Why No One Trading System Works Well All the Time
by Ed Downs, CEO & Founder
of Nirvana Systems, Inc.
I clearly remember the first time I saw a Trading System. It was in 1981, at one of the first CompuTrac conferences, hosted by Tim Slater. I felt the little tingles go down my back, as I clearly saw the rhythm, the patterns, the magic that is market behavior. Every example shown by the speakers, from Lane's Stochastics to Arms' Equivolume looked absolutely scrumptious. Yes, I was hooked. "Hey, I'm as smart as these guys," I patted myself, "And I am sure I can write a system that will make money in the markets. I'm going to do it."
Should YOU Write Your Own Trading Systems?
You have to ask yourself, "Why I am writing my own systems?" I have to admit, the appeal is irresistible. Writing your own system that beats the market! The anticipated joy is downright addicting. And a lot of so-called toolbox software has been sold to folks so they can sit and tweak on stochastics and relative strength until the cows come home. If you've been trying longer than that, I'd like to reassure you - so has everyone else. After sixty some-odd years of system writing, you would think that someone, somewhere would have discovered the magic key to riches, referred to in some trading circles as the "holy grail" trading system. (If you ever found the "holy grail," you could achieve everlasting wealth by just using it religiously) I haven't found the holy grail trading system yet. But, I think I have discovered something which works very well in all markets.
I call it…
The Personality of Markets Theory
You may have noticed that different markets often show an average behavior, or personality fairly consistently. Some contracts are quite volatile most of the time. Others tend to trend. Many system writers have taken to this idea by writing systems for specific commodities, where each system is "tuned" for the specific tradable, with names like "The T-BOND System". And, I think these systems (which are usually very expensive) tend to work better than generic systems or toolbox program systems.
I actually purchased one of these market-specific systems back in 1990, and tested it for profitability. And it worked fairly well. But I found that even markets that tend to be consistent within themselves often exhibit periods of "trending", "trading range" or even "schizophrenic" behavior. I began to realize that no system was going to give me what I wanted (a system I could just use on all markets.) Obviously, what I needed was an approach that would adapt to the personality of the market it was being applied to.
I first discovered this idea by running massive tests on systems using MetaStock, a fine charting package by EQUIS International. Our company created some utilities that could run MetaStock on the outside, and we subsequently ran and collated output from thousands and thousands of tests. What I discovered was this: Markets often acquire personalities that make their behavior very predictive in the next time frame.
Here's a simple test you can run if you have a charting program with system testing abilities:
Write a nine-period stochastic system and test it on all futures contracts over the last 60 days. Undoubtedly, you will find a few contracts that generated good profits over this time period using stochastics. You don't even have to bring up the charts to know that you will find nice wave-like oscillations a trading range market! And, the odds are better than 50% that a short term reversal signal on this contract, today, will be a good signal tomorrow. If you are a veteran system tester, you may be asking about now, "So, isn't that curve-fitting?" No. I didn't say "Trade stochastics on this contract from now on," I said, "The odds are good for a short-term reversal today, because the contract is exhibiting a trading range personality right now." That is, I am using the system to identify which contracts have a trading range personality right now.
Further experimentation led us one step further on this idea. Through exhaustive tests and thousands of runs, we discovered that if you combine multiple systems discovered through historical testing into one, consensus vote, you arrive at an even more accurate indication of current personality. That is, if several different (yet similar) systems arrive at a signal at the same time, the validity of the personality assessment is higher.
OmniTrader is the Result of All this Research
We applied these principles in the design of OmniTrader. The program has 120 systems built in - from stochastics to money flow to candle patterns. OmniTrader determines which systems are working well right now on each individual security, and then uses a consensus vote of those systems to generate market signals, as shown at the right. The signals OmniTrader generates are always adapting - always changing to match the underlying personality of the securities being tested.
The true beauty of this approach is it´s automatic. It is never necessary to write a trading system or "go back to the drawing board". In essence, OmniTrader creates a new system for each security every time the automatic analysis is run. This enables the program to find better trading candidates, in less time, with practically zero effort on the trader´s part. All the trader has to do is peruse through the list of signals generated each day, inspect the charts, and trade according to the personality that was discovered through OmniTrader´s automated process.
The first phase of a bull market. While most investors are discouraged with the market, and earnings are at their worst, some investors start buying shares. Or, an addition to a trader's position.
Adaptive Reasoning Model:
OmniTrader's knowledge-based capabilities, including testing and voting methodology, that generate trading recommendations on the Vote Line and in the Focus List.
Each days declining issues are subtracted from that days advancing issues. The difference is added to (subtracted from if negative) a running sum. Failure of this line to confirm a new high is a sign of weakness. Failure of this line to confirm a new low is a sign of strength.
A buy or sell recommendation accompanied by a number from 1 - 100 that indicates relative confidence in the signal. The signal and numerical rating are based on the active Trading Model, system test, and trading filters you define as processed by the Adaptive Reasoning Model. The advisor rating is an indication of the strength of a signal relative to the other signals for that particular issue. The Advisor Rating is not a probability. Advisor Ratings are accessed from the Vote Line.
Rules for computing, i.e., procedures for calculating mathematical functions.
APR (Annualized Percent Rate):
A mathematical measurement of the success of a trading system indicating the gain or loss of a system normalized to 250 bars of active positions. APR may contain the "BT" or "FT" prefix when used in context with Profile statistics.
Average True Range (ATR):
Average true range is defined as the average of the price movement over a preset number of bars. The default value is set at 8 bars in OmniTrader. The average over the last "X" bars of the true range which is the largest of the following: 1) this bar's high minus today's low; 2) this bar's high minus the previous bar's close; or 3) today's low minus the previous bar's close.
An evaluation of trading systems for a specified portion of historical data. The period of time over which the trading systems are evaluated.
A false signal, which indicates that the rising trend of a stock or index has reversed when in fact, it has not.
The opinion that the market will be going down in the future.
A computerized trading system that generates trading signals without disclosing its logic.
Relates to the number of issues participating in a market move. The move can be either up or down. As a rally develops, and the number of advancing issues is declining, the rally is suspect. As a decline develops, and the number of declining issues falls, the decline becomes suspect.
A false signal which is generated which indicates that the price of a stock or index has reversed to an upward trend but which proves to be false.
Acronym for Commodity and Futures Traders Commission. The CFTC is a regulatory government agency with a web presence at www.cftc.gov The CFTC publishes the COT report every two weeks.
A type of bar chart, developed by the Japanese, in which the price range between the open and the close is either a hollow rectangle (if the close is higher) or a solid rectangle (if the close is lower). These charts have the advantage of making the price movement more obvious visually.
The amount of money in the underlying stock of a company.
The portion of the display containing the price chart, volume bars, and assistants. The chart area is also called the OmniTrader Main Window.
Commitments of Traders (COT):
COT is a group of statistics published by the government (at www.cftc.gov) listing current contract commitments among various futures market participants. OmniTrader's COT feature provides two types of information: Net Longs and (calculated) COT index.
Physical products that are traded at a futures exchange such as grains, foods, meats, metals, etc.
A pause in the market during which prices move in a limited range and do not seem to trend.
A single unit of a commodity or future. For example, a single unit or contract of corn is 5,000 bushels.
A mathematical index used to measure trading activity for futures contracts, computed from COT data. It is the arithmetic sum of the net positions of all participants in a given futures contract. OmniTrader allows the user to determine the number of weeks over which to compute this sum.
The difference between the high and low during one trading day.
Sometimes called the "W" formation, a double bottom is when prices rally, fall back to previous lows, and then take off again.
Reduction in account equity from a trade or series of trade.
Using daily and weekly charts to analyze symbols for potential trades.
Refers to stocks secured by ownership in the company.
The value of your account.
The value of your account over time, illustrated in a graph.
A trading assistant used to indicate reversal points on a price chart using ratios computed from Fibonacci numbers. Fibonacci Retracements can be activated in OmniTrader's Chart Options section.
A way of selecting only data that meet specific criteria.
The study of market factors that influence supply and demand characteristics. In equities markets, fundamental analysis determines the value, the earnings, the management, and the relative data of a particular stock.
When commodity exchanges added stock index contracts and currency contracts, the term "futures" was developed to be more inclusive.
Good Till Canceled. Refers to the "life" of an alert or order, meaning the alert or order will remain active until you cancel yourself (vs. an alert or order that expires at the end of the day).
This can also be inverted. It is a reversal pattern and it is one of the more common and reliable patterns. It is comprised of a rally, which ends a fairly extensive advance. It is followed by a reaction on less volume. This is the left shoulder. The head is comprised of a rally up on high volume exceeding the price of the previous rally. And the head is comprised of a reaction down to the previous bottom on light volume. The right shoulder is comprised of a rally up which fails to exceed the height of the head. It is then followed by a reaction down. This last reaction down should break a horizontal line drawn along the bottoms of the previous lows from the left shoulder and head. This is the point in which the major decline begins. The major difference between a head and shoulder top and bottom is that the bottom should have a large burst of activity on the breakout.
The percentage of winning trades generated by a trading system giving a mathematical measurement of the system's success.
An algorithm or technique used to predict future price movement.
A day in which the total range of price is within the range of the previous days price range.
The relationship between the amount of money one needs to put up to own something and its underlying value determined the amount of leverage one has. High leverage increases the potential size of profits and losses.
An order to buy or sell at a fixed price. A person can also place a limit order with discretion. This enables the broker to buy or sell within a small range, usually 1/8 or 1/4 of a point.
Owning a tradable item in anticipation of a future price increase. Also see Short.
The minimum amount of money required to buy or sell a security. The investor is using borrowed money.
The demand by a broker to an investor to put up money because his security(s) have declined in value. There are minimum amounts of capital required by the exchanges or the broker.
An exchange member who makes a market by buying and selling for his own account when the public is not buying and selling.
An order to buy or sell a security at the present market price. As long as there is a market for this security, the order will be filled. This type of order takes precedence over all other orders.
This refers to an indicator that represents the change in price now from some fixed time period in the past. Momentum is one of the few leading indicators. Momentum as a market indicator is quite different from momentum as a term in physics which equals mass times acceleration.
A term that was frequently use to describe position sizing, but has so many other connotations that people fail to understand its full meaning or importance. For example, it also refers to: 1) managing other people's money; 2) risk control; 3) managing one's personal finances; 4) achieving maximum gain; and many other concepts.
A COT plot. Net Longs is comprised of three components, each representing the net number of contracts traded long (longs minus shorts) by each trading group. Each of the three plots corresponds to a trading group: Commercials, Large traders and Small traders.
The process of finding those parameters and indicators that vest predict price changes in historical data. A highly optimized system usually does a poor job of predicting future prices.
The right to buy or sell an underlying asset at a fixed price up to some specified date in the future. The right to buy is a call option, and the right to sell is a put option.
A buy or sell entry (including stops) in OmniTrader's portfolio. An order carries much the same definition in OmniTrader as it does with financial brokers.
This term refers to an indicator that de-trends price. Most oscillators tend to go from 0-100. Analysts typically assume that when the indicator is near zero, the price is "oversold," and that when the price is near 100, it is "overbought." However, in a trending market, prices can be overbought or oversold for a long time.
A plot of a symbol's data over an existing symbol's price chart. Overlays differ from spreads. You are not concerned with a mathematical relationship between the two charts when using overlays, only the relative movement.
A record of your accounts, their balances, and all open and closed positions.
A price factor is the conversion between points of a chart's movement and the actual dollar amount of the movement. It defines how much a certain commodity is leveraged. Price factors depend on the order of magnitude the data vendor provides price data.
Trading during the day with bars built from tick by tick information from the exchanges.
A comparison of an individual stock's performance to that of a market index. Most times the S&P 500 or the Dow Jones Industrial Index are used for comparison purposes. It is calculated by dividing the stock price by the index price. A rising line indicates that the stock is doing better than the market. A declining line indicates that the stock is not doing as well as the market.
A price level where a security's price stops rising and moves sideways or downward. It indicates an abundance of supply.Because of this, the stock may have difficulty rising above this level. There are short term and longer term resistance levels.
A price movement in the opposite direction of the previous trend. A retracement is usually a price correction.
The average return on an account (on a yearly basis) divided by the maximum peak-to-trough drawdown. Any reward-to-risk ratio over three that is determined by this method is excellent. It also might refer to the size of the average winning trade divided by the size of the average losing trade.
A technical plot used to predict price movement based on past performance on an annual basis. The Seasonality plots in OmniTrader are the result of analysis over many years of price data.
Selling an item in order to be able to buy it later at a lower price. When you sell before you have bought the item, you are said to be "shorting" the market.
An overbought-oversold indicator, popularized by George Lane, that is based upon the observation that prices close near the high of the day in an up trend and near the low of the day in a downtrend.
An order placed which is not at the current market price. It becomes a market order once the security touches the specified price. Buy stop orders are placed above the present market price. Sell stop orders are placed below the present market price.
Stop Limit Order:
This is similar to a stop order. It is an order, which becomes a limit order once the specified price is touched.
A price level at which declining prices stop falling and move sideways or upward. It is a price level where there is sufficient demand to stop the price from falling.
A system is a set of rules for trading. A complete system will typically have: 1) some setup conditions; 2) an entry signal; 3) a worst-case disaster stop to preserve capital; 4) a profit taking exit; and 5) a position sizing algorithm.
The study of historical price movements using mathematical formulas in an attempt to predict future prices. The types of data used include: price, volume, open interest, and market capitalization data.
A software program that provides tools for assisting you with your trading.
Opening a position in the market, either long or short, with the expatiation of either closing it out at a substantial profit or cutting losses short if the trade does not work out.
A methodology of trading that consists of a trading style and a trading term.
A collection of formulas and rules that generate buy and sell recommendations from price and volume data. OmniTrader provides a set of 120 trading systems built into the program.
A time frame used for analyzing a market for trading opportunities. OmniTrader provides three trading terms: short, medium, and long; corresponding to 16, 32, and 64 periods, respectively. A period is one trading day for daily data, one week for weekly data, 15 minutes for 15-minute bars, etc.
Constructed by connecting a series of descending peaks or ascending troughs. The more times a trendline has been touched increases the significance of a break in the trendline. It can act as either support or resistance.
The measurement of how much an underlying security fluctuates over a period of time. See also Average True Range.