How to Select the Best Trading System - Part 1
When selecting a trading system, you should know as much as if you had already created one
I will show you how to find the best trading system available. And I will do this without you having the need for years of experience. With my method, you’ll be able immediately to filter the top percent winning systems.
Further in the article, I will answer the following questions:
I. Where to search for our system.
II. How to choose a system with PE (positive expectation).
III. How to apply adequate Money Management into the System with PE
IV. How to use the Money Management Formula.
(Money Management Calculator .It is not necessary to be a mathematician and to remember all the formulas that we will encounter in the article. I have prepared for you Money Management Calculator. It is as easy to use as a regular calculator)
V. How to determine the size of your account.
I. Where to search for our system
For a long time, many people have realized that the world of trading systems is filled with fraud and delusion. How to separate a huge amount of trash Trade systems available on the internet, and only concentrate on those that work.
Most of the professional traders divide systems into three main types:
1. Backtested trade systems using historical data, with optimized mathematical parameters
used by that system.
These systems do not work in real life. And, if you hear the words “Beck test with Optimization”, immediately throw them away - This is a trash Trade System. Remember, an “optimized back test” does not work.
2. Black box system. A black box system is one where you do not know why trades are being generated. If the statistics of a black box system look too good to be true, they probably are.
A Black box system should be considered with big amount of mistrust.
3. Publicly-viewable track record
There are several sites on the internet where traders can create a publicly-viewable track record that they must commit to publicly, which they cannot “throw away”.
The Dukas contest is one of these sites.
Whether you actually make the trades in a real brokerage account or demo account is of secondary concern. What really matters is that you commit publicly to your trade recommendations as they happen. You cannot walk away from the resulting track record.
Specifically for Dukas contest, I had been looking at these systems that are in the first hundred for 4 consecutive months and then tested them to see what their positive expectation was. It would have saved us a lot of time if Dukas had statistics for these trade systems including:
Ratio average winning trades / average losing trades
Percent of winning trades
II. How to choose a system with PE (positive expectation)?
We have identified where to search for our system. Now, we have to select one with the best parameters, i.e. to match the system with a good Positive expectation.
The definition of a Positive expectation can be reduced to the statement that there exists a mathematically proven probability that the trader will end up with profits, and not losses.
The mathematical equation for a positive expectation is as follows:
PE = [1 + (W / L)] x V – 1
V - Probability of wining trades
W – Average winning trade
L – Average losing trades
To put it simply: To be able to apply adequate money management the trader must have a system that has positive expectation
A Positive expectation is defined by the outcome of the equation being greater than zero. The greater the number, the stronger the underlying statistics, and if the outcome is less than zero, the mathematical expectations is negative. If the outcome is exactly zero, then the expectation breaks even.
Let us consider a few examples:
[1 + (W / L)] x V – 1 =
[1 + (152/123)] x 0.6 – 1 =
2.23 x 0.62 – 1 = 0.39
This system has a positive expectation of 0.39
(1 + 2.62) x 0.431 – 1 = 1.56 – 1 = 0.56
This system has a higher mathematical outcome then the preceding statistics.
Mathematical outcome (PE) = 1.13
If you are actually risking your money in the market, you most likely are doing so with a strategy that has a positive expectation.
When selecting a system, look for those that have a PE greater than 0.5.
If we have to choose between the three examples, of course, we will select Example 3 (Positive expectation = 1.13)
III. How to apply adequate Money Management into the System?
There are definitions of money management that relate to protective stops otherwise known as "money management stops", but this kind of definition is not going to be used in this article. Money management, as defined here, is limited to how much of your account equity will be at risk for the next trade. It looks at the whole account, applies adequate mathematical formulas, and lets you know how much of the account you should risk for the next trade.
This is called anti-marginal money management and is based on the Kelley money management formula:
K = PE / A
Indeed, PE = [1 + (W / L)] x V - 1 is a part of the Kelley formula, where
K is the amount of capital to trade
PE is the positive expectation
V is the probability of wining trades
A is the pay-off Ratio
A = W / L
W is the average wining trades
L is average losing trades