WHAT IS A MECHANICAL TRADING SYSTEM?
Mechanical trading systems are techniques that make trading decisions for you! You input the trading data, and the system
generates a response that indicates the appropriate action. You either buy, sell, or do nothing depending upon the formulas
the system uses.
The latest computer versions of these mechanical systems are complete "black box" operations. Turn the computer on, start
the system, and it updates your data base, and generates trading recommendations, and places your orders directly to the brokers.
Speed is of the essence in these hectic times. Every nanosecond counts when you are trading using five minute charts.
HOW DO MECHANICAL TRADING SYSTEMS WORK?
The most basic systems rely on moving averages. The more "sophisticated" systems use combinations of moving averages of
both price and volume. The most "expensive" systems incorporate stochastics, which are the mathematical techniques for a non-linear
science.
These systems are reactive by design. If a stock or a commodity acts in a certain way, the system assumes that the stock
or a commodity will continue to act that way. It generates this conclusion based on the formulas programmed into the system.
Some" Black Boxes" also compute a large array of indicators in an attempt to increase "confidence" of an action recommendation.
Most mechanical trading systems buy or sell "breakouts".The stock market calls these traders "momentum players".Their formulas assume a continuation of that movement. Should that
movement fail to continue, the system will generate a loss, plus the commission cost.
We must also recognize that most mechanical trading systems always have you invested in the market, either long or short!
Their primary assumption is that the movement that created the breakout will continue. It therefore follows that you must
take each trade to increase the chance of profits.
Mechanical trading systems also require trading in many markets. This is an attempt to reduce total portfolio risk. Simultaneous
long and short positions in many markets can reduce total risk, but it dramatically reduces profitability. The ultimate hedge
results in no change.
Trend following is the mission of mechanical trading systems. There have been many attempts to accomplish this goal. Defining
the trend is the biggest hurdle. There is no universally accepted definition of a trend. Therefore, there is little agreement on how to follow the trend.
CURVE FITTING or DATA MINING is the technique used to develop almost all mechanical trading systems.
Christian Schaer.of Agora Capital Services SA calls Curve Fitting a pernicious illusion!
"Curve fitting, or data mining, is the "art" of drawing conclusions based on past information. When applied to an investment
scheme, or trading strategy, history shows that (too) often such conclusions do not hold true once they are implemented.The
end result is an unpredictable performance, often coming short of expectations. In people’s minds, the issue of curve
fitting is mostly limited to systematic traders such as commodity trading advisors- who are percieved to build models by optimizing
simulated past performance based on given assumptions."
"This article argues that the trap of curve fitting occurs across a wide spectrum of investment activiites and that most
investors engage in curve fitting without know it"
WHAT RESULTS DO MECHANICAL TRADING SYSTEMS ACHIEVE?
We will first look at the daily charts for the last six months. This will give us some insight as to the
actual profitability of momentum trading (acting on breakouts).
We will use Mar Soybeans as one example for this discussion . We can assume that some mechanical trading systems bought Beans at 596 or higher in
August. We may safely assume that these same systems sold Beans in September, at anywhere from a small to a large loss.
Jan Crude Oil is our next example. We may assume that some systems gave a buy signal at $51
or better in Sept. They probably gave a sell signal at break even, or at a loss in Oct.
Jan OJ is interesting. We must assume that many systems gave a buy signal on 10/01. We
can assume a loss on this trade.
Dec Cotton is revealing. Many systems bought at 48 or higher in August.
Many sold at 47 or lower in September. Furthermore, many systems would have gone short at 47 or lower in September. This trade
would have been covered, and you would have gone long at 47 or better in November.
A look at the monthly March Wheat chart is more revealing. The latest CRB factbook discusses the much heralded " breakout " to the upside after many years
of consolidation. A quick look at the monthly March wheat contract ( Use March to March basis! Not nearest month continuation
charts!) reveals that the "breakout" was an fake. You would have bought March Wheat at 334 or better during July 2002. By
April of 2003, March Wheat was selling at 279 ½. That is a loss of 54 ½ cents per contract, or $2700 plus commissions per
contract!
Of course you were using the margins recommended by your broker ($400 to $600), so you were forced out of the market by
the margin calls.This assumes that you did not encounter "limit " moves, which lock you in until the market actually trades!
Fortunately, other observers have described their experiences. Therefore, we are not dependant on any one person’s
experience or biases.
Bruce Babcock offers these observations :
Mathematical analysis of commodity price data has shown that these price changes are primarily random with a small trend
component. This scientific fact is extremely important to those desiring to pursue commodity trading in a rational, scientific
manner. It means that any attempt to trade short-term patterns and methods not based on trend are doomed to failure.
A good example of such a doomed method is Japanese Candlestick patterns. This theoretical conclusion is consistent with
my previous research. Many years ago, just as Candlesticks came into vogue, I attempted to create a profitable trading system
incorporating Candlesticks. I tried many patterns and many types of systems, all without success. I have never seen anyone
else demonstrate the effectiveness of Candlesticks using objective rules either. Successful traders use a method that gives
them a statistical edge. This edge must come from the tendency of commodity prices to trend. In the long term you can make
money only by trading in synch with these trends. Thus, when prices are trending up, you should only buy. When prices are
trending down, you should only sell.
Turtletrader offers us this observation on breakouts:
If you believe Trend Following is simply buying or selling a 20 day breakout, you are dead wrong. If you focus
on breakouts as a Holy Grail, you’ve missed the point and are probably already on your way to losing your capital and, ultimately, your shirt. A
trader who focuses on market entry only is in big trouble. Good trading is mostly money management or risk management. Keep
in mind though, once you have the money management down, trading is 100% your personal discipline and psychology.
For a discussion on the effectiveness of STOP loss orders in money management, see DO STOP
LOSS ORDERS LIMIT RISK? ABSOLUTELY, POSITIVELY, MAYBE!.This article may be found at https://onlypill.tripod.com/factsthebrokersandfinancialreporterswonttellyou/id16.html
Victor Niederhoffer claims that trend following is an illusion:
Although Niederhoffer peruses the National Enquirer for insights into investor sentiment, he also uses less provocative
trading methods. Niederhoffer makes money by finding small anomalies in the day-to-day ripples of markets for everything from
currencies to coffee. He uses a statistical model to reveal how movement in one market might influence another, such as sugar
affecting the price of soybeans.
Most important, Niederhoffer is an inveterate contrarian. He feeds off panic, making short-term bets when prices get frothy.
He condemns the common strategy of trend-following, which helped make his buddy George Soros super-rich. ''A delusion,'' he
declares. Trying to read the future in chart patterns doesn't work, either. ''Deception,'' he insists. And when forces outside
the natural order intervene in the markets, watch out. ''I think of governments as if they're run by a professional criminal
class, taking from one set of pockets and putting into another,'' he says.
The 53-year-old trader came by his unusual theories via a blue-chip education: squash champ at Harvard, finance doctorate
at the University of Chicago, and an assistant professorship at the University of California at Berkeley. His transition to
full-time trader is chronicled in a new autobiography, The Education of a Speculator. ''By paying attention to the little
things, the nitty-gritty, the humdrum things in life,'' he says, ''you become a great speculator.''
Striker Trade Systems was candid enough to share this observation:
|
Catscan was released in 1994. It used the same rules to trade 23 different commodity markets. It was a very unique, dual
nature trading system. 99% of the current commodity trading systems are Trend Following systems. There is absolutely nothing
wrong with that except for the fact that 70% of the time markets are not trending. Instead, they are in a Choppy mode. Trend
following systems tend to get whipsawed to death in these Choppy time periods. |
Anthony W. Warren Ph.D reports:
Trend-following methods typically utilize moving averages of closing price data for buy and sell signals. Often, the signals
turn out to be false due to short-term market fluctuations. Here, longtime STOCKS & COMMODITIES contributor Anthony W.
Warren, correcting one of the major drawbacks of moving averages, introduces a trend-following method that smoothes the data
for trend identification and measures short-term price fluctuations to establish statistical boundaries.
A final statement by Victor Niederhoffer and Laurel Kenner on trend following:
Rule No. 1, carved in stone for all technical analysts, is that the trend is your friend. If ever there were a time that
we could, along with the Cabot Market Letter, report the beauty of using a simple trend-following indicator that makes it
"virtually impossible to miss a major market move," this would surely be that time. No wonder that 830 aspiring chart-readers,
the most ever, registered for the Market Technicians Association’s annual competency exams on April 26 in Jupiter Beach,
Fla.
Granted that some users of trend following have achieved success. Doubtless their intelligence and insights are
quite superior to our own. But it’s at times like this, when everything seems to be coming up roses for the trend followers’
theories and reputations, that it’s worthwhile to step back and consider some fundamental questions:
Is their central rule, "The trend is your friend," valid?
Might their reported results, good or bad, be best explained as due to chance?
But first, a warning: We do not believe in trend-following. We are not members of the Market Technicians Association,
or the International Federation of Technical Analysts or the TurtleTrader Trend Followers Hall of Fame. In fact, we are on
the enemies list of such organizations.
Anotherl observation by Bruce Babcock. He gives a general warning to those individuals who are searching for winning trading techniques.
One of the few real secrets in commodity trading is that most of what you read in books about how to trade does not work
in the real world. Even books by respected authors are full of trading methods that lose money when put to the test. You may
find this shocking, but almost no commodity authors demonstrate the effectiveness of the methods they advocate. The best you
can hope for are some well-chosen examples or a few cursory tests.
Futures Truth Reports...Do the FT Rankings Constantly Change Because the Systems Tested Are Curve-Fitted?
- Vern Nord
Have you ever tried to pass up a rope? I have spent the last two days trying to analyze the Feb/March issue of
Futures Truth. I would like to share my conclusions with your readers to start a discussion.
I know we are all looking for the perfect system which works on all commodities with similar rules and parameters,
but are we really looking for the impossible.
The very best systems in Futures Truth were only good on a maximum of 4 commodities, and if you throw out such
things as Pork Bellies, Live Cattle, Soybeans and Eurodollars, then no system was any good on more than three commodities.
The best systems all had three or less unrelated commodities at the top of their lists. I thought that a good
trend following system would test well on all the Currencies because they are very good trending markets. None of the systems
tested well on more than one currency.
No system worked well on any two commodities in the same group with the possible exception of Gold and Copper.
They both tested very well under Welles Wilder's Volatility Movement System.
There was no system that tested both T-Bonds and T-Notes, but they should test similar on a system.
As I expected, the few systems that tested well on the S&P 500 were very poor on all other commodities. On
non-trending markets like the S&P 500, Wheat, Lumber, Silver, Gold, etc., there probably is no perfect system to handle
the random nature of these markets.
So what I am trying to say is that there can never be only one perfect system for all markets. You need one type
of system for trending markets; one type for random walk markets and one type of system for commodities that trend for a few
months and then go into a trading range.
In all three systems you would need an indicator like the ADX from Wilder's Directional Movement to tell when
to shift gears from trending to trading range or to random markets when you should stop trading for now.
Another surprise from my analysis is that pattern recognition systems don't test well in related markets.
Arnold's Pattern Probability System (PPS) tested well on the Jap Yen, Lumber & T-Bonds - all totally unrelated
markets. This reminds me of something that Hulbert said about his one-year ratings on stock market newsletters and their track
records.
After over 10-years of tracking all the best timers, he finally realized that his six month and one year rankings
were almost totally worthless.
It seems last year's Guru is this year's goat. There's no consistency from one year to next, and you can't make
money following last year's expert. This leads to one last conclusion - Futures Truth rankings continually change and I think
this happens because all these systems are curve-fitted.
If you test any one system's across 36 commodities and stock indexes, you should get the traditional bell shaped
curve results which means that 10% or three commodities would test very good, and 10% would test very poorly and the balance
of 80% would fall in the middle inside the bell curve. This might explain why only 3 or 4 commodities test well on any one
system and why they are totally unrelated. They probably found an algorithm and then curve-fitted it until they got good results
in 10% of the commodities.
These price histories will never repeat the same way and systems are doomed to fail. Look at an old Futures Truth and see
how many systems are still around, or even compare the "Top 10 since Release Date" with the "Top 10 for the past 12 Months".
Only 4 out of 10 in the "Top 10 since Release" are in the current list of "Top 10 for past 12 months".
Louis Mendelsohn made the following points about curve fitting while giving a speech at a Harvard
Business School Alumni Club Dinner:
"Of course, the underlying assumption is that history repeats itself, that somehow by looking at past data, by doing some
work on the past information, by modeling a market in that respect, you're going to be able to make money in the future. Needless
to say, that's an assumption that hasn't fully proven itself in the real world. Nevertheless, that's all that analysts and
traders have to go by. Unfortunately there's really not much new in the mass-marketed trading software area. Most of the technical
indicators that are in software today are really rehashes of technical indicators that have existed for many years, for decades
in fact, since the 70's at least, and early 80's."
"Examples are things like moving averages. While they are very good
at identifying trends, they by their very nature tend to lag the market. Of course there's been a great effort over the years
by technical analysts in the futures markets to try to tweak out the moving averages, to try to reduce the lag in their response
to the market. They've done that with various efforts like weighted moving averages, exponential moving averages".
"There's
been a tremendous effort by technical analysts trying to tweak out these various technical indicators that have been used
for decades. Even displaced moving averages, which I find kind of interesting because basically it is taking like a 5 day
moving average and computing it's value as of tonight's close and then just displacing it out, maybe 2 days or 4 days, into
the future and making the assumption that the value 4 days from today is going to always be what today's value is".
"It
is an extremely primitive forecast that's being made. But at least, I saw, there, an effort towards forecasting rather than
always looking at trend following. We're at least beginning to start to look at some form of trend anticipation, or being
able to look at price anticipation, looking forward rather than just backwards. I felt, of course, that there had to be better
solutions to the problem than just using things like displaced moving averages".
"And, of course, there are other limitations
that exist in technical analysis software today. The whole problem of curve fitting with system testing, which you may or
may not be familiar with. Basically it relates to the fact that you can take a trading system, whatever that system may be,
it could be as simple as a 5 day moving average crossing a 10 day moving average, and you're long when the short average is
above the long, and vice-versa. You might tweak out the sizes of moving averages to optimize them to a specific market."
The CFTC has declared war on fraudulent mechanical trading systems:
Commodity Futures Trading Commission Office of External Affairs (202) 418-5080 Three Lafayette Centre 1155 21st Street,
NW Washington, DC 20581
Release: 5023-04 For Release: December 2, 2004 U.S. COMMODITY FUTURES TRADING COMMISSION
CHARGES NORTH CAROLINA RESIDENT ROGER OWEN AND HIS COMPANIES WITH DEFRAUDING CUSTOMERS IN SALES OF A COMMODITY TRADING SYSTEM
WASHINGTON, D.C. – The U.S. Commodity Futures Trading Commission (CFTC) announced today the filing of a complaint in
the U.S. District Court for the Middle District of North Carolina against Roger Owen, Longhorn Financial Advisors, LLC (Longhorn),
Phoenix Financial Group (Phoenix), all of Greensboro, North Carolina, and Daniel Belbeck of Nashville, Tennessee, alleging
that Owen, Longhorn, and Phoenix used fraudulent advertising and promotional materials to solicit customers to purchase their
computerized commodity trading system. According to the complaint, Owen and Longhorn, as part of their estate planning
services, and Phoenix fraudulently solicited customers to purchase a computerized trading system by falsely representing that
their system had generated huge customer profits. The complaint charges that, in reality, no customer who purchased and used
the commodity trading system ever profited from its use. In addition, the complaint alleges that customers who purchased the
trading system lost funds totaling more than $200,000 trading futures, in addition to paying Longhorn and Phoenix an aggregate
$120,000 for the computer trading system. The complaint further alleges that Longhorn and Phoenix held themselves out
to the public as commodity trading advisors (CTAs) and should have been registered with the CFTC. Similarly, the complaint
alleges that both Owen and Belbeck, the individuals who solicited customers, should have been registered as associated persons
of a CTA. Finally, the complaint alleges that Longhorn and Phoenix failed to provide disclosure documents to customers, as
required by CFTC regulations. In its continuing action, the CFTC seeks full restitution and disgorgement, civil monetary
penalties, a permanent injunction, trading prohibitions, and such other remedial ancillary relief as the court may deem appropriate.
The following CFTC Division of Enforcement staff members are responsible for this case: Frank Rangoussis, Jan Folena, and
Richard Glaser. # # # Media Contacts Alan Sobba (202) 418-5080 Dennis Holden (202) 418-5088 Office of External
Affairs Staff Contact Richard Glaser Associate Director CFTC Division of Enforcement (202) 418-5358 Related Documents
Complaint
SUMMARY
We are forced to stay with what we "KNOW " to succeed in business. Thankfully, we do know the following:
90 percent of all traders lose
5 percent of all traders make no money
5 percent of all traders make all the money
Markets are in a trading range 70 to 85 percent of the time (called ON THE SIDE prior to 1948)
Markets only trend 15 to 30 percent of the time
The real profits from markets come from trending markets
Trend following systems are wrong 60 to 80 percent of the time
Mechanical trading systems generate a lot of trades (Most of these trades will lose money)
Trend following traders experience "huge" equity drawdowns
More trading generates bigger commission bills.
Brokers prefer accounts that generate big commission bills
Only you can determine whether a mechanical trading system is for you! After all, it’s your money!
FORGET THE DRAMA! TRADE WITH THE TREND AND PROSPER!
Wayne N. Krautkramer onlypill@cox.net
https://onlypill.tripod.com/factsthebrokersandfinancialreporterswonttellyou
