The Drawback of System Trading That Few Talk About

08/10/2010 12:01 am EST


Trading with a proven mechanical system can offer many advantages to serious traders, among them being:

  • Stress reduction: No more painful “live or die” decisions over whether or not to take a trade

  • More free time: No more need to stay in front of the trading screen all day long

  • Transparency: If you faithfully follow the system, it will keep you honest and provide you with an accurate statistical account (via extensive historical backtesting and real-life forward testing) of your real-world trading performance, something that can be difficult for discretionary traders to accurately ascertain. I mean, how do you accurately backtest triangle, wedge, and double-bottom/double-top patterns, seeing that no two are exactly alike in the first place?

Click to Enlarge

As wonderful as those advantages are, nothing, and I mean absolutely nothing, is going to stop even the best trading system from enduring periods of drawdown and the accompanying psychological stresses that it can produce. Look at the pink shaded area on the chart above; if you had started trading this high-performance e-mini daytrading system for the e-mini Russell 2000 futures on May 31, 2010, you would have garnered nearly $2,000 in closed trade profits within the first ten days of trading action, only to see the system give back 75% of those initial gains by June 24, 2010. The maximum peak-to-valley drawdown (PV DD) was ($1,512). Honestly, would you have been entertaining thoughts of throwing in the towel right about then? Or would you have focused instead on the big picture that proves that this system typically pulls out of such drawdowns in relatively short order? Only the traders who held fast to the proven statistical reliability of this system would have reaped the gains that ensued since June 24, 2010, as TF Trends proceeded to gain nearly $6,000 in the six weeks that followed, trading a single contract of the front-month e-mini Russell 2000 futures contract. By the way, those walk-forward, simulated gains also include a $20 round-trip commission per contract.

The equity curve chart reveals another vital statistic: The winning percentage rate. If you’re only comfortable with systems that win on seven out of ten trades, then you’re not going to be at home with this intraday trend following system, now are you? Experienced traders realize that it’s the profit factor (net dollars won divided by net dollars lost) that really matters, not just how many times the system actually chalks up a win. If a system makes more than twice as much on winning trades as it loses on losing trades, the system will be a winner, even if it only wins 35% of the time. Conversely, a system that wins 85% of the time but where losing trades are more than six times as large as winning trades will eventually wipe out your entire trading account balance if you trade it long enough.  Learn to intelligently sift through a trading systems statistics before you make a decision as to whether it’s a good system or not and you might be surprised at what the various groups of statistics may reveal to you.

In future articles, I’ll share some other important details concerning trade system statistics and how you can learn to profit from wise interpretation and proper use of them.

By Donald W. Pendergast, Jr. of
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