Bulletin 3 Assembling a system from interchangable parts

The Traderclub Forum: Traders Club Bulletins: Bulletin 3 Assembling a system from interchangable parts

David Elden (Admin) on Monday, February 8, 1999 - 08:23 pm:

Chuck LeBeau's System Traders Club
BULLETIN Vol. 1 Number 3 May/June 98

Table of Contents:
Traders Toolkit:Assembling a system from interchangable parts:
Traders Toolkit: The Volatility Entry


Many of our members have suggested that our systems should be evaluated by John Hill's respected publication: Futures Truth. We thought this was an excellent idea and we are pleased to report that the last issue of Futures Truth featured reports on the "25 X 25" Bond System as well as the Big and Little Dipper Bond Systems. Editor John Hill commented:

"The rules for these systems are unique and quite simple. His approach to successful system trading is quite refreshing. He makes a sound argument for trading multiple systems. Different systems for different market phases. The prices for his systems range from $200-350 which is very reasonable. You systems traders would be making a mistake if you don't at least get some literature from Mr. LeBeau and see what he is all about."

John went on to caution that the performance results in the reports of the Bond systems had the benefit of hindsight and that he would begin tracking the systems on a real time basis in the future. John devoted a total of four pages plus a front page editorial to his review of our bond systems. When I phoned him to thank him for featuring our systems, John was very enthusiastic and supportive of our Club idea. To help the Club along he generously offered any of our STC members a $50 discount on a one year subscription to Futures Truth. This means that STC members would pay only $100 per year instead of the usual $150.

This was a very generous limited time offer by John and we hope many of you will take him up on it. You can contact Futures Truth by phone at (828) 692-0273.

We hope to get other publishers and vendors to make similar bargains available to STC members in the future. As the Club grows (now more than 750 members) perhaps we can become a large enough consumer group to command discounts on many other items of value to Club members. Please let me know if there are any particular firms I should approach with this idea.

Just as we did in the previous Bulletin, we want to continue passing along ideas for ingredients of trading systems. But before we do that we thought it might be a good idea to establish a basic framework and background information so that we can communicate our trading ideas in the proper context.

We view the process of creating a system much like Henry Ford viewed the building of automobiles. We start with interchangeable parts and then assemble them step by step much like an assembly line. When we discover a part of a system that performs a particular function especially well, we save it and store it in our "parts warehouse" so that we can take it out and use it whenever we need a part to perform that particular function. Each individual part of the system should be well tested and proven capable of performing its required role in a logical fashion.

Now lets assume that these parts are all sitting around in our system parts warehouse. When we want to build a new trading system we can't just start throwing various parts together randomly. We need a framework and the parts need to be assembled onto the framework in the correct order. Here is an outline of how we view this assembly process.

STEP I: Market Selection. We need to be able to select the best markets to trade at any given time. We want to focus our trading attention on those markets that offer a high level of liquidity and a high level of potential profitability. Good markets will have a combination of high trading volume, clear direction, and enough volatility to make potential trading profits worth the risk and expense of trading.

STEP II: System Selection. We want to have a wide choice of systems and we need to know how to select the right system for the current market conditions. We want to have long term, short term and intermediate term systems to choose from. We also want to have trend following and counter trend systems available. We want to be capable of buying dips or following strength. We need enough systems in our systems inventory to take advantage of whatever market conditions currently prevail and be able to change systems promptly if those conditions should change.

STEP III: Entry selection. We view the entry process as having three logical functions that will require us to assemble three or more important parts from our system parts warehouse.

A. Direction identifiers. Tell us if the market we have selected is going up, down or sideways.

B. Setups. Alert us when a good trading opportunity is getting near.

C. Triggers. Signal us that the best time to enter the trade is right now.

STEP IV: Exit Selection. We also view the exit process as consisting of several logical functions that will require us to assemble even more parts from our warehouse.

A. Risk control exits. Usually some fixed dollar amount or "worst case" stop order is necessary to clearly limit our maximum loss and protect our trading capital.

B. Trailing exits. These useful exits gradually move in our favor as the market moves in our favor and reduce our initial risk level so that our "worst case" stops are no longer exposed. If the market moves far enough some profits are eventually locked in.

C. Trend reversal exits. These exits signal us when there is an indication that the direction may have changed and our logic for entering the trade is no longer valid.

D. Profit protection exits. Once the trade has become sufficiently profitable, these logical exits keep our profitable trades from turning into losers.

E. Profit taking exits. Large profits eventually must be taken. These critical exits try to take profits as near as possible to the point of maximum potential profit.

There you have our philosophy about the process of building trading systems. Now when we offer Traders Club members an ingredient of a system we will also suggest where we think it fits into our recommended framework for assembling a system. This should help everyone to get the most value out of the ideas we will be presenting.

For example in our last bulletin we offered the "Chandelier Exit". We suggested this versatile exit as one of our first ideas because it fits so well into all of the exit categories and it has been thoroughly researched. It can be used as a trailing exit, a risk control exit, a trend reversal exit, and a profit taking exit. If you were building a system that could have only one exit strategy, the Chandelier Exit would be a good choice. Other exits can perhaps do a better job of one particular task or another but few of them can do so many tasks so well as the Chandelier Exit.

In fact, we recommend that you use the Chandelier Exit as your basic benchmark for all of your exits. Start with it and then see if you can improve on the results by employing multiple exits which have more specific goals.


The Volatility Entry


This simple entry is generally one of the most reliable entry triggers for trend following systems. It's always a good first try when you are looking for a trend following trigger that produces better than random results. It is usually implemented by adding a percentage of the Average True Range to the close of the previous bar or to the open of the current bar.

For example we could design a simple but effective entry statement that says: "Buy when the price reaches the previous days close plus .70 of the 20 day Average True Range." (The .70 value is just an example, not a recommendation. The number of days to use in calculating ATR should usually be set at 20 or more or else the entry trigger can become too sensitive due to brief periods of unusually low volatility.)

This entry trigger seems to be more reliable than most triggers because it would require that prices make a strong directional move precisely as we are entering the market. Of course we wouldn't be entering at the cheapest price but we would be entering after a move that showed the market definitely had confirmed its direction. We would have to sacrifice some potential profitability (buying cheaper) for the higher reliability of getting into the market only when our selected market is moving strongly in the direction we expect it to.

The most common application of this entry is to measure from the previous close but we have a slight preference for applying it from the open.. We find that moves from the open tell us a lot about what the market is likely to do over the short run. You should always test it both ways. There are probably many other ways of applying this entry trigger (from the previous day's high or low for example) but we haven't had the time to explore all the possibilities.

Combine the Volatility Trigger with the Chandelier Exit and you have the basic ingredients of a primitive trend following system. As primitive as this system might seem it can often serve as a useful benchmark. Plug in your favorite values for the ingredients and try it on a market or two. Then use these results as a benchmark and see if you can improve the results with other ideas and other systems.

This will give you some way of measuring your progress and a method of evaluating other ideas you come up with. How does your latest idea compare with the simple Volatility/Chandelier benchmark?

Coding the Chandelier Exit

Several members have inquired about how to code the Chandelier Exit described in the Vol. 1 #2 Club Bulletin. Since I'm not a programmer I put out some calls for help. Quoted below is a suggested solution for TradeStation users provided to us by my good friend Terence Tan in Singapore:


1. Create a User Function called "MaxTradeHigh", with the following code:

If marketposition < > 1 then MaxTradeHigh = -999999;

If marketposition = 1 and H > MaxTradeHigh[1] then MaxTradeHigh = H;

2. Create a User Function called "MinTradeLow", with the following code:

If marketposition <> -1 then MinTradeLow = 999999;

If marketposition = -1 and L < MinTradeLow[1] then MinTradeLow = L;

3. To use the Functions in a program, just reference the User Function names directly, e.g. Exitlong MaxTradeHigh -3 * Average (TrueRange,10) stop;

Once you define the User Functions, you never need to duplicate the code in any system when you need to code the Chandelier Exit.
The code is slightly different (improved) from the version I sent previously so that it works for reversing systems that need to go from long to short directly or vice versa, and also works for those possible negative prices in a continuous data series. Please let me know if you have any further questions or difficulties.
Best regards, Terence Tan


Thanks to David Elden who has been helping us with some of our programming, we can now offer TradeStation and SuperCharts users the ELA code for our three bond systems. Along with the code we also provide simple instructions on how to load the systems into the Omega products. Contact us by email if you own one of the systems and want the zip file (no charge) or send $10 to cover postage and handling if you want us to mail you the disk version.


Please send us your ideas for systems. Let us polish up the your idea and turn it into a complete system with our best inputs. The final system can be given to STC members for free if you are willing or it can be offered for sale at a reasonable price (your choice). We can also do custom system design and consulting if you want us to help you with a proprietary system that will not be made public. We can also help new CTAs get started.


Read any good books or articles? Found any systems on the net? Please bring them to our attention. We are always on the lookout for new information to pass along to members.


The following question was submitted to me via Dr. Van Tharp's web site
(www.iitm.com). STC members should enjoy browsing this very interesting site and playing some of Dr. Tharp's money management and trading games. It's educational and it's free.

Question: What is the best way to create a system that I can backtest in SuperCharts? The entry signals I am using are like Elder Rays and Five Day Momentum. I exit on big range days or at resistance lines.

Answer: Regardless of what software or indicators you are using I would suggest you build and test your system one part at a time. Here are the basics:

The first part to test of course is the entry. Test your proposed entry method with simple time-triggered exits that simulate the time period you want to trade. For example exit after 3 days, 5 days, 10 days and 20 days.
Pay no attention to the dollar amount of gains or losses at this point.. All you want to see is that your entry method is getting you started in the right direction at the right time.

At this point you should have better than 55% winning trades with these simple exits or your entry method is no good. You can flip coins and get 50% winners so why settle for anything less from your system. Concentrate on getting the highest possible percentage of winners with the timed exits. Your profitability, drawdown and the other measures of your system will eventually be improved by adding much more logical exits.

After you have an entry method that works better than flipping coins you need to add several exits, each serving a different purpose. For starters you need a risk control exit that limits your worst loss. Don’t worry if this is a fairly big number. You won’t expect your worst loss to get hit very often, if ever. Your other exits should prevail and limit your loses most of the time.

Assuming that your system is intended to be a trend following system, you also need a trailing exit that gradually reduces risk and locks in profits as the market moves in your direction. (Your resistance lines for example.)

Finally you need a method to lock in large profits. Once you have a profit of X amount or more you can exit using your big range days or a much closer set of resistance lines.

Do you have any questions we can help with? If you do, just email them to us . We will try our best to answer promptly.

In addition to designing more trading systems we are formulating plans for an exciting new web site for the Traders Club. You will be hearing more about this in future issues of the Club Bulletin.