Trading A Mechanical System

A. Why System Trading?

Provides discipline

Removes emotional judgments

Gives more confidence

Alleviates guesswork

Enables better sleeping at night

Doesn’t depend on a person

Gains more profits over long term

Repeats performance results

B. Basic Rules Trading A Mechanical System

Do your homework before putting your money online.

Discipline, discipline and discipline. Follow the trading signals.

Don’t second guess the signals

Don’t over trade

Don’t average down

Any price better than the trigged price is a good price in system trading.

Slippage should be taken care itself in long term

The system is your friend, don’t fight with the system

Take next signal after a few consecutive losing trades

C. Understanding Drawdown

Some mechanical trading systems are profitable year after year, and there are people who regret not following the system. People quit when the system experiences drawdown, especially major drawdown. A major reason why people fail to follow the mechanical system is lack of understanding about the nature of Maximum Drawdown (MDD).

Concept of drawdown and maximum drawdown


Drawdown is an inevitable part of system trading. The system might have a few consecutive losing trades, which will cause drawdown in the account equity. MDD occurs in a choppy market. Adequate margin reserve is needed to sustain the MDD. The following formula is suggested:

Initial Account Balance = Minimum Margin + 1.5 x MDD (using 5-year MDD)

Figure 1. Drawdown and Maximum Drawdown (MDD)

Drawdown is a cost of doing business

To start a business, you plan all the costs. You wouldn’t say, "I wish I didn’t have to buy inventory, to lease office space, or to hire people to do the job." Likewise, if you trade, you can’t say, "I hope I don’t have any losing trades!"

Accept drawdown as inevitable

Picking only winning trades is wishful thinking; it’s impossible.

As a trader, you cannot hold yourself to the standard of the impossible.

Instead, you should make your mind clear: it’s not your job to know whether a trade will be a winner or a loser while you conduct system trading. Your job is to recognize the signals and execute. Losses are an expense of system trading, and expenses are planned for and accepted. In a very short period new highs in the equity curve occur. All trading systems spend most of the time in some sort of drawdown after reaching the occasional highs.

Take a long-term view to system trading

By taking a long view, a system trader can remain optimistic while the system experiences a drawdown period. When a drawdown is believed to be merely transitory, it won’t discourage a trader’s faith in his proven strategies. Trading is about winning over time. It’s about gradually building a growing equity curve. Day-to-day trades are only part of a much larger picture. If you are frustrated unless your system constantly shows a profit, then consider that system trading might not be appropriate for you.

Risk only the capital that you can afford to lose

Risk capital is the money that you can lose and still maintain your lifestyle. You don’t start trading with capital that you need to live on. The market takes scared money.

D. Making a Commitment

Trading as a business requires a serious commitment. Commitment is the start of any great success.

Commit with the understanding of the nature of drawdown

Once you verify a system that works for the most part, you can be comfortable with the drawdown. By knowing that system trading will win over time, you are willing and able to tolerate losses. With the knowledge that losses are part of the system trading process, you replace fear with confidence.

Sufficient capital

A system trader needs to have sufficient capital. To sustain the maximum drawdown, the initial account balance is recommended to be: minimum margin + 1.5 x MDD (using 5-year MDD to be conservative).

Persistence after consecutive losing trades

Experienced system traders are persistent in taking trades after consecutive losses. Some traders even purposely start to trade after consecutive losses, because they know that a drawdown is usually followed by large profit.

E. Trader Talk

Here is a message that a trader posted on our message board of AbleSys web site. We want to share it with every system traders.

He said, if you want to pick trades, you might as well do something else. I fully understand what he (another trader) means. I have the same experience before. Somehow, the market seems to "know" what you think and what you do.

It will test your patience and discipline by giving you some losing trades and whipsaws. The moment you quit because of fear, it will be trending for sure !! Since it is trending, your greed will dominant and you will come back to the game. This is the time the market will be testing you again. (You can even prove that market knows what you think and what you do. In the downward market, if you really want to market go up, you just go ahead and sell(short) it). It caused me a lot of money to switch (symbol/interval/strategies) every time. It caused me a lot to stop trading and start trading.

I realized that "smart" in trading may be stupid sometimes and "stupid" in trading may be smart. So I stop to play smart. The biggest obstacle we have is that we still have feelings and we have positions (money) in the market. Only the system has no feelings and no positions. The market knows our weakness and can beat us easily. But the market has a difficult time to beat a system that has no emotion and no position. Once we know why we lose (fear/greed), we give up our judgment. We only make one decision that is letting the emotionless computer program to take over. The system disclosed its losing trades and draw down up front (just like you hire someone who discloses his previous mistakes in his/her resume. No body is perfect). But once we decide to let the system take over, we need to completely give up our judgment. We have a chance to enjoy our life this way.

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