When is Your System Better than Random Entries?

Aug 20, 2007: 8:50 PM CST

I’m currently testing various simple strategies and discussing the results as I learn more, but one may ask what is the point in studying random entry trading systems?

First, newer traders believe that if they can find the perfect settings or the perfect combination of indicators on a chart, then they will be very successful in trading. In fact, many new traders believe that professional traders contain ‘secret indicators’ or ‘secret knowledge’ that they aren’t sharing with the mass public, and that is how they are professional. If they could only acquire that knowledge….

Most professional traders will tell you that there is not ‘big secret,’ and that trading success comes from market knowledge, experience, and a system with even the slightest statistical edge that puts the odds of taking profits from the markets in their favor.

There are literally thousands of “systems” that have been developed by traders, but there are only a handful of categories to quantify these strategies, and also a handful of set-ups that comprise trade entry in these systems. Examples of broad system categories include breakout trading, momentum trading, ‘fade’ trading, mean-reversion strategies, reversal strategies, trend-following (or anti-trend following) strategies, etc.

How can you tell if a given system is better than another system?

Before you attempt to answer this question, let’s ask a more broad (and easier to answer) question:

“How can I be assured that my system is better than a ‘random entry’ trading system?”

To answer this question, your entries and exits – however they are determined – must ‘beat’ the outcome parameters of a ‘dummy’ system that essentially “throws darts” or “rolls dice” to determine entry and exit. There are ways to improve upon a random entry system, and even ways to (virtually) guarantee that your random entry dummy system will generate a win% of greater than 80%.

You will need to tweak the parameters of a random entry trading system to match closely what you are attempting to test with your current system, and this may include adding filters or conditions to create similar situations.

When is Your System Better than a Random Entry System?

But for the sake of simplicity, your system will be deemed better than a “random entry” trading system if the following conditions are met:

  • The overall profitability and ‘expectancy’ is larger (winners larger than losers)
  • The %win (or correct trade) rate is higher than the random entry system (though this is not as crucial as the first two)
  • The length of a drawdown period of your system is smaller than the random system
  • The severity (deepness) of a drawdown period of your system is less than the random system
  • Your system takes fewer trades (less commissions) to achieve similar or better overall results

In order to assess whether your system is better, you must first understand the results – or generate your own results – from a random entry trading system. Simple logic can be used, but it is best to test out these strategies in your own strategy backtesting program. Personally, I use TradeStation, but I have heard from other traders that WealthLab Pro is very effective. I do not endorse any product, but do encourage backtesting a number of strategies.

Also, it is best to test only one variable at a time. Utilize a specific exit strategy – time stop, trailing stop, large stop, small (tight) stop, volatility stop – at a time. Run all your entry signals through each test before trying to combine factors into a complex analysis. Do not simply randomly combine entry and exit strategies without reason – always have a purpose behind what you study. Note any anomalies in the results you find.

It is difficult to compare systems to systems, given the complexity of entries, exits, holding periods, position sizing, targets, etc. Start with simple comparisons, learn from them, and then move on to complex comparisons.

More to come!

2 Comments

2 Responses to “When is Your System Better than Random Entries?”

  1. Dbmoen Says:

    I just read Thomas N. Bulkowski's book titled Getting Started in Chart Patterns. In his book and on his website he described how he calculates a volatility stop but I couldn't find an automated calculater to do this anywhere on the web so I created one. Here's the link to my Stock Volatility Stop Calculator.
    -Bert

  2. wealthLab Says:

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