A COMPLETE MECHANICAL TRADING SYSTEM IN FOREX

A COMPLETE MECHANICAL TRADING SYSTEM IN FOREX

One of the problems witb Katz’s early trading was that his “system” only provided entry signals, leaving the determination of exits to subjective judgment; it was not, therefore, a complete, mechanical trading system. A complete, mechanical trading system, one that can be tested and deployed in a totally objective fashion, without requiring human judgment, must provide both entries and exits.

To be truly complete, a mechanical system must explicitly provide the following information:

1. When and how, and possibly at what price, to enter the market

2. When and how, and possibly at what price, to exit the market with a loss

3. When and how, and possibly at what price, to exit the market with a profit

The entry signals of a mechanical trading system can be as simple as explicit orders to buy or sell at the next day’s open. The orders might be slightly more elaborate, e.g., to enter tomorrow (or on the next bar) using either a limit or stop.

Then again, very complex contingent orders, which are executed during certain periods only if specified conditions are met, may be required-for example, orders to buy or sell the market on a stop if the market gaps up or down more than so many points at the open.

A trading system’s exits may also be implemented using any of a range of orders, from the simple to the complex. Exiting a bad trade at a loss is frequently achieved using a money management stop, which tertninates the trade that has gone wrong before the loss becomes seriously damaging.

A money management stop, which is simply a stop order employed to prevent runaway losses, performs one of the functions that must be achieved in some manner by a system’s exit strategy; the function is that of risk control. Exiting on a profit may be accomplished in any of several different ways, including by the use of pm@ targets, which are simply limit orders placed in such a way that they end the trade once the market moves a certain amount in the trader’s favor; trailing stops, which are stop orders used to exit with a profit when the market begins to reverse direction; and a wide variety of other orders or combinations of orders.

In Katz’s early trading attempts, the only signals available were of probable direction or turning points. These signals were responded to by placing buy-atmarket or sell-at-market orders, orders that are often associated with poor fills and lots of slippage. Although the signals were often accurate, not every turning point was caught. Therefore, Katz could not simply reverse his position at each signal.

Separate exits were necessary. The software Katz was using only served as a partially mechanical entry model; i.e., it did not provide exit signals. As such, it was not a complete mechanical trading system that provided both entries and exits.

Since there were no mechanically generated exit signals, all exits had to be determined subjectively, which was one of the factors responsible for his trading problems at that time.

Another factor that contributed to his lack of success was the inability to properly assess, in a rigorous and objective manner, the behavior of the trading regime over a sufficiently long period of historical data. He had been flying blind! Without having a complete system, that is, exits as well as entries, not to mention good system-testing software, how could such things as net profitability, maximum drawdown, or the Sharpe Ratio be estimated, the historical equity curve be studied, and other important characteristics of the system (such as the likelihood of its being profitable in the future) be investigated?

To do these things, it became clear-a system was needed that completed the full circle, providing complete “round-turns,” each consisting of an entry followed by an exit.