BarroMetrics View: Elements of A Mechanical System
Assuming a mechanical system is ideal your personality, the questions that arise are:
- What are the qualitative elements of a reliable system?
- Where can I test my system?
- What are the quantitative measures to be aware of?
Turning to the qualitative elements…..whenever I am creating a new system, the first question I ask myself is what assumptions will the system be making? For example, in the system that is currently taught in Ultimate II, the underlying assumption ‘is the market is producing directional momentum’.
The next question is, what are the elements of the system? Then I ensure that I structure the system correctly so that it flows. Essentially the system has to answer four questions:
- The instrument to be traded
- The entry criteria
- The initial stop criteria
- The target criteria
Once the qualitative measures are completed, the next step is to have a system tested.
When I first started trading, there was limited software for testing and innumerable services that would do it for you. Now, the shoe is on the other foot. When I googled “back testing for mechanical trading systems”, I found innumerable referrals to testing software, and none in the way of testing services. I’m sure some there are some services, but you may need to perform some deep searching to find them.
Back testing and forward testing are not my areas of expertise. I am lucky enough to have the services of an excellent programmer who is well versed in probability theory.
It looks as though if you are mechanical traders, you will need to acquire the programming expertise. One piece of advice I can pass on, my programmer says that all back testing and forward testing should include a Monte Carlo simulation. In this way, the testing will ensure that the result has not been caused by a favourable sequence of trades that understate the risk.
If any reader knows of back testing and forward testing services, please do drop a comment.
Once the back testing has been completed, you will need to analyse the results. Some of the things I would look at are:
- The probability of risk of ruin
- The number of consecutive losses
- The number of consecutive wins
- The average dollar win
- The average dollar loss
- The win rate
- The loss rate
- The average percentage return (on Capital)
- The average percentage loss (on Capital)
- Return divided by drawdown
Next week we’ll look at a discretionary trading plan and answer Baz’s questions on stop placement. Tomorrow I’ll reply to Wenda’s query