Great Mechanical Trading Systems that Aid Success

Trading for a Living: Can It Be Done? Yes.

Everyone who is trading, but not for a living, has probably asked themselves this question. When people ask us, we respond: Well, what is a living? For one person, it is $50,000 a year, for another it is $500,000 a year. We don’t know how much money you have or how much you want to make. One trader might risk more and make 100% on his money, but another might risk less and make 30% a year. Some traders may have a losing year — it happens to the best. The real crux of the matter amounts to what is a living for you, and whether you are able to follow a system to make your goals happen. The answer ultimately depends on your self-discipline and whether you have that needed deep desire to win at all costs. Famed trader, Jim Rodgers, gives this perspective:

Most of us don’t have the discipline to stay focused on a single goal for five, ten, or twenty years, giving up everything to bring it off, but that’s what’s necessary to become an Olympic champion, a world class surgeon, or a Kirov ballerina. Even then, of course, it may be all in vain. You may make a single mistake that wipes out all the work. It may ruin the sweet, lovable self you were at seventeen. That old adage is true: You can do anything in life, you just can’t do everything. That’s what Bacon meant when he said a wife and children were hostages to fortune. If you put them first, you probably won’t run the three-and-a-half-minute-mile, make your first $10 million, write the great American novel, or go around the world on a motorcycle. Such goals take complete dedication.

How Much Time is Needed? Not much if you follow a Trend Following system. Trading signals can be generated manually via a simple PC spreadsheet in a few minutes per day. Just keep careful records and a trading log. You can also automate trading signals with products as discussed here.

Mechanical trading
Be a Mechanical turtle, following a mechanical trading system allows diversification and frees up time to concentrate on the trades that matter. Picture by Ken Teegardin, CC.

Orders can be placed before the market opens and do not need hourly monitoring. Most top traders don’t spend all day trading. If the markets are not moving there is nothing to do! What do they do? They manage their trades in 10 to 60 minutes per day. Richard Donchian offered great wisdom decades ago:

If you trade on a definite trend following loss limiting-method, you can [trade] without taking a great deal of time from your regular business day. Since action is taken only when certain evidence is registered, you can spend a minute or two per [market] in the evening checking up on whether action-taking evidence is apparent, and then in one telephone call in the morning place or change any orders in accord with what is indicated. [Furthermore] a definite method, which at all times includes precise criteria for closing out one’s losing trades promptly, avoids…emotionally unnerving indecision.

Price: Right or Wrong

“There’s something very reductive about the stock market. You can be right for the wrong reasons or wrong for the right reasons, but to the market, you’re just plain right or wrong.”
John Allen Paulos

Are you comfortable with the concept of right and wrong? The price you analyze everyday is the truth. Price does not lie. The price is always right.

Taking price a step further we can see…

Markets are also the same because of price. All markets are most directly measured by their individual price movements. What do cotton, crude oil, Cisco, SUN, GE, US Dollar, Australian Dollar, soybeans, wheat, Microsoft, JDS Uniphase, EMC and Oracle all have in common? Let’s say you know nothing about trading cotton. Moreover, you also know nothing about fiber optic networking (a specialty of JDS Uniphase). Oracle and databases? Let’s say you are clueless about them as well. Does it matter that the fundamentals of cotton, JDSU and ORCL are all different? What if you just analyze their market prices?

Trend following does not require an understanding of the market fundamentals. Take the price data and apply your rules. If your trading is pure trend following, all markets are the same in terms of price analysis.

The Universal Chart


William F. Sharpe, Reprinted from The Financial Analysts’ Journal Vol. 32, No. 4, July/August 1976. p. 4, Copyright 1976, Association for Investment Management and Research, Charlottesville, VA:

Some years ago, in a land called Indicia, revolution led to the overthrow of a socialist regime and the restoration of a system of private property. Former government enterprises were reformed as corporations, which then issued stocks and bonds. These securities were given to a central agency, which offered them for sale to individuals, pension funds, and the like (all armed with newly printed money). Almost immediately a group of money managers came forth to assist these investors. Recalling the words of a venerated elder, uttered before the previous revolution (Invest in Corporate Indicia), they invited clients to give them money, with which they would buy a cross-section of all the newly issued securities. Investors considered this a reasonable idea, and soon everyone held a piece of Corporate lndicia. Before long the money managers became bored because there was little for them to do. Soon they fell into the habit of gathering at a beachfront casino where they passed the time playing roulette, craps, and similar games, for low stakes, with their own money. After a while, the owner of the casino suggested a new idea. He would furnish an impressive set of rooms which would be designated the Money Managers’ Club. There the members could place bets with one another about the fortunes of various corporations, industries, the level of the Gross National Product, foreign trade, etc. To make the betting more exciting, the casino owner suggested that the managers use their clients’ money for this purpose. The offer was immediately accepted, and soon the money managers were betting eagerly with one another. At the end of each week, some found that they had won money for their clients, while others found that they had lost. But the losses always exceeded the gains, for a certain amount was deducted from each bet to cover the costs of the elegant surroundings in which the gambling took place. Before long a group of professors from Indicia U. suggested that investors were not well served by the activities being conducted at the Money Managers’ Club. Why pay people to gamble with your money? Why not just hold your own piece of Corporate Indicia? they said. This argument seemed sensible to some of the investors, and they raised the issue with their money managers. A few capitulated, announcing that they would henceforth stay away from the casino and use their clients’ money only to buy proportionate shares of all the stocks and bonds issued by corporations. The converts, who became known as managers of Indicia funds, were initially shunned by those who continued to frequent the Money Managers’ Club, but in time, grudging acceptance replaced outright hostility. The wave of puritan reform some had predicted failed to materialize, and gambling remained legal. Many managers continued to make their daily pilgrimage to the casino. But they exercised more restraint than before, placed smaller bets, and generally behaved in a manner consonant with their responsibilities. Even the members of the Lawyers’ Club found it difficult to object to the small amount of gambling that still went on. And everyone but the casino owner lived happily ever after.


Risk Taking & Systems Trading

When most people first start trading they often start small. As they get better at it, they trade more. They might start with one contract and then move to ten contracts. As time progresses, they reach a certain comfort level with their trading, but are still afraid to take risks beyond that level. As a result, they never trade at levels of 100 contracts or 1,000, so they never experience large profits.

There is a better way in which the object is to try to keep things in constant leverage terms. In other words, you trade the same as your equity increases. By using a trend following approach to money management, you are never afraid of getting big. You are prepared, so you know what you will do in advance as your account grows. This is a key to the trend following money management.

Mechanical Systems

Risk taking is essential to successful trading, as long as it is calculated risk. When you take a risk it is useful to have a mechanical trading system for several reasons: You increase your diversification, reduce your work load and make your trading life easier. Mechanical trading systems enable you to take a risk without getting personally involved. Although you might not be happy when you are going through a drawdown or taking a loss, at least you’re not agonizing over your trading decisions on a day-to-day basis. It’s the rare individual who can sit in front of a quote screen and make consistently good trading decisions day after day. Other components of your life will always impact your thinking generally and your trading decisions specifically, unless you rely on a mechanical system.

Trend following trading is predicated on the fact that human beings are not psychologically equipped to interact profitably with markets. When money is involved, psychological pulls interfere with objectivity. As a result, human beings who have money on the line tend to take their losses too late and their profits too soon. The problem of taking profits too soon particularly affects traders. They often feel a strong desire to close out a profitable position when it starts to move against them. Mechanical systems overcome these psychological and emotional reactions.

Recovering From A Drawdown

Consider the following table:

Loss of capital (%) Gain to recover (%)
5 5.3
10 11.1
15 17.6
20 25.0
25 33.3
30 42.9
35 53.8
40 66.7
45 81.8
50 100.0
55 122.0
60 150.0

Bear in mind that consecutive runs of losses are not merely possible, but will ultimately occur over time, given enough trades. However, when they do happen, this is the point when it is crucial to have a strong money management plan to keep you in the game.

Profit Taking? Let Profits Run

Trend followers know the trick of letting their profits run is key to trading. Once you learn that to maximize your profits you must be willing to give up some part of your accumulated profits, you are on your way to sustained success. For example, let’s say you start with $50,000. The market takes off and your account swells to $80,000. Many people might quickly pull their $30,000 profit off the table. They feel that if they don’t take those profits immediately, they will disappear. Refusing to give up a part of that accumulated income due to fear is their big mistake.

Trend followers understand the nature of the market. They realize that a $50,000 account may go to $80,000, back to $55,000, back up to $90,000, and from there, perhaps, all the way up to $200,000. See the mistake of quickly taking a profit just because you might not like volatility? Those people who took profits at $80,000 were not around to take the ride up to a $200,000 account. Pretend you are one of those people with the $30,000 gain in your account. Instead of simply protecting your entire $30,000 profit, why not be more aggressive with it? Do you think great traders have been successful by taking profits? Or have they compounded their profits?

Letting profits run is tough psychologically. It’s counter-intuitive for most people. It feels risky. But, once you understand that in trying to protect every penny of your profit, you actually prevent yourself from making a bigger profit, you have learned an important reason why trend followers are so successful.

Money Management

Trend Followers Adapt and Adjust

If You Consider Volatility in Your Trading
You Can Adapt and Adjust Your Direction

Quick! Volatility is changing. What move do you make?

What direction do you take now?

Trend following traders use a philosophy of trading that adapts to different markets and different market conditions. Trend following is based on keeping things proportional to the market’s current volatility. The ability to adapt to changing volatility (the market’s daily ups and downs) is built into the core of any successful trend follower’s trading system. If you don’t measure and consider volatility everyday you are missing a core component of trading success.

What do we mean? During a high volatility period, for example, a good trend following trading system will dictate that you trade fewer contracts or shares of a given market. During periods of lower volatility, trend following dictates that you trade more contracts or shares. In other words, trading commitments are increased during favorable risk/reward periods (low volatility) and decreased during less favorable periods (high volatility). This doesn’t mean high volatility is a bad time to trade. It simply means that you can’t trade as much as you can during low volatility periods. Trading the same number of contracts or shares no matter the volatility simply decreases your odds of success. Who wants to do that?

A main reason for always measuring volatility is for the psychological benefit. If you have too much volatility (and your trade size is not correctly decided) in any one position it attracts your attention. Your focus shifts to one particular position and you can lose sight of the big picture. Measuring volatility and then adjusting your risk exposure for any given trade keeps you psychologically balanced. If one particular market has an explosion of volatility you can trust your rules to decrease your trading size to reflect the new level of uncertainty. Sounds simple enough? Perhaps it is, but most people ignore the wisdom.

Stock Tips & Volatility

Have you ever received a stock tip from a friend, CNBC, or your broker that also included a volatility measure? Have you ever heard a market commentator tell you how much of a stock to actually buy or sell within the context of what current volatility is? If you do not consider volatility daily are you not one step closer to the blowout of all blowouts?

More on Volatility.

Time Horizon Based On Quarters?


“Jim DiMaria learned an important trading principle in the less lucrative arena of baseball statistics: The players who score the most runs are home run hitters, not those with consistent batting records. It’s the same with trading, DiMaria says. Consistency is something to strive for, but it’s not always optimal. Trading is a waiting game. You sit and wait and make a lot of money all at once. The profits tend to come in bunches. The secret is to go sideways between the home runs, not lose too much between them.”
Jim DiMaria

Why is basing your time horizon on quarters such a big mistake? The preoccupation that so many people have with twelve month returns is not smart trading. Top traders could not care less about twelve month returns, so why must you? The prime objective of top traders worldwide is to make money.

Quarters do not predict: Top traders know that focusing on quarterly objectives has nothing to do with success since that would assume you can control how much you make. Does anyone believe they can control how much they make? Quarterly performance reporting is nothing more than another way to mislead yourself pretending you can predict the market or shoot for profit targets.

Quarters are not real: They are artificial start and stop points. You are bombarded by references to quarterly performance numbers from almost every media outlet right? Most people focus on their portfolios from a quarterly perspective only. Why? Because the perspective may not be real, but it is easy, and most people prefer to go through life mindlessly. However, to properly evaluate any trading style a rolling 36 month window must be employed at a minimum. For example, say your trading system had little performance gain for the last 3 months of the year, but since trend following is long term in nature, it explodes with profit in the first month of the new year. With quarterly reporting you would look at this system as having a bad fourth quarter and a good first quarter. How does this interpretation help you? It does not.

Ponder what Jim DiMaria said above. Home runs may not feel easy or safe, but what is your alternative? You can either trade aggressively putting yourself in position to get rich or you can give your money to a mutual fund and buy and hope. DiMaria is really talking about being trapped in the quarterly performance cycle spin. You can worry about meeting some artificial time objective or you can be a home run hitter and take what the market gives no matter when it arrives.

Trend Following Products

Review simple trend following systems and training:

Michael Covel Trend Following Products
Michael Covel Trend Following Products

More info here.