There’s so much confusion in the trading community when it comes to finding tools to help make trading decisions. Should you use indicators, black-box systems, price action, news, or shades of the moon to enter and exit trades?
And with so many trading systems, strategies, and indicators on the market, how can you tell what’s fluff and what actually holds any merit?
In 2008 computer algorithms started to dominate the financial markets, especially in the futures, options and forex markets. This made a lot of the old-school trading strategies obsolete. I won’t get into the argument around if it’s morally right or not; I just want to look at what traders need to know in order to have a shot at success in today’s post-algo trading arena.
Every indicator, oscillator, and candlestick pattern is useless – by itself.
Over the past decade, I’ve seen hundreds of trading indicators, oscillators, and candlestick patterns. And I’ve seen traders get mesmerized by fancy charts and “lucky”, or cherry-picked trades. There are many “gurus” who will waste valuable time showing subjective “hindsight” trades, without knowing if it really holds any merit of potentially making money in the future.
Individually, no single indicator or price pattern has any value. Here’s why…
There’s a major difference between using random indicators, and having a quantifiable strategy. I can look at any chart with any indicator, and justify reasons why it would have been a good idea to buy or sell based on a certain indicator. But that doesn’t mean it’s going to be a money-maker in the long-run.
I highly recommend reading “Fooled By Randomness”. which talks about how people like to find patterns in things that are totally random. The popular example is how people see animals in clouds, where there really isn’t anything there. The same logic can apply to stock charts.
Also, try buying or selling every “doji” candlestick pattern you see in the market. At best, you’ll just burn up your account with commissions. The more realistic expectation, however, is that you’ll get chopped out of the market and have a 100% drawdown.
Let’s look at the old-school “moving average crossover trade”. which basically says to buy when price is above a moving average and sell when it’s below. I can go back in a historical chart and find some very convincing examples of why this is a great “strategy”. Take a look at the chart below, and notice how this strategy picked the tops and bottoms in the market!
Doesn’t this chart look great? Sure, I can find a place in time where you would have made money with this strategy, but let’s take a look at that happens over the long run…
Here’s how the “moving average crossover strategy” worked over about 6 weeks. Ouch! Even though we could cherry-pick a few trades that looked nice, this strategy has close to 0% chance of making money in the future.
Recently, an Emini Trading Program copycat started making up excel documents with cherry-picked hindsight trades. Let’s not mention the fact that he recently deleted his “income statements” after proclaiming himself to be “so transparent”. Looking back in hindsight and marking up an excel spreadsheet with “hypothetical scenarios” is NOT a way to quantify a strategy.
Limitations of Backtesting, Forward-Testing, & Live Market Testing
If you’ve been trading for a while, then you probably remember the Forex Trading Robots that used to litter the internet with ads like, “$99 trading robot with 89% win ratio guarantees 134,485% monthly returns”. In other words, give us $99 and you’ll be an instant millionaire!
Let me explain what they did to find those outrageous returns. First, they took a few random indicators or
parameters and ran a backtest to find what trades would have made money in the past. Then, they optimized (or curve fit) the data to find out the absolute best case scenario. In other words, let’s look at what we could have done in the past to make a bunch of money, then assume those parameters will make the same amount going forward.
The problem is that what made money in the past will almost NEVER make money in the future. You may be thinking, “Then what the hell is the point of backtesting in the first place?” I’ll get back to that in a minute.
In most cases, backtesting a strategy is absolutely useless because you’re basically stumbling on the luckiest, most profitable possible scenario. And the chances are probably one in a billion that you would have actually traded that exact way.
So how do you find a strategy that has a chance of standing the test of time? First off, it has to show favorable results over long periods of time. A strategy that shows big profits for one month, but gives it all back over the long run is most likely not a good strategy to live market test. My favorite trading platform, NinjaTrader has a tool to actually help traders forward-test their strategies. This has been a great tool tool to help guard against curve fitting.
There are also many other things to consider when testing like: cost of commissions, slippage, once-in-a-lifetime trades, and large drawdowns.
A static system with fixed parameters will ALWAYS blow up!
Another mistake traders make is thinking the same strategy will always make money without any adjustments. As I’ve beaten like a dead horse in past posts, the markets are dynamic and always changing. This means that if you use the same risk management and trade setup parameters, your strategy will eventually become a loser.
For example, now days it’s very difficult to use a fixed profit target in the futures and forex markets. This is because the speed and range in which a market trades are constantly changing. Sometimes a $500 target works best, and sometimes a $500 target will cause you to lose money over time.
The Key to Keeping a Complicated Strategy Robust With Changing Market Conditions.
The goal is to find a truly non-random, long-lasting strategy with a unique edge. versus a system that just happens to get lucky from random inputs.
For our MAP Trading Strategy. my team and I are constantly monitoring market conditions and forward-testing to make sure we’re aware of the best current parameters. This is by no means an easy process, and takes at least 2 or 3 people working full time for days or weeks.
The “magic ” is in anticipating which risk, reward, setup, and management parameters are going to work in the future. This is where trader skill comes into play. Here are a few things an experienced trader can help you do:
- Determine which setups and risk/reward parameters have the best chance of making money in the current (and future) market conditions.
- Be able to make adjustments on the fly because of changing market dynamics
At the Emini Trading Program. our main goal has been to help our student traders learn how to implement a rules-based strategy in a way that allows them to stay flexible with current market conditions. We also spend a lot of our time practicing the art-form of making real-time adjustments to our trading execution.
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