A trading system is merely an approach to organizing facts and understanding relationships about markets. Presumably, the idea behind a trading system is to arrive at a series of steps which, generally translated, result in expectations based on if-then scenarios. It is presumed that by following the procedures and rules of a trading system which has been effectively back-tested, the trader will, assuming perfect adherence to the rules, produce profitable results. At the very least, it is hoped that the trader will stand a better chance of profiting through the use of a trading system than through the use of no system.
I have serious doubts about both assumptions. Here's why. A trading system is developed by imposing a hypothetical and artificial framework upon a set of data which has a considerable amount of built-in random behavior. The course of trading system development consists of trial and error until an effective combination of market indicators has been ascertained. These indicators, frequently combined with principles of risk management, purportedly indicate what would have happened historically had they been applied to the particular market or markets. In the vast majority of cases, the trading system themselves do not reveal any underlying truths or realities about the markets but rather reveal that a superficially imposed set of rules can result in acceptable results provided the two essential elements of all trading are contained within that system. And these two elements are the limitation of losses and the maximization of profits. In other words, extensive system testing reveals that the vast majority of trading systems produce results which are accurate 50 percent of the time or less. Trading systems which are correct 60 to 75 percent of the time are fairly rare, and those which are correct 70 percent of the time or more are extremely rare (assuming a reasonably large data sample). The lengthier the historical test, the less accurate the results. Statistically, this is called regression to the mean. Putting it in plain old-fashioned English, most trading systems don't work. And again, in plain old-fashioned English, trading systems which have the principles of risk management built into them increase the odds of success dramatically. The random walk hypothesis as proposed by Malkiel in his classic book A Random Walk
Down Wall Street (Norton, New York, 1973) poses a particularly cogent argument in opposition to system development. Malkiel's thesis is that the vast majority of market behavior is random, and hence, attempts to predict prices are essentially useless and moreover unprofitable. Although I don't fully agree with everything Malkiel has said in his classic book, I do believe that he has made some good points. I have long felt that traders who can consistently follow a rational, unoptimized method of trading and who can, at the same time, employ strict principles of risk management can, at the same time, employ strict principles of risk management can achieve profitable results, possibly equal to or greater than the results which may be achieved by rigid trading system followers. The essence of any trading system is not the system itself but rather its approach to risk management and the skill of the trader implementing that system.
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