How to Spot a Winning Trading System

12/19/2011 12:25 pm EST

Focus: TRADING

Jackie Ann Patterson

Author, Truth About ETF Rotation

Focus on metrics like win/loss ratio and drawdowns when analyzing systems, says Jackie Ann Patterson, but also make sure that system fits your personality and trading style.

Everybody’s looking for the “perfect” trading system, but how do you evaluate one to make sure it’s good for you and is working? 

Our guest today is Jackie Ann Patterson to talk about some of the metrics you can use to evaluate them.  So Jackie, how do I evaluate a trading system if I’m starting from scratch?

Well, I think there are several things you have to think through when evaluating a trading system. Of course, the most basic is what is the system: when do you trade in, when do you enter a trade, and when do you exit? 

Along with that, you also need to think about what you’re going to trade; which market, and which time frame, whether that’s intraday, end of day…. and also, look at how to manage the risk or what size to trade. 

I think there’s a set of metrics to look at that applies more or less to all of that, and that includes of course the win rate and the expectancy of profit, whether that’s in that gain or a mathematical expectancy. Also, looking at the drawdown. 

Out of all that, I think you need to get the cold hard numbers and look for things that you can expect to make a profit or hope to make a profit, but also look at how it feels. 

I think it’s important to evaluate and to try and get a sense for how you will feel with this trading strategy and does it fit how you think?

A lot of people, when looking at trading systems, they’re going to buy one from somebody who has written one rather than trying to develop one themselves. How important is it that I know what’s going on in the “black box,” as they call it, or is it not important as long as I see the returns and it’s been backtested and works and I’m comfortable with it?

Well, I think that’s somewhat a personal choice. Some people are going to need to know all about it, need to “own” the strategy, if you will, need to modify it a little bit to make it their own, and others I think are going to feel more comfortable just taking the expert’s strategy and building on top of that or just using it as is. 

I think the most important thing though is to understand how it’s going to behave. Is it going to offer a lot of entries or just a few? And does that match up with your expectations? 

If somebody has a very active personality and wants to do a lot of trading and wants to take a lot of activity, then looking at a long-term trend-following system may not be the best fit, at least to start out.

In terms of the metrics, “drawdown” is one of the items you mentioned. If I’ve got a system that is drawing down more often, or more than it has been for the past ten years (or however long I backtested it), when do I know that something in the system needs to be tweaked, or if it is just par for the course?

Yeah, that’s a good question. I think certainly if you can look at the backtested history and see that it’s within normal parameters—even if it’s big—and there’s usually been some outliers. 

We’ve had some big moves in the market recently, and it’s easy to think those were really huge. If we look back in time, we can compare them to other times in history and see that yeah, they were big for the recent context, but they’re still fairly small. 

So that historical perspective can give people the confidence maybe to stick with the system a little bit longer.  When you see something that’s completely out of spec, it might be time to take a breather if the drawdown has become painful. 

If it’s impairing a trader psychologically, that’s probably a good indication to get on the sidelines and kind of regroup.

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