Fundamentals of System Trading — Part 2
In our previous part, we mainly focused on the design, development and profile of a trading system. In today’s part, our focus would be to build a profitable trading system in the long run without blowing up the capital.
What is a Trading Edge?
A trading edge is a strategy, observation, or approach that allows you to gain a financial advantage over other market participants. It doesn’t have to be complicated to accomplish its goal; anything that adds a few points to the winning side of an equation creates a lifetime advantage. Also, most of the traders don’t understand their edge in the market. It’s the main reason why a few people make a lot of money while everyone else makes a lot of losses.
For example: A trader may believe that using a specific indicator (e.g., the Relative Strength Index, or RSI) in a specific way (e.g., making short trades when the RSI is above 90) gives them an advantage over traders who do not use the same indicator in the same way) gives them an advantage over traders who do not use the same indicator in the same way.
How to find a Trading Edge?
Many new traders spend years experimenting with various indicators or indicator settings (e.g., a length of 10, then a length of 15, etc. ); they also experiment with various chart settings, such as time-based charts, tick-based charts, or volume-based charts, in order to find the combination that gives them an edge.
To find an edge, the edge must be practical, and no irrational thinking is permitted. A trader must recognise that an edge may not work 100 percent of the time, it is possible to gain a lot of money with an edge, only to have it stop working later.
If you think you’ve discovered a competitive advantage, back test trading systems precisely by defining the rules and then applying them to historical market data or forward test the system.
How to quantify your Trading Edge?
Quantifying is an important part of creating a successful trading system. It is performed by backtesting trades that would have occurred in the past following rules set by a specific strategy using historical data. The end result provides statistics that may be used to assess the strategy’s sustainability.
The following are the key metrics used to quantify a trading system:
1. Compounded Annual Return %
The compounded annual growth rate (CAR) is one of the most precise methods for calculating and determining returns for a system that has the potential to rise or decline in value over time.
Trading systems outperforming benchmarks in terms of CAR for a specified time period have an edge, by default
2. Hit Rate
The Hit Rate is usually represented as a percentage of the number of winning or successful trades for a trading strategy over a period of time, divided by the total number of trades during the same period.
Though, hit rate should not be the only metric you should consider while looking into stats as it might give you a blurry picture.
For example:
System 1 with 30% hit rate and a profit of Rs. 50,000
System 2 with 60% hit rate and a profit of Rs. 10,000
Here, System 1 is clearly more favourable than System 2 with higher profits.
3. Positive Expectancy
Expectancy is the most crucial metric for determining how profitable your trading technique is, but it is also the most misunderstood metric among traders. Almost every rookie trader is obsessed with hit rates, being correct, and finding the perfect entry and exit.
Contrary to popular assumption, hit rates, being ‘correct,’ and having flawless entries do not offer you an advantage. Calculating the system’s expectation is the only method to determine if your strategy has an advantage and will be profitable in the long run.
4. Maximum Drawdown (MDD)
A maximum drawdown (MDD) is the biggest loss experienced by a trading system from its peak to its trough before a new peak is reached. The maximum drawdown is a measure of the risk of losing money over a set period of time. Trading systems with lesser MDD should be considered.
For example:
System 1 with 50% MDD and a profit of Rs. 20,000
System 2 with 25% MDD and a profit of Rs. 15,000
Here, you can clearly observe that System 2 is more favourable than System 1.
5. CAR/MDD Ratio
Compound Annual Return (CAR) divided by your Maximum Drawdown (MDD) is your CAR / MDD. It signifies how rapidly a trading system may recover from its lowest point.
For example: if your system’s highest drawdown is 20% and its average yearly returns were 40%, we divide 21 by 35 to get 2. Anything above 1 is regarded as good.
The Bottom Line
If all of the above mentioned statistics are considered to compare trading systems then a trading edge can be obtained. However, as markets are dynamic, such trading edges can shrink after a while. So, timely optimization of the trading system needs to be done.
Written by Aashutosh Chandra (aashutosh.chandra@xumitcapital.com)
