Bulletin 25 If If It Ain't Broke, Should We Fix It?

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webmaster (Admin) on Tuesday, April 27, 1999 - 07:08 pm:

Chuck Le Beau's System Traders Club
April 27, 1999

Bulletin #25

If It Ain't Broke, Should We Fix It?

When should a trading system be changed or abandoned? This is an important question with many possible answers.

The disclosure documents of most professional trading advisors (CTAs) indicates that trading will cease when the program offered has declined by 50% or more. This popular industry standard for professionally managed accounts is often applied to systems as well. If you are using conservative position sizing and find that you are losing 50% of your starting capital, something is obviously wrong and trading should cease. However we would strongly advocate that this is a classic case of "locking the barn after the horses are gone". Our goal, obviously, should be to avoid losing 50% in the first place. To accomplish this our systems need to be monitored closely on a regular basis regardless of whether they are winning or losing.

There are many ways to evaluate system performance on an on-going basis. However we must get out of the mindset of thinking that we only need to look at our losses to point out weaknesses. We also need to spot weaknesses in our profitable trades. After all, we stand to gain much more by improving our winning trades than by improving our losing trades. For example, assuming that our system has more winners than losers and that our winners are larger than our losers, then we stand to gain more by increasing the size of our winners by 10% than by reducing the size of our losses by 10%. Hopefully the losing trades are always tightly controlled and we certainly don't expect to trade without encountering our share of losses from time to time. However, anything out of the ordinary in the way of losses deserves close scrutiny. We especially want to look for patterns in our losses. We once were able to make a substantial improvement in a system by observing that any four-day pattern of low volatility would draw our Average True Range based stops in too close and create whipsaws. Once we spotted the pattern and identified the cause of our whipsaw problem, the solution was easy.

Also, in addition to evaluating both winners and losers, we must also be alert to spot missed trades. If the market is presenting repeated opportunities that our system is frequently missing, we need to look into our system's entry logic and see if there is some way to participate in a higher percentage of these potentially profitable situations. Perhaps our system should contain more than one set of entry conditions or maybe we need to develop a separate system to capitalize on the opportunities we are missing. It is generally easier to work with two systems than to try and make one system do everything.

In addition to routine trade by trade reviews we also need to be aware of our attitude about trading a system. We should always be trading with an attitude of confidence and optimism. Once we start thinking about skipping trades or thinking that the next trade is likely to be a loser it is a sign that our system might need some improvement. Sometimes even a change that deteriorates the historical profitability is worth considering if it will improve our morale. It is extremely unfortunate whenever a good system must be abandoned simply because the trader lacks the confidence to implement it correctly. Rather than to begin second-guessing a system it is much better to go into the system and see what is creating the stress and then modify the system accordingly.

We have been describing various situations that might prompt us to modify our system but we must also guard against our temptation to implement changes needlessly. All systems go through periods of adversity and our best and worst periods are always ahead of us. One of the advantages of trading on a systematic basis is that we can go back and review historical trading results and get a realistic idea of what to expect in the way of adversity. For example if we have just experienced four losing trades in a row it might put these trades into better perspective if we knew that there were several historical periods with six losses or more and that the system always recovered from these losing trades within three months or less. The primary reason we provide historical trade by trade results with all of our systems is so that our clients can go back and review them and get a good feel for what to expect in the way of adversity. The importance of the historical trading record is not in the precise results and statistical ratios, which will probably never be duplicated. As a trader it is important to realize that we are always in the process of either making new highs or suffering a drawdown. Neither event should be given too much significance.

We should make a practice of reviewing our trading systems on a regular basis regardless of whether they are winning or losing. Late last year many of our members may recall that we made a modification in our "25 X 25" Bond system. ( You can view the Bulletin regarding this change here http://traderclub.com/discus/messages/107/119.html ) This improvement was not prompted by an unusually large loss or a series of losses. Quite the contrary; we modified and improved the system simply as the result of closely observing an unusually profitable trade. The modification did nothing to improve the historical results but it was very logical and we expect that it may improve the results in the future. As I write this Bulletin we are in the process of making a minor change in the newly released Prudent S&P system. Much like the change in the "25 x 25" this change was prompted by the exceptional profitability of our very first trade since releasing the system. (Buyers of the Prudent system should be receiving an upgraded version in the next few days.) My purpose in pointing out this revision is not to draw attention to the excellent start by this system but to highlight the importance of carefully studying and reviewing your profitable trades as well as your losers. You will also note that we practice what we preach in terms of reviewing our systems on a continuing basis.

When reviewing our trades on a regular and frequent basis we should be aware of the importance of maintaining an adequate sample size to keep the trading in the proper perspective. For example, when calculating the winning and losing percentages we must be sure to look at twenty or thirty trades or more. To conclude that our system is losing 80% of the time because four out of the last five trades were losses is not very relevant if the system has actually made money on twenty out of the last thirty trades. Recent trade experience can be very significant however if it can help us spot a pattern and identify a recurring problem. There is clearly no need to wait for twenty losses if we can see what the problem is after only four or five losses (or one profit). Be aware however that using small samples to change our system can be misleading and we may create even more problems than we solve. We must be sure to test our proposed improvements and ideas over an adequate period of data. Implementing changes that eliminate those last four losses can be a big mistake if the testing over the last ten years of data shows that our "fix" has a severe negative impact on the historical results. Also be aware that maintaining correct logic within our system is as critical when repairing or improving the system as it was when we designed the system in the first place. Sound logic must always take precedence over statistical reports. Whatever we do must make sense in addition to being statistically sound. Don't settle for changes that just happen to improve the results without any rhyme or reason behind them.

Speaking Engagements

We will be out of the office from April 29 through May 4 while participating in Dr. Van Tharp's Advanced System Building Workshop in Raleigh, North Carolina. Go to IITM.com for more info.

We will be speaking at the Market Technicians Association (MTA) Conference in Manhattan Beach, Calif. (close to home) on May 13 through 16. Send e-mail to Shelley@mta.org for more info.

Many members have asked if we will be speaking at the OmegaWorld conference in Las Vegas in May. We may attend this conference (not sure yet) but we will not be speaking.

MEMBERS ALERT: New Book Warning

Day Trading Systems and Methods

There is a mini-book that is now being offered that is called Day Trading Systems and Methods by LeBeau and Lucas. This is not really a new book and it is not being recommended or promoted by us. In fact we regret that our publisher authorized it. This so-called book is merely a reprint of the chapter on day trading from our original book Computer Analysis of the Futures Market. This mini-book has been widely advertised and I am concerned that our members might buy this book thinking that it is the new book we have been writing.

The material in the Day Trading Systems and Methods book is old material and in my opinion most of the techniques described there are out of date. Unfortunately our publisher gave official permission for this book to be created but we think it was a bad idea. If you have our original book, don't buy this one. There is nothing new here.

That's all for now

Good Luck and Good Trading