Featured Article

System Trading

samseiden
Sam Seiden
Online Trading Academy, Chief Education, Products, and Services Officer

I have been in the business of market speculating and market trading education for about 20 years. While Futures and Forex have always been the main markets I trade and manage accounts in, I have also spent plenty of time trading stock options as well. My path began on the floor of the Chicago Mercantile Exchange, well before the average retail client had access to online trading. After time on the trading floor, I left and pursued trading from the friendly confines of home.  Back then, I was faced with shaky data and charts at best and the task of phoning in orders to a trade desk. Needless to say, change and growth have been explosive in this industry since my early days.

The Birth of Trading Systems

Advances in technology have been the driving force behind the change and growth. One of the many recipients of faster and stronger technology is system trading as high speed computers now help retail and institutional traders develop systems, crunch numbers, and back test real and hypothetical results in seconds. In the world of professional money management, I have seen plenty of trading systems. Ironically, most don’t seem to work and of the ones that do, they typically work for a bit and then fail. Being on the education side of the industry as well, I have seen hundreds of automated systems yet, I can only say that I have seen less than a hand full actually produce a consistent profit year after year. I often get emails from people who have read an article I wrote that want to share an automated strategy with me. They are sending it so I will help them review it and perhaps improve it. Traders will send me back tested hypothetical performance reports from these strategies that suggest they have the holy grail of trading systems. Most of these will show 80% winning trades or better and huge profits. Most of the time however, when they take the next step and trade the system with real money, they lose and lose fast. With explosive advances in technology and market information, why is system trading so difficult for most who give it a try? There is a very simple reason I will discuss later. In this piece, I will focus on the foundation of a profitable trading system, offer specific tools and rules of a profitable system, and expose the dangerous traps that lead to system trading failure.

The Most important Aspect of a System

As much change and growth has occurred due to technology, there is one component to trading that has not changed one bit and that is how the consistently profitable trader derives consistent low risk / high reward profits. The key to a proper trading strategy all comes down to the foundation of that strategy. To have the proper foundation, you must have a solid understanding of how markets work and why price moves as it does. If you have one flaw in your thought process, you can be sure it will lead to poor trading results. The reality is that markets are nothing more than pure supply and demand at work, human beings reacting to the ongoing supply/demand relationship within a given market. This alone, ultimately determines price. Opportunity emerges when this simple and straightforward relationship is “out of balance.” When we treat the markets for what they really are, and look at them from the perspective of an ongoing supply/demand relationship, identifying sound trading opportunities is not that difficult a task. Market speculators who understand this simple concept and what this opportunity looks like on a price chart typically derive their income from market speculators who don’t. In other words, those who “know” get paid from those who “don’t know.”

Who Is On The Other Side Of Your Trade?

If we want a consistently profitable trading system, we had better make sure that the person on the other side of our trades is making a mistake. Our system had better be an expert at finding a novice trader or we are in trouble. We don’t need to know the exact person on the other side of our trade, we just need to know if they are a consistently profitable trader or a consistent losing trader, and the chart will give us most of this information.

Let’s face it, when it comes to charting and technical analysis, most active traders use indicators. While many people including myself have often beat up the indicators, they are actually a fine tool when used properly for automated or semi – automated trading systems. The problem is that people tend to take every buy and sell signal an indicators produces and this is the last thing you want to be doing. Those who take each buy and sell signal an indicator offers are likely to lose there trading capital fast. It is not that the indicators are doing anything wrong. They will always produce what they are programmed to. The key for the trader is to use them in conjunction with proper trend analysis and the proper foundation based on the laws of supply and demand. One of the benefits to using indicators and oscillators the right way is that they allow you to trade based on a mechanical set of rules. Let’s use a single moving average and stochastics in our attempt to use indicators in our system to find the consistent losing trader to trade with.

 Trading Chart 1

On the chart is a 50 period moving average and a slow stochastic oscillator. To begin with, we must assess the trend of prices in this market. For this task, I use a 50 period moving average. Notice that the slope of the moving average is up suggesting we are in an uptrend. Once we know this, we only want to buy pullbacks in price. The mechanical signal to buy comes when the stochastic produces a buy signal in over sold territory (moving average cross, circled above).  While this turned into a nice low risk buying opportunity, notice the price action just prior to this buying opportunity. During the uptrend, the stochastic was very overbought, producing sell signals during much of the uptrend which would have led to many losses had you sold short at those times. This is a trap new traders can fall into when using these tools without reality based logical rules.

Buy Rule: When the moving average is sloping upwards, take the stochastic moving average cross in oversold territory as a buy signal. When the moving average is sloping upwards, IGNORE EVERY sell signal the stochastic moving average cross in overbought territory produces.

The Reality Based Logic: When prices are moving higher, we want to find a buying opportunity when things are on sale. Most importantly, our buy signal told us objectively that someone was selling after a decline in price and selling in the context of an uptrend. This can only be the action of a novice seller. A consistently profitable trader would never sell after a decline in price and in the context of an uptrend. So, we want to buy from this novice seller.

AS you can see, this is a two part process and it’s important to understand this when building your trading system. The two parts are as follows:

The “Switch”: The switch is an on/off switch that says its either “ok to buy” or “ok to sell” but not both at the same time in this case. For example, when the moving average is sloping upwards, the switch is turned on that says “it’s ok to buy” which means it’s not ok to sell.

The Trigger”: The trigger is the actual entry. So, if the moving average is sloping upwards, the “switch” is turned on that says it’s “ok to buy.” This means that the buy signal produced by the stochastics cross in over sold territory (the trigger) is turned on. If the moving average were sloping down however, that buy signal trigger would be turned off and the sell signal trigger would be turned on.

Perhaps your trading system is not going to include indicators and instead, will focus on supply and demand levels. In this case, you would still have a “switch” and “trigger.”. Your switch would be price reaching the supply or demand level and your trigger would be the actual entry which may be a reversal candle at the level, price reaching the level, or one of many more triggers. Whatever the strategy, there is always a “switch” and “trigger”.

Trading Chart 2

On this chart, we also have a 50 period moving average and a slow stochastic oscillator. Here, the slope of the 50 period moving average tells us the trend is down. Once we know this, we only want to sell to a novice trader who is buying after a move higher in price in the context of a down trend. The mechanical signal to sell comes when the stochastic produces a sell signal in over bought territory (moving average crosses, circled above).

Sell Short Rule: When the moving average is sloping downwards, take the stochastic moving average cross in overbought territory as a sell signal. Also, when the moving average is sloping downwards, IGNORE EVERY buy signal the stochastic moving average cross in oversold territory produces.

The Reality Based Logic: When prices are trending down, we want to find a shorting opportunity when prices are high. Furthermore, we want to sell short to the buyer who is making the mistake of buying after a rally in price and in the context of a downtrend (a novice buyer).

Is this or any trading system perfect? Certainly not, there is no perfect trading system and there doesn’t need to be. If there was, that person would have all the worlds’ money. However, wrapping some simple rules and logic around your trading is the key to stacking the odds in your favor. Even Las Vegas does not win all the time, nor do they want or need to. They do well over time because they realize they don’t have to always win. They just need to stick to their rules that allow them to keep the edge which means betting against people who don’t have the edge.

Any Market and Indicator Will Do When You Think the Markets Correctly

Trading Chart 3

Here is another example with the same 50 period moving average. In this example, I simply switched the Stochastic for the Commodity Channel index, better known as CCI, we will get almost the same signals.

Technical Reason for Shorting:

1)    The down slopping 50 – period moving average suggests this market is in a downtrend.

2)    A CCI Overbought reading (circled are on the chart).

Logical Reason for Shorting: Sell short to a buyer who buys AFTER a rally in price and in the context of a downtrend. The only type of mindset that would take this action is someone who makes decisions to buy and sell anything based on EMOTION, not simple and proper logic. This is the pedigree of the trader we want on the other side of our trades.

Trading strategies that work don’t change with time, markets, or changing market conditions. Quite frankly, to think market conditions ever change at all is a strong illusion that can only be removed when one focuses on the foundation of price movement, pure supply and demand. The systems I see working are very simple. The example below is an intra-day chart, let’s apply our same basic principles.

Trading Chart 4

Technical Reason for Buying:

1)    The up slopping 50 – period moving average suggests this market is in an uptrend.

2)    A CCI Oversold reading (circled are on the chart).

Logical Reason for Buying: Buy from a novice seller who sells AFTER a decline in price and in the context of an uptrend.

Summary

Uptrend/Oscillator Overbought: Ignore               Downtrend/Oscillator Oversold: Ignore

Uptrend/Oscillator Oversold: Buy Signal             Downtrend/Oscillator Overbought: Sell short Signal

Turning Failure Into Success

I see the vast majority of traders that go down the system path spend year’s form-fitting indicators and oscillators and crunching numbers based on back tested hypothetical results (numbers). I see very few people develop strategies based on the simple logic of how and why price moves as it does in any market. From my reality based market experience, trading is a simple transfer of accounts from those who don’t understand simple market logic into the accounts of those who do. Trading systems just expedite the process.

As I mentioned earlier, most traders who develop trading systems don’t take this approach or think in the simple terms I am suggesting. Why? It is because of how most people learn about markets and trading. Most will not begin their learning path as I did by handling institutional order flow on the floor of an exchange. The vast majority of market players will start with a trading book or seminar written or delivered by someone who writes books and delivers seminars, NOT a real market speculator. These books are filled with conventional use of indicators and chart patterns that simply don’t produce results. If they did, the author would certainly not be selling the book to you. This leads to a novice trader thinking they can take a trading system short cut and add a few indicators and oscillators to a price chart and let the computer find the parameters for each of those indicators that would have produced the best results in the past (back testing). Typically, when the novice system trader begins trading with real money based on those quality hypothetical results and begins losing money, they take the next wrong step, they begin adjusting indicator settings and worse yet, they add more indicators. This is a path that leads to trading disaster yet the novice system trader does not even know it. They say, “How can a system with such great back tested numbers not work?” It doesn’t work because the system is based on number crunching and curve fitted back testing results. The reality of how markets work is ignored. When designing your trading system, make sure you bring your foundation back to the basics of how and why price moves in any and all markets. Lastly, if you want to super charge the information in this article, add supply and demand levels to your system. If you look at all the examples above, there was always a supply or demand level at the turning point. There has to be…

Hope this was helpful. Have a great day.

Sam Seiden

sseiden@tradingacademy.com

 

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.