Weekly Insights: System Trading — What Is It and Why Do I Need It?

System Trading — What Is It and Why Do I Need It?


There is an endeavor of futures trading that is popular among many traders, but also about which many other traders are unfamiliar. It is called “system trading.” In this educational feature, I will define system trading and detail the advantages and disadvantages of the methodology.

What is System Trading?

System trading (also known as mechanical trading systems) is the deployment of a well-defined and very strict set of criteria for trading a futures market or individual stock–including entry and exit points. The trading criteria for a particular trading system can include all kinds of technical indicators, chart patterns, volume, open interest, and even fundamental factors. All kinds of trading systems are available for sale, and even more trading systems have been developed by individual traders, for their own use.

The key tenet of a trading system is that strict signals are given for entry and exit points, based on the parameters of the system. Most trading systems are computer-program-based, due to the complex nature of most of the trading parameters. Indeed, trading systems can be highly complex and have dozens of parameters plugged into the system. Alternatively, a trading system can be as simple as a moving-average “crossover” method that provides buy and sell signals with each moving average crossover.

Advantages of System Trading

A major advantage of system trading is that it takes the human emotion factor out of a trade. By strictly adhering to criteria built into a trading system, a trader cannot be swayed by such emotions as fear or greed “in the heat of battle” during the trade. Many veteran trading professionals argue that the major downfall of futures traders is their own emotions and lack of trading discipline. A trading system attempts to control both emotions and trading discipline.

Trading systems can be “back-tested” by running the trading system program through many years of previous price data for one or many markets. A trader may discover that his trading system works best in T-bonds or best in grains. When doing back-testing, a trader can refine the trading system’s parameters to get what he or she feels is the very best trading system, based on past price history, and for various markets. This is what trading system advertisers and marketers call “hypothetical” trading results.

For some traders who are also computer programming “wonks” anyway, much of the enjoyment of a trading system is derived from designing it, building it, and testing it–before it is ever actually put through the paces of real-time trading.

Disadvantages of System Trading

There are at least a few significant disadvantages of the “system trading” methodology. A major drawback is a potential for severe drawdowns in one’s trading account. Since many trading systems have a trader in the market–either long or short–all the time, then unexpected big price moves can be devastating to a system trader who does not have a bigger trading account.

Another disadvantage is the propensity for marketers to “hype” a trading system as generating immense profits, based on hypothetical results. For example, a trading system may be advertised as generating 300 percent profits over the past five years, based on hypothetical back-testing. What the marketers and advertising do not tell you is that the drawdowns on a trading account may have been so severe that most traders would have been wiped out before the market ever turned around.

While mechanical trading systems attempt to eliminate the potentially negative human emotion factor, they also eliminate the very important “trader intuition” and experience tools that can be extremely valuable. While computer trading programs are very powerful and consider many, many variables (as many as the developer wants to add), there is no substitute for the power of the human brain and its flexibility.

For comparison, my “toolbox” approach to trading means that I may use all trading tools available to me in any given trading situation. I will use different trading tools for different trading circumstances. To program a trading system to have such flexibility would be extremely difficult, if not impossible.

Finally, I get many inquiries regarding the use of trading systems by individual traders. There is no single right answer regarding the viability of trading systems for individual traders. “Different strokes for different folks,” as the saying goes. However, my universal response to those seeking out a trading system and who ask for my opinion on the matter is this: Do not spend hundreds or thousands of dollars purchasing a trading system and think you are on your way to Easy Street. Instead, at least first spend less than $200.00 on some classic books on futures or stock trading tools and strategies. Learn and fully understand some of the basic trading tools and trading methods before diving into any trading system.


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