Developing a Trading System or Strategy

Q:How do you improve your trading strategy?

A: A complete answer to that question would be quite involved and whole books have been written on the subject!

Assuming you have a specific strategy in place – you can improve it by reading relevant books and publications about on the topic of trading strategies. You can also improve it by acquiring feedback and answers from people considered experts in this trading strategy. Join a network of investors/traders who utilize this strategy. I used to work in a discount brokerage firm for a very long time, and I can assure you that there are plenty of investors out there who trade but either do not have a trading strategy in place or have a weak strategy. With that said – choose a benchmark such as S&P 500 and measure your monthly returns vs. it. If you beat the index on a steady basis – great. If you keep missing the mark – then your time can be better spent doing other important things while your money is parked in an index ETF.

So, let me go through some basic steps:

1. Start with a trading strategy….either one that you’ve seen others have success with or one that you’ve developed on your own from market observation.
2. I like to run it through a back testing program to see if it lends itself to that and have it generate as many trades as possible that meet the broadest range of conditions.
3. I take the trades it generates and apply “filters” to them to see what factors most positively influence these trades. I select the factors based on the conditions that caused me to take the trade, the timeframe, risk tolerance, etc. Some of these may be things like: Is it an inside/outside day?; Is it making a new hi/lo? Is it’s VWAP extended more than 1%? Is it at 2x or more volume? As you can see, these go on and on.
4. I take these factors and apply them using my backtesting software or Excel (I often find Excel much more efficient at this) until I get a reasonable number of trades.
5. If I like the profitability, risk-reward ratio, and maximum equity curve drawdown of the trades, and they dove tail nicely into my other strategies (i.e.: a trend following to match up with a revert to mean strategy), start trading them with say, 200 shares.
6. As profitability is achieved at the 200 share level, increase gradually in case one of those big down days comes so that you won’t have 2 weeks’ worth of profits sucked up by one days trades only because you increased size too quickly.

For myself I -:

1. I write my strategies down and strictly adhere to them (particularly my exist strategy).
2. I make extensive use of both technical and fundamental analysis tools to try to optimize choosing companies on earnings growth potential and timing of purchases and sales.
3. I track my performance to evaluate what worked and didn’t work so I can refine strategies over time to increase the probability of success.

More information about devising trading strategies and trading systems here.

Q:What is risk appetite and risk aversion?

A: Higher risk usually implies either bigger gains or bigger losses. Risk appetite suggests you are looking for risk to try and maximize your gains.

Risk aversion is the reluctance of a person to accept a trade with an uncertain payoff rather than another trade with a more probable, but possibly lower, expected payoff. For example, a risk-averse investor might opt to put his/her money into a bank account with a low but locked-in interest rate, rather than into a stock that is likely to have higher returns, but also comes with the risk of becoming worthless.

Q:How do you (as an amateur) win against institutions armed with analysts and access to a ton of information and other services?

A: Being a small trader doesn’t mean that all odds are against you – you have the benefit of having a smaller capital base which allows you to dip in and out quickly and thereby you should be able to control losses more efficiently – it would be a lot more difficult to enter or exit a trade quickly if you had 000’s of holdings. Also, unlike institutions you have very little compliance constraints. Personally my strategy for trading shares is to look for value in solid businesses and try and find a good reason to have them with a medium to long term view. I’ve had stuff from mega-cap down to AIM miners/explorers in my portfolio in the past. I know mining and oil and gas so I like to focus on this to some extent. I don’t try to mess around with stuff that I don’t understand, and that includes interest rates and commodities in general although I do have a gold position at the moment.