Saturday, September 05, 2009

How Trading Systems Can Inform Discretionary Traders

Here is an update of an indicator that I wrote about a while back. Suppose you create a channel defined by a moving average of the high prices for the past 10 trading days and a moving average of the low prices from the past 8 days. When you close above the upper band of the channel, you buy and go with the strength. When you close below the lower band of the channel, you sell and go with weakness. The position is closed when you re-enter the channel; no other stops.

According to Barchart. com, such a "system" would have produced eye-opening results for the S&P 500 Index (SPY) from March, 2004 to the present.

There would have been 248 completed trades, averaging about six days in holding time.

A total of 68 of the trades would have made money. 180 would have lost money.

The net number of points lost in SPY would have been over 100.

If someone had merely bought and held since March, 2004, the return would have been about zero. No significant gain or loss.

If they had followed this channel system, they would have lost all their money.

It is human nature to extrapolate the future from the recent past. This is one reason why traders who enter trades impulsively, needing action, invariably lose money.

The patterns that markets follow are not necessarily the ones that come to us intuitively. That is why knowing historical odds of markets moving up or down under various conditions can provide useful decision support.

Yesterday was a pretty strong day in the stock market, as we made a nice bottom this week. It was logical to want to go home long over the extended weekend. Maybe that will work; I see, however, that Vertical Solutions' backtested trading system went home short.

Buying strength and selling weakness, over time, has lost people money. Indeed, I see where MarketSci identifies "mean reversion" as "the most effective directional trade".

There are limits to human discretion: The best trades are not always the ones that feel best.