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How To Develop A Trading System – Part 1

How To Develop A Trading System – Part 1

by The MoleSeptember 3, 2012

In recent weeks I have been quite prolific regarding the current state of affairs on the equity front. There really is not much to add and if you have been following my work then you should be well prepared and ready to pull the trigger with confidence once equities decide to pick a direction later this week. Thus instead of regurgitating my long term charts I have decided to use this Labor Day as an opportunity to indulge your recent requests for some perspectives on basic trading related concepts.

As I am a big fan of the ‘jumping in feet first’ method this series will cover how one may develop a complete automated trading system. This will not only allow me to cover various pertinent concepts but more importantly put them into context. Most recently I have continued to refine our Mole entry signals in my spare time and therefore I will use some new discoveries as our starting point. This will be a comprehensive journey which we will undertake together as things are unfolding on my end. As time progresses I am going to walk you all through the various steps involved. Each consecutive part  of this series will cover important concepts to be considered at each stage of development. From the inception forming the basis of a system, the definition and tweaking of entry/exit rules, the resulting MAE and MFE, the definition of expectancy and SQN (and why I don’t care about Sharpe ratio), back testing, forward testing, tools, etc. We’ll go through all the motions and once we’re done you will not only be able to develop your own trading system but you will also have developed a deeper understanding of what separates the wheat from the chaff.

The best way to teach is to lead by example – at least that’s what they say. Let’s pretend I just came up with a promising new indicator – let’s call it the Mole, not so humbly named after yours truly. I am convinced that there may be an opportunity in developing it into a full fledged trading system. So what now?

Today we will cover the first phase – system discovery – which of course is the most exciting part. You are still wearing your rose colored glasses and are filled with hope, convinced that you have uncovered something truly remarkable. Of course throughout the remainder of this series we will go about smashing many of such dreams but that’s how we roll here at Evil Speculator.

What you see above is a screen grab of my current 1-min Mole indicator prototype. The Mole indicator you are currently seeing on the live Zero Lite runs against a 5-min E-Mini chart and  that’s a commonly favored chart interval for intra-day swing traders. However two or three signals max a day may be insufficient for a black box trading system capable of dealing with the type of tape we have been observing in the past few years. There are also other considerations based on expectancy and the frequency of trades necessary to maximize profits during a six to twelve month testing period – we’ll explore that in more detail in a future installment of this series.

It does not take much imagination to realize that this system will be based on short term reversals. In other words the aim of our Mole black box system would be to trigger near tops and lows, allowing us to scalp a few ticks and then exit. To some of you this may sound self evident – after all everyone wants to sell the top and buy the very low. But in reality many types of other trading approaches exist. FWIW – attempting to define tops and and bottoms is rather ambitious and borders the arrogant. Many have tried and most have failed – at least on a long term consistency basis. The ones that really work you’ll probably never hear about as the originators have little interest in sharing. Of course that does not keep us from trying – consider the Mole my humble contribution to the search for the Holy Grail of scalpers everywhere 😉

As you can see from the current edition the Mole nails the tops and bottoms pretty well. The current phase of development is one of manual trial and error. Basically you produce your indicator and find some way of visualization that gives you the information you are after. For instance – on the bottom you see the various signals that comprise the original Mole indicator. A few months ago an email from a subscriber gave me an idea [1] [2] which in turn resulted in what you now see on the price panel as blue reversal arrows. And that is step one: Your indicator (or whatever you use for your system – you may be only looking at candles) exhibits some type of repeatable prescience in the context of ensuing price movements. You want to exploit that and thus you are starting to think of a possible system. Assuming you know how to code you plan to turn your indicator into a full fledged trading system.

But wait – not so fast. Before you write one line of code (or pay someone to do it) I recommend you spend a lot of time playing with the settings, changing the chart interval, looking for patterns, etc. The human brain has an amazing capacity for recognizing patterns and for putting them into context. Computers are getting pretty good these days but there are certain aspects of the human brain and imagination that still remain outside the scope of even the fastest number crunchers. So use it – get a ‘feel’ for your system. Because the better you understand what drives your system and how changes affect it the less time you will spend later optimizing it. It is tempting to immediately write code and to define a dozen or more settings you plan to later use for optimization. But believe me when I tell you that the time spent planning ahead and simply observing will save you days if not weeks or months later down the line. As many other things in life I have learned that the hard way.

This is basically what I am doing right now. I am still fiddling with various settings to arrive at something that ‘visually’ appears to provide a valid edge. This phase can take anywhere from days to months, depending on the complexity of your indicator/system, your tenacity, patience, or obsession to find the perfect settings. Which do not exist – that much I can assure you. I suggest an iterative approach in which you spend a few days or weeks and then proceed to the next phase, which is initial implementation.

The next part of this series will cover the concept of edge and in particular some theory on expectancy and system quality number (SQN). Both are basic ways to determine the expected profit (or loss) potential of your new system. And without knowing that you pretty much have nothing to rely on but your human subjectivity. Usually not a good basis for success, for we have met the enemy and it is us! Of course a predicate for defining your edge is the creation of entry and exit rules which we will cover next time as well. Once you have developed a sound understanding of how to measure success and failure, as well defined standard deviations of returns, we will be ready to implement and start testing your new system.

To be continued…


About The Author
The Mole
Mole created Evil Speculator amidst the chaos of the financial crisis in early August of 2008. His vision for Evil Speculator is a refuge of reason, hands-on trading knowledge, and inspiration for traders of all ages and stripes. You can follow him and his nefarious schemes at the usual social media waterholes.
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  • Schwerepunkt

    Guess everyone’s on holiday. Grilling burgers, dogs and tossing back a few cold ones. Futs and forex are open again . . . 

  • molecool

    Can’t really blame ’em – maybe I should have done the same. But I had too many errands to run today and it somehow sucked the holiday spirit out of me.

  • MrMargin

    And don’t like trading in low liquidity periods. Seems to me that a lot of things don’t behave the way they normally would thus negating many edges.

  • Darth_Gerb

    cook a burger, avoid theta burn.
    *this has been a public announcement*

  • StrikeFirst

    Thanks for the great post.

    Very intelligent and very well thought-out.

  • combust

    hi mole & mollers this system making sounds great . Wheres does one get a coder and how good is it to have a nda agreement. I have a method  that a want to try putting into a system.  heres to  prosperous live trading  cheers.

  • Skynard

    AUDJPY loosing it, EURAUD gettin it:)

  • Skynard

     Let me get this right, the Aussie along with AUDJPY just sold off 1% and the /ES has been up? WTF! Time for some catch up it seems. See what you mean.

  • Skynard

    Looks like /HG had a false break out and has now fallen out.

  • newbfxtrader

    Needs China to perk up. So does the Aussie. /ES may not correlate to Aussie anymore as you think. Short term Aussie is oversold. I would rather short Cad.

  • newbfxtrader

    FCX tends to lead copper and its perking up a bit. So maybe /Hg will perk up too.

  • molecool

    Your NDA will almost be useless. Learn how to code or expect someone else to share your system with you at minimum. More on that later in the series.

  • Skynard

    Put one on, thanks!

  • Skynard

    Shorting EURAUD, tagged the 100sma on the daily.

  • mothwhoflysbackwards

    In the immortal words of Spock: Fascinating Captain! Reminds me of the old “sweet buns” ladder series in that it is more of a long term learning post as opposed to a what’s the market going to do next. Thanks Mole!

    What is strange is that I just (right before I read Mole’s post) got into this wealth lab pro crap that lets you to do backtesting of a system and you don’t (so they say) have to be a programmer/coder or whatever the hell that computer crap is, so I can specify rules (e.g. buy at lower BB cross etc.) with out “coding”. Goddamn if I knew how to code I would kick my own ass! Many of the concepts Mole mentioned (e.g. MAE, MFE, sharpe ratio) are in the back test. They (wealth lab) also have optimization, it did not work for me because I think I have to use these “sliders”(not code — whatever that is) to set the range of the parameters (wtf am I talking about? do you know? I am not sure I do) for the optimization. They also have monte carlo simulations whatever that means.

    Guess what guys? If you short FAZ when it goes above it’s top BB (20,2.0) have a “break even” stop that triggers when it (FAZ) is 5% up AND a trailing stop 30% below you would have made a tidy sum since it’s (FAZ) inception. Like I needed a computer to tell me that!

    Anybody code AND have wealth lab? Is it true that I can do a lot (using WLP) with out coding? In short I know nothing of coding, but do get the concept — tell the little dumb monkeys in this box they call a computer EXACTLY what to do. If you know WLP I would be very interested in your opinions weather you code or not. If you do code do you think the drop down menus work as well as code for the subjects covered? Any comments/insights regarding the auto rules based trading would also be very welcome.

    But damn that FAZ short trade at top 20,2.0 was great, only triggered 14 times though… so I do get the “rose colored glasses” comment. Needs better exit rules and I will be rich!

    Very much looking forward to the next post on this subject.

  • antonio nab

    Lots of talk down under that Aussie terms of trade is falling rapidly (largely due to collapsing iron ore price) which will put downward pressure on interest rates and AUD. So unless China does some stimulus soon (seems unlikely) which might perk up iron ore price, talk is to start shorting AUD (or go long iron ore if u think iron ore is undervalued)…. any thoughts?

  • molecool

    Yes, plenty of tools are out there and I’m not going to denigrate them as not everyone wants to learn how to code in C#, C++, Java, etc. What’s important are the basic concepts – many people use these things and never think about what they actually mean. For instance – do you know what standard deviation means and how it’s calculated? We are going to cover all of these things which will give you a whole new perspective and lead you to using your tools more efficiently/intelligently.

  • molecool

    By the way there are also scripting languages out there (e.g. Thinkscript) which have their uses. Personally they drive me crazy as I prefer a full fledged dev environment and strongly typed languages. BUT I invented the Zero and the Mole in ThinkScript so they have their uses.

  • StrikeFirst

    Dollar weekly:

  • StrikeFirst

    “There really is not much to add and if you have been following my work then you should be well prepared and ready to pull the trigger with confidence once equities decide to pick a direction later this week.”

  • Skynard

    Agree, think it is Buck’s turn for a bit driving everything back down.

  • MrMargin

    “There is time to go long, time to go short and time to go fishing.”
    –Jesse Livermore

  • Skynard

    Still short /CL, /HG, /SI, /GC, /ES, /ZS, AUDJPY, EURUSD  and long /OJ, /DX. Was stopped out of /ZS and reloaded. Knocked out of my EURAUD position.

  • StrikeFirst

    Well, I guess that big gap up in the VIX should have been a clue/warning.

  • ronebadger

    new VIX step one today?  maybe, watch for it… or, it just might ride up the upper BB

  • molecool

    Most likely yes – but I’m very cautious given the lack of participation.

  • Darth_Gerb

    if ROC hits zero, Silver will be a serious consideration. 

  • ridingwaves

    What is reasoning behind SLV as attribute? serious question as its just a JPM silver hedging tool…

  • bdoone

    Maybe Mental Masturbation but seems a bit manipulated:  A long weekend of ‘Sept. is bearish’ articles everywhere and market conveniently drops thru  SPX 1400/DOW 13K out of the gate?
    Bear traps set at these levels on Aug 24, 30, 31.

  • Darth_Gerb

    I’m not sure what you are asking.
    please drop the ZeroEdge conspiracy angle if that’s what you mean.

    here is a top list of institution holders for SLV. 

  • ridingwaves

    what’s zero edge? let me reframe that question, Why not use XAG pr SI as attribute as SLV is seriously managed etf…. 

  • Darth_Gerb

    yes, why not? if SLV is something not to watch, please let me know!

  • BobbyLow

    Afternoon folks.

    Just watching the post holiday price action and as a swing trader, I’m not impressed one way or the other.  

    I’m still Long PRU and remain neutral on Oil.  

    In the past, I would try to force a trade.  

    But for the time being, I’ll heed the Jesse L. quote that Mr. Margin posted this morning.

    “”There is time to go long, time to go short and time to go fishing.”
    –Jesse Livermore

  • ridingwaves

    DG, I was just trying to figure out why you chose SLV instead of Si…nothing more…not trying to roil the evil spec as it was more of a question of how you settled on that one…I love the chart…Silver strong seasonality is here..great time to be in some beaten down miners.. better if you were in them before thurs..

    shot from the lanai where I’m typing right now, last night

  • Darth_Gerb

    don’t mind me, back to work sucks.
    another week in the Islands?! (DG bites his tail repeatedly)

  • molecool

    ¨°º¤  S H A K E   N ¤º°¨ 
    ¸„ø¤º° B A K E !“°º¤ø„¸