As you can see from this simple exercise it is not where you enter a position that determines your success. It is how much you make on average over your trading career not how many times you are right. Traders are judged on how much they make not how many times they are right, in fact being right is irrelevant to whether you make any money. Yet the majority of traders are obsessed with entry signals, each of them has a desperate need to be right. This is a sign of a trader’s ego creeping into their trading and it is an early warning signal of impending doom.
System design is therefore far more than entry signals. Implicit within the mechanics of trading system design is the concept of the expectancy of your system. That is how much you make per trade versus how much you lose per trade. Any slippage you face when you place an order, this includes costs such as brokerage, stamp duty and any difference between your intended exit point and your actual exit. How often you actually get to trade, there is little point in having a system that has a huge expectancy if it only produces one trading signal per year. Finally what are your exit criteria, getting into a position is easy, it is when you get out that determines whether you make any money.
It should be obvious that system design is not a matter of looking for a magic system but rather of developing a comprehensive approach to engaging the market. Yet even with these additional features trading system design is still a minor portion of your trading armoury. The key features that determine your success are money management and psychology almost everything else is irrelevant.
I am firmly convinced that trading is a psychological and not a financial endevour. Traders focus upon system design for a variety of reasons. The first is that it is easy. All technical analysis software consists of almost nothing but entry signals and these are very easy to manipulate in the search for the ideal indicator. To illustrate how absurd this can be consider Fibonacci numbers, many traders default their indicators to reflect these numbers but in essence how is a 13 day moving average superior to a 14 day or a 12 day moving average. In doing this, traders are obsessed with what they perceive to be the secrets of the market, that somehow they must discover these secrets.
The second reason why traders concentrate upon entry signals I alluded to before, it is the need to be right. In simple terms each of us has an ego, therefore we have an emotional stake in all the decisions we make. It is difficult for us to be faced with a situation where we are wrong just as many times as we are right and this is what happens when we accept that the most common entry signals such as moving averages are right approximately less than 50% of the time. Therefore we attempt to redress this balance by looking for a system that is right all the time. Thus traders attempt to protect the fragility of their ego from the realities of trading.
The third reason traders spend so many fruitless hours on entry signals is that trying to get a perfect entry gives the illusion of control. Traders believe that somehow their entry signals give them control over the market. This has often been referred to as the lotto bias and the example often cited is that people pick numbers in a lottery based upon a variety of superstitions rather than having them picked at random by a computer when the lottery ticket is purchased. Once again such people have a need to feel that they are in control even when it is clear they are not, the chances of winning a lottery remain the same irrespective of the method used to pick the numbers. The same is true in trading your chance of success or failure is unaltered by the fact as to whether you pick the numbers for your moving averages based upon Fibonacci numbers or whether you pick them randomly.
I don’t want to give the appearance that developing a trading system is irrelevant, traders do need a form of entry signal. We need to have some idea of what the prevailing trend is and what conditions to expect in the market upon entry. But to concentrate on entry signals alone is to ignore the complexity of systems and the vital importance of money management and trader psychology. Once traders begin to understand the importance of these two key elements they are on the path to being long term successful traders. Ignore these features and concentrate only on the search for the Holy Grail and you are certain to join the 8 out of 10 traders who make no money.
James
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