Components of a Good Stock Trading System
All Great Stock Picks Have the Same Common Elements at The Onset
Dec 22, 2008
As most veteran traders will attest to, profitable trading is much more likely when trading 'signals' are generated by software designed to inform its user that a particular set of trading criteria has been met. While it's possible that discretionary trading can be profitable, discretionary trading lacks the built-in discipline and consistency that most serious traders rely on. As such, a true, unbiased system-based approach is generally the heart of an effective trading strategy.
But what makes for a good trading system? There are only four considerations someone building a system really needs to consider.
1. Profitability
It should be understood that a system must be profitable over a relevant time frame, though some traders can and have overlooked this reality while creating an impressively complex - yet ineffective - strategy.
It's also important to build a system that is consistently profitable in all sorts of market environments. Why? Because unusual markets can create very positive net results, but the bulk of (or perhaps all of) that system's gains were achieved with just one trade. The system should be able to reproduce the results all the time.
2. Win/Loss Ratio
Somewhat related to consideration #1 is the frequency of losses to the frequency of gains. In general, a system-based approach should yield a winning trade about half the time when back-tested. Any more than that and it may not be realistically reproduced in the future. Any less than that, and it may be too negatively volatile to stomach.
3. Average Win/Average Loss Ratio
This is slightly different than consideration #2, which wasn't concerned with the size (percentage) of wins relative to the size of losses. The idea here is simply to insure the average winner outsizes the average losing trade by a wide enough margin to make the system worth employing.
Said another way, it does a trader no good to win 60% the time and lose 40% the time if the winners gain an average of 20%, while the losers post an average loss of 30%. That system would actually be a net loser.
4. Limited Drawdown
Drawdown is simply the degree of loss between a system-based portfolio's peak value and its low point following a string of losing trades. All systems create some sort of drawdown; the goal is to minimize that drawdown with more winners, and bigger winners. Thus, the limitation of drawdown is a function of the other three criteria.
However, it's also worth noting that minimizing a portfolio's drawdown is primarily for the mental benefit of the trader using that system. Most traders can tolerate two or three losing trades in a row. However, a few more than that and the odds are good that he or she will abandon that system. That defeats the purpose of using automated signals in the first place.
The Benefit a Stock Picking Strategy
These may not be the only factors a trader would want to consider when building a trading system, but they are the foundations of an effective set of system criteria. When a trader has faith that his or her system can consistently meet the standards surrounding these four criteria, executing that system becomes quite easy.
The upside of such a system for the trader is the removal of bias from the selection process, which is the key to consistent success.
