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01/18/2011

Why Are Systems Necessary?


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Technical AnalysisNo stock market goes up forever. Indeed, most world stock markets have declined to zero at one time or another. The buy-and-hold strategy so popular in the U.S. today is based on a statistical anomaly. It is a strategy based on a survival bias in the U.S. and the U.K. markets, the only countries in history, so far, whose markets have not completely disappeared at some time (Burnham, 2005). This has caused a misleading assumption that U.S. stocks and stocks in general will necessarily continue to rise. “It would be naïve to expect the future of U.S. stocks to be as bright as the past” (Burnham, 2005, p 175).

We certainly know that individual stocks can go to zero. How about buggy whips in 1910, or canals in 1830, or bowling in 1950, or junk bonds and REITs in 1980, or more recently the autos and the banks? Thus, a long-term plan that excludes a means of controlling risk is eventually doomed.

On the other hand, most technical and fundamental methods, by themselves, are not profitable over time either. Some of the exceptions have been covered earlier in this book, but these methods primarily depend upon the market circumstances at the time, on the method used, and on controlling risk. Traders’ and investors’ greatest misconception is that the market has order and that by finding and acting on that order, profits will be consistent and large. It presumes that a magic formula exists somewhere that can predict markets. This belief is not true. In looking at the previous studies in this book, there is no magic order to the markets beyond the fact that they sometimes trend and, more often, remain in trading ranges. The money made is based on the use of well-controlled entries and exits, especially those that limit the amount of loss that can occur and that will react to changing conditions in the market. A system will aid the investor or trader in timing these market entries and exits.

DISCRETIONARY VERSUS NONDISCRETIONARY SYSTEMS

Systems are the next step in the development of an investment plan after understanding the methods of either technical or fundamental investing. Systems can be discretionary, nondiscretionary, or a combination of both. In discretionary systems, entries and exits are determined by intuition; in other words, the trader or investor exercises some discretion in making trades. Nondiscretionary systems are those in which entries and exits are determined mechanically by a computer.

Think for a minute of the stereotypical discretionary trader. Imagine the ultimate discretionary trader behaving like the man in the antacid advertisement with two or three phones yelling, “buy” in one, “sell” in another, with computer screens showing prices and charts of securities all over the world, with ringing phones, with news broadcasts from financial TV stations, and with a large contact list of people in different specialties. This type of trader is generally looking for the home run. It is a great image, one that has in it a bit of the swashbuckler, the gunslinger, and so on. In fact, many truly exceptional traders are like this. They have the gifted intuition to be able to do this consistently and profitably.

Most people, however, do not have the time, the knowledge, the contacts, the equipment, the quickness of thought, or the stomach to do this. In fact, most people who attempt to trade like this either burn out or go broke. They have no way of evaluating what they are doing except from the equity in their account at the end of the day. It is as if the excitement is more important than making profits.

The nondiscretionary trader, on the other hand, is usually calm, calculating, and likely bored. The majority of successful traders and investors use nondiscretionary systems (Etzkorn interview of Babcock, 1996). Some have been engineers; others have that type of mind, familiar with statistics and systems. They have studied the markets, the methods of profit making—both fundamental and technical—and have tested the techniques using modern statistical methods. They understand that nothing is perfect and that markets change character over time. However, by testing their methods and strategies, they have derived a mechanical system that minimizes risk of loss and maximizes return.

Rules are the structure of a system. An example of a rule would be “buy when one moving average crosses above another.” Variables are the quantities used in the rules—two moving averages, and parameters are the actual values used in the variables—two days and seven days. A system will include all these factors, and their usefulness is determined by testing different rules, variables, and parameters over varied markets and market conditions.

A purely nondiscretionary system is one that runs by itself on market data that is continually fed into it. If our rule is to buy when the two-day moving average crosses above the seven-day moving average, for example, a buy order automatically is placed when this occurs. Once the trader has determined the rule to follow, the system is on autopilot and the trader does not make decisions.

A trader or investor can also choose to use a partial discretionary system. The partial discretionary system is one that generates signals that then are acted upon by the investor based on personal confidence in them and experience with them. By having some discretion, however, the system cannot be tested accurately because emotion can enter into the trading decisions and cause unquantifiable errors.

Is it always better to choose a nondiscretionary, mechanical system over a discretionary one? Let us look at some of the advantages and disadvantages of this approach.

BENEFITS OF A NONDISCRETIONARY, MECHANICAL SYSTEM

A nondiscretionary, mechanical system provides a mathematical edge as determined by testing and adjusting. This is the principle behind the casino and an insurance business, both of which profit from many small profitable trades and occasional losses.

Using a nondiscretionary system avoids emotion. This is an advantage because traders often lose money due to emotional decisions. The nondiscretionary system also reduces other trading pitfalls—overtrading, premature action, no action, and constant decision making. Trading with a properly designed mechanical system also prevents large losses and risk of ruin, which most traders have never quantified or understood. In fact, risk control can be one of the most important advantages of a mechanical system.

Trading with a nondiscretionary system also provides certainty, develops confidence, and produces less stress. Anxiety comes from uncertainty. Although a nondiscretionary system cannot predict the future, it can structure how to react to possible outcomes. It gives a list of responses to events beyond one’s control.

PITFALLS TO A NONDISCRETIONARY, MECHANICAL SYSTEM

Though there are many benefits to a nondiscretionary, mechanical system, pitfalls also exist. For one, extrapolating will not have the same results as tests; history does not repeat itself precisely. The more a system is optimized or curve-fitted, the less reliable it will be in the future. In fact, in their book, The Ultimate Trading Guide, Hill, Pruitt, and Hill (2000) suggest that you should generally expect half the profits and twice the drawdowns as shown in tests of past data. Having been tested, the system designer expects results that are often unrealistic. The designer must be careful not to lose confidence when unrealistic expectations are not achieved.

Nondiscretionary systems often will make profits in clumps, especially if it is a trend-following system. The trader then loses small amounts waiting for the next clump and protecting from large losses. In other words, great creativity may have gone into inventing the system, but its operation is boring. In addition, some system designs allow large drawdowns but still eventually produce profits. The emotional problem for the user is the wait for the drawdown to be recovered and meanwhile the possible loss of confidence in the system. A loss of confidence results in fiddling with the rules or giving up just as the system is about to kick in.

Although a good system adjusts to a changing market, it does require periodic updates. This can often be a source of confusion for the designer. Is it time to update an underperforming system because of a changing marketplace? Alternatively, is the lackluster performance period a time for the trader to sit by patiently waiting for the system to kick in? The answers to these questions are not always obvious.

Remember that the system falls apart if it is not followed precisely. This is what the testing was for, and violations of the rules established from the testing negate the value of the system. This requires considerable discipline.

Using a nondiscretionary, mechanical system is not easy—otherwise, everyone would do it. There is a lot of work in coming up with a system, testing it, adjusting it, and trying it correctly and convincingly. The tendency for many people is to “wing it” and see if it works. That method leaves the trader nowhere.

–Charles D. Kirkpatrick II and Julie R. Dahlquist. Excerpted from Technical Analysis: The Complete Resource for Financial Market Technicians (FT Press).


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