Developing a trading system that fits your personality

Introduction

After seeing the number of excellent discussion threads on FF, I thought I'd give this a shot. I've been trading for 16 years (full-time for the last three) in the equities & equity options markets and now Forex as well for the last four. I got the trading bug from working in the financial industry designing and developing computer systems and often working in direct contact with traders in the electrifying atmosphere of the trading floor. I started out knowing nothing about trading and initially got my rear-end kicked a number of times until I realized I had to treat this endeavor like a business if I wanted to have a chance in the long run. Why would an otherwise sane person step into a ring with a black-belt thinking they've got a chance past a lucky quick shot (read successful single trade)? When you take a position in a market, there are plenty of pros out there who will be happy to take your money if you don't know what you're doing.

Today, trading comes "fairly" easily as do the profits. And while I've improved as a trader, the number of inquiries from people regarding my trading style and how I develop systems has increased as well. I hope to cover some of these questions here as it relates to (mostly) system development.

Most everything I've learned about trading, I picked up from someone else at some point and then adapted into my own style of trading and I'd like to now help others. "A candle loses nothing lighting another candle" as the saying goes if I may be so bold as to assume I've got something worthwhile to pass on to others. For starters, I've learned (the hard way) that the success formula looks something like: Quality Input + Hard Work + Discipline + Some Originality = Success in trading -- or any other business. While this may be old hat for the seasoned traders on FF, if you're just starting out, be aware that no matter how much you learn from other people, no one will be able to do the hard work for you, especially in the key areas of trading psychology and discipline -- and one could argue the latter is an integral part of one’s psychology as well although I like to separate the two out for practical purposes.

So, what I'd like to do here is first go over some background info on trading itself (as I understand it) to give this topic a proper backdrop without which even the "best" trading system will fail, so hang in there for a bit. Then we can discuss what goes into developing a trading system that suits your trading style, i.e. something you're comfortable with and know inside out that you can then ultimately stick with in the market(s).

(I will add posts as time permits)

bluemeasure, nicely stated and looking forward to reading more..

Let me cut to the chase as to what trading is -- or at least what I believe it to be. It's often said that the three most important things in real estate are location, location, location. In a similar fashion, the top three criteria a trader needs to master to become successful are discipline, discipline, discipline. This doesn't sit well with some of the folks I've tried to coach in the past. What everyone is after are the killer setups and/or the magic indicator. The forums abound with people starting out in trading suffering from “indicatoritis”: everyone's after the one indicator (or combination of indictors) that will tell them exactly when to buy and let them know when the very top of a bull run has been reached so that they can be the first to get out of a position as well. So, my message is often met with disappointment as the word discipline sometimes makes some would-be trader uncomfortable. Let me expand on what I mean by discipline as it relates to trading:

1. The discipline to do one's homework before putting money on the line. This includes learning about the tools (trading s/w, indicators, trendlines, Fibanocci #'s, etc.) even if you choose not to use some of these. There’s something valuable to be found in each of these and they will help you get a better feel for the markets.
2. The discipline to find out what market(s) to trade. Bonds, equities, forex, futures, ...? or some form of derivatives (e.g. options)? Or maybe multiple markets? Each has distinct advantages/disadvantages and idiosyncrasies you need to be aware of.
3. The discipline to find the timeframe(s) that's suited to your lifestyle and temperament. Daily charts behave differently from 5 min charts and your trading style will likely have to be different as well.
4. The discipline to find a trading system or methodology one knows inside out and is very comfortable with. Ideally, it should be custom built so as to suit the trader's personality (more on this later). That said, there are some great systems out there for sale or even for free that might do the trick for you.
5. The discipline to follow one's trading rules to get in and out of the market(s).
6. The discipline to learn about money management and position sizing (e.g. how many shares/lots should I buy/sell?)
7. Last, but not least, the discipline to keep an extensive trading journal.

If you do your homework, you'll come to have a healthy respect for the markets which will save you from reckless trading. You'll also likely start to treat trading as a business, which you should. All things being equal, profits will then come fairly easily. If you lack in any of these areas, you'll keep on struggling and wonder why you're not getting ahead. What's often frustrating in trading is that what you think is holding you back might in fact have little to do with the actual problem (a big topic on its own). If you're stuck for a long time or if you just want to speed the learning process along, a mentor can be of invaluable help.

So, how do you acquire the necessary discipline? In one word: determination. In my case, it came from watching my account balance going down continually when I first started all those years ago until the pain of losing money became so great that I decided to learn whatever I had to in order to become a successful trader. At the outset, I thought this would take me about 6 months. In reality, it took me three years of tribulations and lots of sweat to become profitable -- and I'm still learning every day. That’s the kind of determination it takes to succeed but it would appear that most unfortunately give up too quickly maybe because at the outset they didn't develop a proper plan -- a proper business plan.

Excellent post. I know this takes reseach and a lot of time to write and I appreciate your work. I can't wait to see how it ends.

So, if you have a good handle on points 1 through 3 from the last post, you should have some of the basic components for your business plan. Put down on paper what you know so far. This is a powerful little exercise that will add clarity in your mind as to your ultimate goal of becoming a successful trader and ensure you have a solid trading plan. Later, once you have an actual trading system in hand, you can add it to your business plan.

What should go into your business plan? You can google the subject for more details (for example “The Trading Plan by Linda Bradford Raschke “ and “Kane Trading on The Difference Between a 'Plan for a Trade' and the 'Trading Plan'” amongst others) and I won’t repeat what these and other excellent articles cover, but at least the following should be in an early draft of your business plan at this stage:

1. System goals. What are the criteria for the system you’re going to select/create? Yes, I know: “It should make lots of money”, but we’re after more details here. What kind of a system are you looking for? For example, how often should it give you a signal, what should the ideal profit factor and recovery factor be? how about winning %? In other words, what would an ideal (and realistic) system look like? Lots to think about here.
2. What markets? what timeframe? Why?
3. While the above cover portions of the trading plan, in my mind a business plan should also make a business case: i.e. why choose this business? what makes you believe the time invested will be worthwhile vs. starting another business you may ultimately be more suited for?

1. and 2. should help narrow down the list of the myriad of potential systems out there. I'm trying to squeeze a lot of information in just a few lines, so if there are any questions, please let me know.

Another key component in determining what trading system to choose: your personality.

Thanks Bunton and Phil for the kind words.

Very good stuff I feel a sticky coming.

Coming back to a point I alluded to earlier. Your system needs to suit your personality. While I believe that most people have to change some of their habits to become successful traders, we still all have different personalities, different strengths and weaknesses and we will behave differently within a same market -- that’s what makes a market after all. The key here is “know thyself”.

Are you aware of your own tendencies and idiosyncrasies? I would recommend taking a personality test of some sort if you’re unsure, ideally geared towards analyzing your behaviors as it relates to trading. Knowing you're INTP for example isn't specific enough. Better find out now than when you’ve drained your account and realize you need to go back and do this. As the old saying goes (credited to George Goodman afaik), “If you don’t know who you are, the stock market [or any other] is an expensive place to find out.”

I recently took such a test with the Van Tharp institute (another excellent source of info btw) during a beta test and the final test might be available online now. Even if it costs a bit of money to take this or another test, do yourself the favor and find out what your strengths and weakness are. This is one of the best investments you can make. You may even find out about some weakness that you weren't consciously aware of. And that will help you tremendously.

I took that test a while ago from a e-mail that was sent out.. It is a pretty good eye opener..

Before you think I'm a stickler for the kind of work the last few posts require, I used to be the type of guy that tends to say “yeah, whatever...” skipping over the type of stuff I wrote above just to get to the meat of the topic, thinking I'm smart enough, know myself enough etc that I don’t need to do any of this. The fact is what it would be very hard for anyone to keep all this information above straight in just one's mind, especially at the level of detail these topics require. Writing things down allows you to cross-reference ideas, give them clarity and go into much more detail than would otherwise be possible. Think of it as a blue-print. If properly designed, the journey to achieving your goals will be much simpler and pleasant. Ultimately, it’s a time saver even though it doesn’t seem so at the outset. How I wish I would have known this a few years ago, but that’s another story...

However, if you are interested in this topic and would like to dig a bit further into finding out about your own personality, I can wholeheartedly recommend a book I picked up a few years back: “Zen and the Art of Making a Living” by Laurence Boldt.

Ok, let's move on to the key criteria in picking or designing a system.

If you’ve done the exercises above, you’ve covered one of the dimensions necessary to find a suitable trading method. At the risk of repeating myself because this is a key point: whatever system you pick, it has to fit your personality / preferences in the following areas so that you’ll actually be able to trade the system especially during tough market conditions:

1. Type of system: I’ve only encountered three in my career: 1) trend following (sometimes trend anticipating), 2) volatility based and 3) breakout based (or combinations of these. if anyone knows of any other type, please let me know) If you’re new to trading, you may not know yet which to pick and that’s fine. Again, try to get exposure to all three to find which you’re drawn to and have an idea what methodologies other traders are using. For example, expect larger drawdowns in trend following systems. If there’s interest, I can provide further information on advantages and disadvantages of each type of system in a subsequent post.
2. How often the system trades, sometimes referred to as the Opportunity Factor.
3. How smooth should be equity curve be? A more erratic (volatile) one may be more profitable, but will you be able to trade it? This also ties into the drawdown. What is the avg (and max) drawdown of the system you’re considering using? Are you comfortable with that number?
4. Winning %. Be careful here. I’ve seen many systems tout a high percentage but that number in meaningless if you don’t know what the average winner will bring you and the average loser cost you. Keep in mind that the Expectancy (profit per avg trade) is equal to the (Winning % × avg win) – (Losing % × avg loss). So, is a higher number better? Overall yes, as long as you’re comparing systems over the same (and long enough) time period.
5. If you’re trading Forex, you probably don’t have any market direction preference, but be aware that some systems do.

Some absolute system properties, no matter which you choose:

 

1. Profit Factor: this is the system's Gross Profit divided by Gross Loss. Look for systems that have a Profit Factor of 2 or higher. (from Wealth-Lab’s help)
2. Recovery Factor: it is equal to the absolute value of Net Profit divided by Max Drawdown. Recovery Factor should typically be larger than 1. A healthy Recovery Factor is an indication that a system can overcome a drawdown. (from Wealth-Lab’s help)
3. Payoff Ratio: this is the absolute value of the system's average profit per trade divided by the average loss per trade. Unless the system has a particularly high Win/Loss ratio, we look for high Payoff Ratios. (from Wealth-Lab’s help)
4. For more experienced traders another question is: should the system be 100% mechanical? Or do you want to allow for some discretion as well? If so how much and under what conditions? For example: because I’ve been looking at charts for a while, I have developed a feel for the markets I trade and the system I use in one of my accounts is based on MAs and their interpretation is often subjective. This is a hybrid system that works fine and I use it when I happen to be at the computer trading live.

So, in short, the system has to be sound, in other words an existing should have been profitable over the long run in whatever market(s) you choose to trade. Some people say the testing period should include at least x number of time periods, others x number of trades. My own inclination for e.g. a new daily trading system I devise is 5 years of daily data plus stress testing before roll-out.

Now that we’ve had an overview of the different aspects and types of systems, let’s come back to the personality characteristics. Our own personality analysis should cover key areas such as:

 

1. objectives
2. personal strengths
3. personal weaknesses
4. beliefs about the market
5. values

If you have trouble coming up with a list for these categories, try doing a “brain dump”. Write down 100 brief statements about e.g. your values as quickly as you can without giving thought to grammar. After a while, you should see patterns emerge.

Also, for more help, have a read through the myriads of articles by Brett Steenbarger as well as his book; he’s another leading authority in the area of trading psychology along with the Van Tharp institute I mentioned earlier. There also used to be a brief personality test on his website.

Let’s take a simplified version of what a fictitious trader has come up with and try to determine what kind of system we could build or recommend for him/her.

1)Objectives

1. To trade once a day
2. To grow the account at a steady pace achieving 20% return per annum
3. To not take undue risk (even at the expense of foregoing maximum profit)

2)Strengths

1. Strong analytical skills
2. Highly motivated (greatly interested in the subject of trading)
3. Flexible in the type of trading system (or combination of trading systems)

3)Weaknesses (or “challenges” if you prefer)

1. Tendency to jump ahead of trades
2. Sometimes make being “right” a stronger motivator than getting out of a losing trade
3. Often close a winning trade prematurely out of fear of losing potential profit

4)Beliefs

1. The market moves in discernable long-term cycles.

5)Values

1. Money is a limited resource. It should be dealt with carefully.

Note: a real analysis should be longer and more in-depth but for simplicity sake, I’ve kept this list brief.

What kind of system could we propose for this trader?

Excellent insights.!!

The headline should be'' Developing a trading system that fits into profit''

trading psychology ? it assumes that the trader knows what to do only the emotions get in the way. i sincerely doubt that.

Personality and Trading Systems:
The idea that using a methodology that suits your personality is an essential component of trading success also helps explain why most people lose money using trading systems they bought. Why is that true? Is it because most trading systems don’t work on data not used in their development? I am not implying that.Actually, I have no idea what percentage of trading systems sold to the public provide a market edge. But even if I assumed that more than 50 percent of the systems sold would be profitable if applied as instructed, I would still expect over 90 percent of the buyers of those systems to lose money trading them.
Why? Because every trading system, regardless of the strategy employed, is going to hit periods when it does poorly. Now, if you buy a system, by definition, it has nothing to do with your personality or beliefs.In many, if not most, cases, you won’t even have any idea what drives the system’s signals. Consequently,the first time the system hits a bad period, you are not going to have the confidence to stay with the system,and you will stop trading it. That is why, invariably, most people who buy systems will end up losing:
They will stop using the system when it goes through a bad period, and they won’t be there when the system recovers.

Lessons from the Greatest Traders
Book by Jack D. Schwager