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A Rational Approach to System Development

I do not totally oppose optimizing trading systems; however, I do favor a rational approach to this procedure. My rule of thumb is simple: Your trading system should have no more than four to six variables. You should search for the best combination of entry and exit variables, as well as a reasonable combination of stop loss and trailing stop loss amounts. But this is where the optimization should end. The more variables you build into the system, the less likely will be the future performance of the parameters.

Another aspect of system development relates to market personality - a topic that has received little attention by most traders and market analysts. Rather than heavily optimizing a system, I recommend tailoring your system to the personality characteristics of the individual markets, provided that such characteristics exist and that they are sufficiently stable.

Summary

The development and testing of trading systems is perhaps one of the three most important issues in trading. System results can be specious if the developer uses faulty rules, optimizes excessively, or fails to understand the differences between reality and fantasy. Armed with a computer, historical data, and a few ideas, a trader can easily fall into the trench of highly optimized systems that look good on paper but that fail to produce results commensurate with the back-test.

In addition, guidelines for effective system development were presented with the proper caveats. I defined a number of terms and gave you some ideas of how to differentiate systems that were likely to go forward with similar results to their back-tests and systems that were unlikely to perform as expected.