The object of this first article on Trading Systems is the establishment of the different phases through which the Operator or Trader passes. It consists both in a categorization and in an evolutionary process. When we talk about Traders, we come to mind the image of a person who works for a Financial Institution, with 10 screens from which he does not move away and with an important level of stress.
Introduction to system trader
In this article, I will refer both to Professional Traders and to those who operate from their homes, either full-time or part-time. Anyone who buys or sells a single lot of shares, to benefit from the difference in prices between purchase and sale can be considered a Trader. According to this broad definition, established by Charlie F. Wright (www.elitetrader.com), there are four types of Traders: the Discretionary, the Technical, the Initiated in Systems and the Expert in Systems.
The difference between these four categories is not always clear and often we can find Traders who believe they are in the third or fourth category when they are actually in the second. To become a good System Trader you have to go through the four stages, do not skip any, and our goal is to minimize the loss of time and money produced by the passage through each of the phases.
According to many Traders of recognized prestige, the best university for the study of Trading is the own operation, the day to day in the markets. If you are in the first phase, try to reach the fourth, in the fastest way and with the least possible loss. If on the contrary you are in the third or fourth you are sure that you identify with this classification and recognize having passed through the previous stages. The time dedicated to each of the phases depends on the ability of each Trader and the free time available to analyze their operations and improve their training.
Different types of traders
But if there are different types of trading, necessarily there must be different types of traders. After all, a scalper or intraday trader will not have the same information to consider as a swing trader.
Next, we review the different types of traders, according to their operations:
I. Discretionary Trader
“People want gurus, so they will keep coming. Every Trader must realize that, in the long run, no guru will make him rich. We must learn to trade independently”. Alexander Elder
The Discretionary Trader uses a combination of intuition, expert and friend advice, and ultimately, a set of non-objective data to enter and exit the market. They do not have a set of defined rules, so our rules will be constantly changing with the risk that this entails. The Discretionary Trader moves by impulses, by the comments of the gurus, by the recommendations of the salmon press and the Brokers, even by the comments of friends. Whatever method we use, we will immediately change it if we start to lose money, creating a chain that will end when we have lost enough money to think that something is wrong with our overall approach.
Generally the Discretionary Trader, because we are in an initiation phase, operates in cash, buys and sells shares and still does not handle Short Operation, nor uses financial derivatives. He is a lover of strong emotions, needs to be always in the market and is unable to keep his money in liquidity, he still has not understood that in addition to buying or selling, there is also the option of staying out of the market.
According to my own experience, I remember that I used to make trades following the recommendations I heard on the radio and read in the press. You can imagine the result. Do not be confused if in a bull market, you make money with such recommendations, you have not won money for the recommendations of the always-bullish, you have won money for the market in which you have operated. You have to have very little brain, or a lot of bad luck, to lose money, buying shares, in a bull market.
A discretionary trader can make money in one operation, even in a set of consecutive operations, but in the long run it is predetermined to lose money, and recognize that the lack of certain rules is harmful to our current account. This leads him to start looking for other methods and at that moment he finds the technical indicators, which he begins to mix with the rules he has been using so far. If we see that our favorite guru recommends buying BBVA and also see that the RSI is oversold, we already have the perfect excuse to buy. In this way we have added a more objective component to our operations and we already feel prepared to act in the market and recover all the money we have lost.
II. Technical Trader
“I realized from a technical perspective that, the charts tell the truth, they don't lie. The charts are never wrong.” Oliver Vélez.
The Technical Trader begins to realize that the use of rules is very important and that it is important to use confirmation parameters before making a transaction. He has developed a set of rules, which he follows on certain occasions and not on others, depending on the money he is winning or losing and above all on his emotional control. If a technical indicator gives us a buy signal, we will skip the signal if our broker does not recommend the purchase. On the other hand, if we are bought and we are winning a good sum of money, we anticipate the sell signal, violating one of the great maxims of Trading: “Let the profits run and cut the losses immediately”.
The Technical Trader discovers a new world of books, newsletters, seminars and all this information begins to pressure our Trader. Too much information and little time to assimilate it. MACD, RSI, SMA, EMA, ROC, DMI, ADX, MFI, ATR, SAR, CCI, are some examples of Technical Indicators. He begins to experiment with all of them, and embarks on the search for the best indicator, the one that nobody knows and with which we are going to make a lot of money. The search for the Holy Grail has begun and the Trader submerges himself in a pathological process of Fascination with Indicators or Holy Grail Syndrome.
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Our Trader assumes that there must be someone in the market who knows how to do it, there must be an expert, someone who has developed a magical Indicator, so the goal of finding the Super-Indicator is based on finding the person or entity that offers us the Holy Grail. The search is complex but surely it is worth it, in this phase the Trader discovers the stop losses and other risk management techniques and little by little he begins to realize that Trading is a more complex process than the simple use of an Indicator. The search is sterile and in this process we have continued to lose money so our global strategy continues to be wrong.
The recognition that there is no Magical Indicator and that it will never exist, implies a great leap for our Trader who begins to enter the next stage. Our Trader realizes that he should do a testing of the Indicator to see how it has worked in the past and use these statistics to know what we can expect from our Indicator in the future. This will generate confidence in the operation since we have finally realized that we cannot predict the behavior of the market, so we simply need a tool to be able to follow it and put the odds in our favor.
We have overcome the second phase and we begin to feel the need for a set of rules. He realizes the importance that price databases have in the development of our operations and the need to learn to develop our own Trading System.
III. Trader Initiated in Systems
“Only those who expect nothing from chance are masters of their destiny”. Mathew Arnold.
It is essential for success in the markets to use an operational based on a set of predetermined rules, from which we must not deviate under any circumstances. Of course, we can improve these rules, but never while we maintain an open position in the market. We must work on the development of the system, using our imagination and intuition, but once the system is in motion, we must be inflexible with our framework of operations. If the system indicates buy, we must buy and if the system indicates sell, we must sell.
We can read the salmon press (Expansion, Five Days, Business Gazette, etc.), watch our favorite financial channel, but never let this information influence our operations that must be guided exclusively by our System. We must be able to dissociate our operations from the financial culture. We trust our System because it is based on logical rules. We have dedicated many hours to the development of this set of rules and we have tested them on a completely reliable, extensive database and with a sample that includes all phases of the market (bull market, bear market and lateral). These last two characteristics are critical for the operation of the system and for generating confidence in the Operator.
From now on, it will be our system that will guide our operations. We have left behind the great gurus, the recommendations of our broker, our intuition and we no longer focus on trying to predict the movement of the market, but on following our system and although we know that the market will never replicate the past, it is much more comfortable to use a system that has been tested with historical data than to operate through our intuition. Now we know that the success of the system is not exclusively linked to the indicator or indicators used to generate signals, but to other factors such as risk management and money management.
The System Trader realizes that risk management through the stop loss is fundamental, although a stop too tight will make many operations close with this stop and that the result of the system decreases, while a stop too loose offers us results similar to the original system, but does not limit our risk and this is when one of the most important parts of the trading systems comes into play, money management or money management.
IV. Expert Trader in Systems
“Since people don't change, if rigorous enough methods are used so that retrospective knowledge does not distort the results, it is possible to test systems and see what results they would have obtained in the past to have a fairly approximate idea of how those systems will work in the future. That is our main advantage.” Larry Hite.
We are now in the final phase, in which we have perfected our risk management rules and have learned money management techniques, we operate in different markets and probably use different systems in each of the markets. The Advanced Trader of Systems knows that the key to long-term profits is in the management of our capital and not in the search for the magical indicator. Trading is no different from other businesses and to survive we need a good business plan and good management skills. This is, without a doubt, the most important part of the entire model and by incorporating it into our system it provides us with the necessary tools to operate in the market with guarantees of success.
Diversification in different markets is another guarantee of success. This diversification will lead us not to depend on a single market in our operations, so our results curve will be smoothed and our profitability-risk ratio will improve. Examples of success of this diversification we have in the system of the turtles (www.turtletrader.com), which used a single system (trend following) applied to multiple markets, with a solid base of money management, which led to annual returns close to 100%.
In addition to diversification by markets, we also have diversification of systems in the same market. This type of diversification finds its reason for being in the nature of the markets, which go through different phases, in this way when we are in a market with an accentuated trend the Trend Systems will generate good operations, while the systems that seek lateralization or periods with high volatility will lose money and the same when we are in a lateral period or in a period with high volatility. The key is to develop a set of systems that complement each other well and that have the lowest possible correlation.
It is also very important to discover the psychological aspects of Trading, since after many years of effort in the development of a good system, when we finally consider that we are ready to operate in real time, the only way to get our results account to resemble the result that the system throws in our software is a firm discipline and a strict control of our emotions. Psychological aspects are constantly undervalued by the Trading Industry and are not part of the education of the Novice Trader, which makes him an easy prey for the Traders with more experience.
Another important aspect in the evolution of the trader is the emergence of a critical mind with everything that comes from the outside, as Traders we should not believe anything they tell us, we should experience everything and stay with what really works, we will increasingly have more confidence in our abilities and less need for external support. We must train ourselves not to depend on anyone when generating our buy and sell signals. Another important point is that what we initially considered essential, predicting the future, has already gone to a second term, it is no longer part of our objectives.
Conclusions about the system trader
In the following figure and as a summary, the different stages previously described are established, below each stage are the tools we use for our operations in each phase and at the top of the figure the main characteristics of the changes produced when passing from one phase to another are shown.