To Modify, or Not to Modify

08/12/2014 6:00 am EST

Focus: STRATEGIES

Kevin Davey of KJ Trading Systems shares a question-and-answer between him and a relatively new trader about a trading system that he purchased. When it comes to these trading systems, for Kevin, the key is to believe in the system before you buy it.

A while back, I received an e-mail from a relatively new trader.  He was trading a system he purchased, based on its alleged stellar performance.

Question: I've been using this system for a few weeks, and sometimes I just know the signals it gives will be wrong. What do you think if I take the signals and combine them with work of my own, to get modified signals?

Here is what I told him...

Answer: Obviously, since you bought the system, you can do whatever you like with the signals, since the final decision to trade or not rests with you. The signals are only a recommendation—you control what happens in your trading account. Don't underestimate the magnitude of this fact.

I can tell you that in systems I develop, I use the signals AS IS, with zero modifications. I trade many of my systems fully automated, where it is almost impossible for me to interfere. I'm not smart enough to know when the automated signals will be good or bad, so I've taken myself out of the equation. It is funny, but the days I think "why did the system go short/long today?" usually turn out the best—the system is typically right, and my hunch is usually wrong.

But that's me.  I make sure I have the confidence in the system before I start trading it.  It sounds like you need to develop that confidence, too.  Here is how to get it:

  1. Only buy systems or follow signals from trading system developers you trust (or better yet, develop your own system with a proven process).  Ask a lot of questions before you buy.  Establish a general comfort level.
  2. Evaluate the historical performance in detail.  Can you trade that type of system, whether it scalps, swing trades, or position trades?  If the system adds to losers, will you be able to always do the same?  Do the historical results look too good to be true?  That's a tipoff that the system might have been curve-fitted or over optimized.
  3. See if you can track the performance in real time for a month or so, before you buy.  It is amazing how many systems that look good today will look terrible after another month worth of real trades.  Treat this as a cooling off period to prevent buyer's remorse.
  4. If you decide to buy, start small.  Give the system a chance, but with limited capital.  You'll quickly find out if the system is something you can handle both financially and psychologically.
  5. Once you are ready to go live with full size trading, and you've satisfied all the conditions above, never override a signal, unless you have the ability to fully backtest and evaluate it yourself.  Modifying signals on a whim or a feeling is almost like flipping a coin—it rarely gives you any kind of extra edge.

Here is another way to think about modifying system signals: you can buy a new car and modify it to get better performance. It might work much better for a short while, but then maybe the engine will seize (and maybe it won't). You just don't know. It is the same thing with modifying or overriding signals from a system—you might make improvements in the short-term that really hurt the long-term performance. You just don't know.

Because of the possible unintended and unknown consequences, I recommend, for systems you believe in, that you follow signals as is.  The key is to believe in the system before you buy.

By Kevin Davey of KJ Trading Systems

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