs during the projected time-window. This type of system as before works very well on past data but difficult to implement real daytrading.
Trading systems based on Elliott waves:
Another popular and over-rated approach is trading systems based on Elliott-Waves. Elliott-Wave methods and trading systems are popular, because there are obviously waves in the markets that can be seen by anybody looking at a chart and the idea of using the market-waves to predict market turning-points and also riding these waves, is naturally very appealing to traders.
The truth is that Elliott Waves if used by themselves are of little value in actual trading. In case of most traders they are difficult to count. You typically will get 5 different wave counts when an identical chart is shown to 5 different traders.
Why is this? There are in fact “waves” in the markets. However, defining what constitutes a “wave” is near impossible. A wave is largely a matter of visual interpretation and judgment and is highly subjective.
So what’s the correct approach to daytrading?
Read the ‘6 steps to profitable daytrading’ article posted on this site and other articles on daytrading on this site. Do not expect to automate the trading by buying a piece of software or a trading system. Do not expect to get winning trade recommendations from a website or a person. Practice well with a good paper trading software/daytrading simulator. When ready to trade, trade only good trending markets that have reasonable amount of volatility. Read our article on money management and put it to use. Stay out markets that are either too volatile or are very sluggish. Use software that acts as your fishing pole rather than a fish. Understand that nobody can hand you a fish in the market. If somebody has it they won’t be selling it for $30 (or even for $2500).