When first introduced to systems trading, a lack of knowledge and experience leaves many traders with limited options on which system to trade. As they expand their knowledge, these traders can soon become overwhelmed by the number of systems that are out there. Deciding which system is the best fit for a trader can require a tremendous amount of analysis, and many traders don’t consider all of the proper variables when making these decisions.
Many novice traders assume that the system with highest overall return is the best system. This is almost never the case, though. Many times, incredibly high returns are the product of a level of risk that most retail traders are not comfortable with. No amount of money is worth losing sleep over. The same case can be made for a system that either trades too often for the trader to keep up with, or not often enough to make any money.
When reviewing different trading systems, we want to consider their returns with respect to profitability, volatility, and risk. We also need to consider the frequency of their trading signals to make sure that all of the system’s components will mesh well with our personality.
Criteria for comparing trading systems
Profitability
The most commonly used profitability metric is Compounded Annual Growth Rate (CAGR). This takes the long term return of your system and averages it out as if it occurred in a straight line. Clearly, the fatal flaw here is that no system is capable of producing returns on a perfectly steady basis. However, CAGR does give us a convenient way to quickly compare systems. You will certainly want to dive deeper before investing real money!
Another interesting profitability metric is the number of winning trades, or the Win Ratio. This is simply a percent that measures how many of a system’s trades are winners versus how many are losers. The interesting thing about Win Ratio is that systems can be profitable overall with incredibly low Win Ratios. They can also be unprofitable despite very high Win Ratios.
For that reason, Win Ratio is very closely tied to Profit Ratio. This is the average return of a winning trade divided by the average return of a losing trade. Breaking down these two components is a good way to find out how a system is achieving its CAGR.
Systems like the 3 Day HIgh/Low Mean Reversion System can be profitable despite a low Profit Ratio of 0.64 because almost 74% of its trades are winners. On the flip side, a system like the SPY 10/100 Long Only System is profitable despite only winning on 41% of its trades because its winners are more than four times the size of its losers.
Volatility
While profitability is the end goal of just about every trading system, it may come at a cost. A prudent trader will identify what that cost is and then make an educated decision regarding whether the value is worth it.
One of those costs is volatility. Some systems, like the Moving Average Crossover with RSI System or the 50 Unit EMA System provide an excellent combination of Win and Profit Ratios at the cost of severe volatility. These systems are known to experience drawdowns of 40-50%. At that steep of a drawdown, even the most seasoned systematic trader will begin to question his system and whether markets have fundamentally changed.
Even systems with less severe drawdowns can cause traders to lose sleep. As a general rule, you should estimate the maximum drawdown you believe you can tolerate, and then cut that number in half.
Risk
Another cost of high returns can be excessive risk. Most trading systems provide the option of dialing up or down returns based on adjusting risk through leverage. Taking on too much risk in order to chase higher profits has been the nail in the coffin of many formerly successful traders.
The amount of risk you expose yourself to is one of the few things that you can actually control when it comes to trading. It is essential to your success that you constantly monitor your exposure and always keep your risk of ruin at an acceptable level.
Frequency
It is also important to consider the frequency of the signals generated by your system. This is a two-fold issue. First, you have to make sure that your backtesting results contain a significant sample size. If you backtest over a ten year period and your system only generates three signals, the odds are pretty good that your results will be skewed.
You also want to make sure that the system trades at a frequency that matches your lifestyle. A profitable system with low volatility and risk won’t help you if it never trades. On the other hand, the same system will be equally as useless if it forces you to monitor trades 24 hours per day.
The bottom line is that there are no right answers, and there are hundreds of different approaches to systems trading. The key is to find a system that works for you and stick to it.
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