How to Selecting a stock Trading System
Successful trading is similar to a successful business. You see, every successful business has a business plan so do successful traders. The astute reader knows that, successful traders have a systematic way they approach the market.
The definition of a trading system is a trader’s business plan; it defines your approach to trading…
1. A properly constructed trading system will leave no room for human judgment
2. It will define your actions given any circumstances that may arise.
3. It is a distinct set of rules
4. Which instructs the trader what to do and when to do it.
The importance of this trading plan cannot be understated. Without a consistent set of guiding principles to govern your trading decisions, most traders will hop from one trade to the next, guided by emotion or hysteria.
This article describes the model of a natural relationship between trading system performance, trade position size, stop loss settings and profit goals. The model consists of algebraic equations that specify the trade size and stop loss settings needed to meet profit goals over a specified time period for any consistently used trading system for which historical performance data is available.
Most of us think of a trailing stop loss when the term money management is mentioned. William O’Neil in his book, “How to Make Money in Stocks”, used a value from 7 to 8%. Many stock advisories, including Stansberry and Associates, Outstanding Investments and the Oxford Club, typically use a 25% trailing stop loss. Option advisories use still higher values in the 35% range, as is done by Michael Lombardi, and up to as high as 50%, as used by Dr. Stephen Cooper. Trailing stops are typically used along with a maximum percentage of capital per trade to avoid large portfolio draw-downs in the event that a given trade goes badly.
Beyond this precaution, there is little theory to explain how position size and trailing stop losses should be arrived at, leaving the impression that they can be arbitrarily chosen based on one’s risk comfort level. However, this is not the case. Too narrow a stop loss setting can eat into profits by exiting volatile trades too early. Too wide a stop loss setting can eat into trading profits by consuming too much capital. A systematic way is needed to choose an optimum position size and stop loss setting to achieve a precise level of money management.
Important Trading System Criteria
Profitability is not the only criteria by which a trading system should be evaluated. Drawdown and stress should equally be considered as well… for example, before you open a trading account:
Are you satisfied that your system is reliably profitable?
Will drawdowns wipe out your account?
Is your system trading in a way you can tolerate?
Can you tolerate long periods of no trading or too much trading?
Can you tolerate a large string of losses?
The only way to answer these questions is to subject your trading system to extensive back testing.
William is an investment advisor and has been writing about objective, methodical
approaches to investing for over 10 years. He has helped hundreds of people make better
investment decisions. To find out more about his approach and his FREE Newsletter, please