Designing a trading methodology – Part 3 Specify the objectives of your edge

Having set out on the path of constructing your own trading system, it is now time to consider the aims and objectives of your system. In other words, what you are really doing, and why you are doing it.

If you don’t specify what you want your edge to deliver, how will you know when to stop developing and start trading? This is a major problem for many analysts and system designers. They get so caught up in the application of analysis techniques and trying to develop a ‘perfect’ system, that they forget that they are supposed to be developing a system that can be applied to the markets in order to make a profit. They continue developing for years on end with some never actually getting to the implementation stage because they haven’t specified what it is they are trying to achieve!

You need to be very specific with the stated objectives of your edge. Listed below are some of the questions you need to consider when defining the objectives of your trading system or edge.

• What is your time availability to trade an active investment edge? I see this as the most important decision that any trader or systems designer has to make. There is little point in setting out to design a short term trading system for example if you have a demanding full time job, or run a business that requires your presence for long days every day.

• The time you have available to trade will determine the timeframe in which you trade: intra-day, short, medium, long or ultra-long term trading. Intra-day is largely day trading. Short term might be defined as average hold periods of 2—10 days, medium term 6—12 weeks, long term 6—12 months and ultra-long term as 1—2 years. Greater than two years might be termed buy and hold. The shorter the timeframe traded, the more trades that will be completed, the more time it will take to trade but the higher the potential percentage profits that can be made through leverage and compounding of re-invested profits.

• How many opportunities to trade will you require your system to generate for you? Is it on average 1—2 trades a month, 8—12 trades a month, or even 50— 70 trades a month? This is closely linked to your time availability which will determine your timeframe for trading which, in turn, will determine your opportunity to trade; these three factors essentially go hand-in-hand Opportunity to trade will also determine how effectively you use your capital, e.g. having $100,000 to actively invest and only having sufficient signals to ever have $50,000 of it in the market is not a high probability method of generating good returns on your investment capital.

• Will the trading system be totally mechanical or will there be a component of discretion applied? If so, where and when will the discretion be applied? Specify how this will be researched as discretion can be difficult to research with a computer, especially over a large sample of trades!

• Will the system be a directional strategy that signals trends? Will it be a directional strategy that trades in range bound markets—long and/or short? Will it be a non-directional strategy that trades multi-legged options?

• What exchanges will it be designed to trade: ASX, SFE, LSE, USA? What instruments will it be designed to trade: equities, CFDs, stock futures, equity indices, ETFs (Exchange Traded Funds), bonds, Forex (currencies), commodity futures, a single market such as a single equity index, single futures market or single currency, or others? The timeframe traded will play a major role in deciding what instrument to trade.

• What is an acceptable maximum drawdown for you when running a portfolio with and without money management? When money management rules are applied the maximum drawdown percentage should increase as position sizes are increased.

• What average loss per trade are you prepared to accept? While specifying what portfolio maximum drawdown you are prepared to accept is more important, the risk per individual trade is still important. Be aware that the smaller the average loss that you are prepared to accept the shorter the timeframe that you will be forced to trade. If you want long hold periods because you only have time to turn over 1-2 trades per month then you will have to accept wider stops to allow trades to run which will, almost as an unwritten law of the markets, lead to larger average loss trades. This is just the way it is.

• What is the minimum winning rate that you are prepared to accept over a large sample of trades? Is it 35%, 40%, 50% or even as high as 65%? Trying to even specify this without a good dose of trading experience is difficult; it’s even harder to achieve it in research.

• What profit ratio (or reward to risk ratio or payoff ratio) are you prepared to accept? This should be a minimum of 1.5. (i.e. the average size of profit trades are 1.5x the average size of loss trades). This is closely linked to the winning rate. For your system to have a ghost of a chance of being profitable requires knowledge of what determines a breakeven edge.

• What returns are you looking for on your invested capital? Is it >50% pa or around 10% pa? This will determine what timeframe you trade in and what instruments you trade. For example, there is a low probability that you will generate >50% pa returns trading equities in the largest 100 market capitalisation stocks with no leverage.

• Do you need to trade leveraged instruments to achieve your performance objectives? Leverage can assist in generating greater percentage returns but can also generate greater percentage losses. The more capital that you have to invest, the less you need to include leverage in your strategy because larger absolute returns can be made with larger capital bases. Certain instruments are leveraged by default such as commodity futures, CFDs and FX. Also, if you intend using your Super Fund (applicable in Australia only – roughly equivalent to a 401K in the United States) to trade your methodology then leverage may not be able to be used. (You should research what the best entity is for you to trade through).

These are all questions that need to be answered BEFORE you step into the system design process. You cannot design and build a successful trading system with an edge over the market if you are unable to answer these questions.

In next week’s posting we will take a look at entry and exit signal concepts.