The Advantage of Trading Systems

04 May

People are slow to change. People tend to remain skeptical about new technology simply because they are unfamiliar with it and because it is not widely accepted by the public. Interestingly enough, the need for public acceptance is more of a driving factor in validating new technology than the actual merits of the technology itself.

Trading systems are simply sets of rules that traders use to determine their entries and exits for a position in the markets. For many years, the investment public has viewed trading systems as a mysterious technology, or “black box,” that cannot be trusted with something as important as investment dollars. However, more investors are now taking note of investments that utilize trading systems as this technology has been meeting with notable success in recent years.

Lao Tzu, a 6th century BC poet, once stated that

“Those who have knowledge do not predict and those who predict do not have knowledge.”

Trading systems are data based and not designed to predict the direction of the markets. System traders are more interested in developing reliable trading approaches that react to and take advantage of changing market trends. There have been many potentially profit producing trends throughout history. Systematic approaches (void of EGO; see pg. 3) offer a significant advantage over those who rely on their “prediction abilities” (or lack thereof).

Using Boeing stock we will compare two scenarios that highlight the benefits of trading systems. In Scenario #1, a broker buys Boeing early on and recommends a buy-and-hold strategy for his investors. The broker is predicting that Boeing prices will go up over the long term, and is willing to expose the investment dollars of his clients to all price corrections and bear markets along the way. In Scenario #2, a well researched computerized trading system is used to generate buy and sell signals over the same time period. The trading system has no opinion about the direction of prices. By design, the trading system detects changes in supply and demand and generates a buy signal when demand increases by a certain amount, or generates a sell signal when supply begins to strengthen against demand. The trading system reacts to Boeing price changes, which represent the vote of all of the traders and investors in the market.

Trading System Buy and Sell Signals in Boeing Stock (1985-2009)

Boeing stocks 1985-2005 - Trading SystemsAs we analyze the trading system applied to Boeing stock in the chart above, we can see that in general the trading system bought when up trends developed and sold, or exited the long position, when down trends developed. The trading system did not buy at the exact bottom or sell at the exact top of the price moves in Boeing, buy rather captured profits from the middle of the trends. In scenario #1, the broker would have simply bought Boeing stock and held on through all downward corrections in price and all bear market trends.

Broker versus Trading System (Boeing Stock 1994-2009)

Boeing stock Trading SystemReferencing the above chart, we compare the results of Scenario #1 (orange), using the buy-and-hold approach of the broker, and Scenario #2 (green), using the trading system. We can see the equity curves of two hypothetical $100,000 accounts invested in January 1994 through December 2009. The advantage that the trading system offered in this example is that it sold out of Boeing stock when Boeing prices encounter a bear market or when Boeing prices experienced a downside correction. Trading systems are designed to get out of a position when prices reverse or when trends change. The risk of investing with a trading system is that the system may generate false signals that results in losing trades or the system may fail to generate a buy signal for an uptrend that develops in a market. However, trading system designers believe that the benefits of system trading far outweigh the risks.

Furthermore, managers who rely on trading systems believe that properly designed and properly tested trading systems are much more reliable and much more effective than humans because systems remove the “EGO” from the investment process. The “EGO” acronym stands for Emotion, Greed and Opinion. The “EGO” forces are at work in every human and can be detrimental to the investing process when the pressure is on. When brokers or portfolio managers attempt to predict future price moves in the markets, they rarely have accurate information on which they are basing their decisions and they generally don’t know how or when to exit losing investments, which often forces investors to “weather the storm.” 2

Trading systems, on the other hand, are not designed to predict the future but rather are designed to read the current supply and demand forces at work in the markets as reflected by price. Because of this, trading systems are much better equipped to handle and react to surprises or unexpected events in the markets that are sure to occur over time, even when these events are not understood at the time. This ability to read and react to changes in supply and demand forces, as reflected by price changes, allows trading systems to potentially exit positions when trends change instead of holding onto losing positions through painful bear market environments.

Because the broker in Scenario #1 utilized a buy-and-hold strategy, he was willing to expose the investment dollars of his clients to any financial storm that popped up over time. And because market surprises and financial storms cannot be predicted, investments of this type typically incur significant losses as they ride out these difficult periods which can be seen in red below.

Scenario #1: Broker buy-and-hold Strategy (1994-2009)broker buy and hold trading systems

System traders realize that market surprises and financial storms cannot be predicted and therefore work to develop systems that can react when supply and demand forces change and when price trends change. System traders don’t attempt to understand why prices are acting in a certain way because the real news affecting the markets is typically not known until after the fact, when it is too late.

Because the trading system developer in Scenario #2 developed a trading system that was able to react when price trends changed, the investor was not exposed to the brunt of the financial storms and bear market price moves. Instead, the systems trader was able to effectively capture profits and stand aside during the difficult market periods.

trading system strategyScenario #2: Trading System Strategy (1994-2009)

When comparing the results from Scenario #1 (broker buy-and-hold strategy) and Scenario #2 (trading system strategy), we can see that the performance results from the well designed trading system strategy were superior to the performance results from the broker. By having the ability to take advantage of attractive bull market environments and, in addition, by having the ability to effectively react to financial storms that are sure to develop over time, the trading system strategy severely outperformed the buy-and-hold strategy which had no ability to react to negative surprises in the markets over time. It is important to note that trading systems are only as good as the developer and are not guaranteed to produce positive results over time. However, well designed trading systems have demonstrated the ability to effectively trade the markets and, most importantly, effectively manage risk.

Investors are now casting aside the myths associated with trading systems and are realizing that trading system technology can represent a huge advantage when investing in the markets.

Past performance is not necessarily indicative of future results.

by Mark Helweg and Drew Day

Lexington Asset Management

Clifton House, 75 Fort Street

PO Box 1390, Grand Cayman

KY1-1108

Email: info@ LexingtonAM.com

Web Site: LexingtonAM.com

Phone: 239.273.0142

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