What Makes a Good Trading System

Copyright (c) 2010 Scott Cole

When you read advertisements regarding trading systems for stocks, commodities or currencies (forex), most of the advertisements tout a high percentage of winners. At the bottom of the advertisement, there is a disclaimer that states that hypothetical performance is not indicative of future results. The bottom line is that if a trading system were indeed so powerful, it would be sold to the public.

Too often, new traders are focused on trying to find the Holy Grail of trading. They buy books and trading systems that imply performance that will make you a millionaire within a couple years. They show 80% to 90% winners, meaning that the system is just like an ATM machine. Yet, it is widely known that 90% of all traders fail.

Professional traders understand that it is not the system or strategy for entering and exiting trades that will make a trader wildly profitable. Traders need to learn how to manage their risk and how to preserve capital during times when the system or strategy is not performing very well.

So what are the characteristics of a good trading system or strategy? Well, the main thing is that it must provide the trader with a defined edge. This edge simply means that, over the long run, there is a probability of success. For instance, all games in a gambling house provide an edge to the house. Therefore, in the long run, the house is always profitable, because it systematically employs this edge ALL the time. This edge may only be that the house wins 51% of the time. But if the payout is the same, whether the house wins or loses, it will come out on top in the long run.

This is why gaming theory is often employed in strategy and system development by professional traders and trading firms. They are constantly looking for new edges in the market, because often times old edges get discovered by too many market participants, and that results in that edge disappearing over time. This is the case with many trend following trading systems in the commodities markets.

However, most new traders are more concerned with having a high percentage of winners, and they develop unrealistic expectations. On the other hand, professional traders know that they can be profitable in the long run even if they only have 35% to 40% winners. They understand that if they make significantly more money on their winning trades than they lose on their losing trades, they will make money in the long run. Professional traders are generally not concerned with trying to be profitable every day or even every week. They know that if they have a decent edge, they will be profitable most months. If a traders is profitable 8 months out of 10, then that is a pretty good track record. Only a handful of hedge funds have ever been that consistently profitable.

So when looking at trading systems, or trying to develop your own, focus more on developing an edge that will be profitable in the long run. After that, you must simply develop the discipline to stick with it, and that is where most traders fail.