Sytems, Indicators, Signals and Methods

Some of My Thoughts

All too often traders tend to misunderstand the differences and similarities between a trading system and a timing indicator. Although the differences may be subtle in some cases, its worthwhile discussing them in order to arrive at a clear understanding; one which will help lead to productive results from market analyses and systems trading.

Definitions

Here are some basic definitions which will help you with the discussion that follows.

1. Indicator

An indicator is a technical representation of market data used to determine market trend, market strength and anticipated market direction. Indicators are usually, but NOT ALWAYS specific. In most cases they can be expressed as algorithms (specific mathematical descriptions). In some instances chart analysis indicators such as head and shoulders formations, trendline support and resistance, etc. are difficult to quantify, but they are still considered indicators.

2. Signal

A signal is one step up in objectivity from an indicator. A signal tells the trader when to buy, sell or liquidate a position. A signal can be an individual indicator, or it can consist of a collection of indicators, which when combined, yield to a decision to buy, sell or hold.

3. Method

A method consists of signals and indicators all combined into an approach which the trader considers to be valid, reasonable and reliable as well as objective. But which is not necessarily entirely mechanical.

4. System

A trading system consists of specific signals, operationally defined, combined with a set of decision making procedures and risk management rules, all designed to make trading objective and mechanical.

Indicators

There are literally thousands of indicators. The creation of a market indicator is limited only by the imagination of the
creator. Hence, anyone can create indicators, but the simple and sad fact is that the overwhelming majority of indicators are useless and don't tell us much about a market. The search for valid and effective timing indicators is an age old search. The Japanese use of Candlestick , Kagi and Renko charts, as well as the works of Edwards and McGee who wrote the classical work on technical analysis, are all designed to reveal worthwhile indicators that will facilitate the quest for profits.

Perry Kaufman has written several outstanding books on technical analysis (Commodity Trading systems and Methods among others) as has John Murphy. These and other excellent books are readily available. In them you will find a plethora of timing indicators.

To pursue the validity of them all would take many hours and the result would be generally unfruitful. This is because timing indicators tend to work better in some cases than in others. They tend to be specific to markets and they tend to work better in combination with other timing indicators than they do alone.

Timing indicators are often subject to interpretation. Traders who want to analyze markets in a semi-intuitive fashion are more apt to use timing indicators as opposed to trading systems. I believe that the vast majority of traders falls into the category of intuitive trader. Most traders use timing indicators and timing signals to interpret markets and to make trading decisions.

A trader who has developed a timing indicator or a combination of timing indicators may wish to develop them into a trading system. In other words, once a trader has enjoyed success with a combination of trading indicators the desire is to operationalize them and turn them into a trading system.

Trading Systems

A trading system is simply a compilation of objective trading rules and algorithms that are quantified and collected into a complete approach. What's interesting is that even the most logical and valid indicator or indicators, once developed into a system with risk management and defined entry exit seems to lose its effectiveness. What is it about a trading system that causes seemingly effective indicators to fail? There are many reasons. Here are just a few:

1. In making decisions that are NOT objective, traders often violate their own rules. When one adds the specificity and objectivity of a trading system, one eliminates the intuitive and subjective inputs. This can work in favor of a system but frequently works against the result since traders often delude themselves when using subjective indicators.

2. Traders often mentally test indicators and combinations of indicators on a very limited amount of data history. Hence, what they think is real in terms of performance isn't real but rather a wish developed on a small sample. When the method is objectified and tested rigidly on a large span of data the results often disappoint.

3. The added element of risk management in the form of stop losses can either help or hurt a system. When traders use a method or an indicator in an unsystematic way, they often fail to include a specific method for limiting risk. When this is added to a method in order to develop it into a system, the results can vary. Most often the addition ofspecific rules of risk management will decrease the accuracy of an indicator since traders who do not use a system are apt to let their trades ride without specific risk limits.

4. When indicators or methods are back-tested on a large amount of data their performance tends to deteriorate since they are subjected to all types of markets. Typically, the farther back one tests a combination of indicators, the worse their performance gets. This often leads traders to optimize their indicators and systems. In other words, since what they were using fails to work, they ask the question: what would have worked?; Once it is discovered, they use the new indicators, not knowing that they will likely fail to go forward in real time with the same results as the back test.

The Bottom Line

So what's the best way to approach trading decisions? Is there a best way? How do you decide? Here are some of my well considered thoughts in Q and A form:

Q. Is a trader better off with indicators, methods or systems than using intuition?

A. To a large extent this depends on the trader. While most traders will do better in the long run if they follow a specific methodology in the form of a system, there are those traders who appear to have a well developed artistic sense of trading. Their intuition and internalized sense of the markets serves them well. The bottom line is, of course, whether they can use their talents to generate consistent profits. If they can, then they ought to continue what they're doing. On the other hand, many traders who fail to use a mechanical system will make many mistakes that will result in an overall loss of money. In such cases a system is much better than a method or a signal.

Q. How can I find a good system?

A. Good systems tend to come from good indicators. Good indicators are not necessarily logical indicators. Many times what appears to make good sense and what is based on sound market logic fails to work in actual practice. Hence, do not consider the face validity of a method or system, but rather consider its performance in the markets as your guide.

To find a good system you will need to search and test. And you'll have to make certain that you follow the rules of good system testing and development.

Q. Can a computer help me find a good system or indicators?

A. Yes, by all means! A computer and a lengthy historical data base along with the right software are important in helping you develop the right indicators, systems and/or methods. There are many systems available for this purpose. Shop wisely before you spend any money on these.

Q. What is optimization?

A. Simply stated, optimization is curve fitting. It's a method by which a trader or system developer can create a system that fits the past perfectly, but which has very little likelihood of performing in the future as well as it did in the past. There are many ways in which systems can be optimized. The most simple way to find a system that has been optimized is by looking at its entry/exit rules. The more rules there are, the more likely it is that the system has been optimized to show the best case scenario. Steer clear of such systems. The odds are that they will never work.

Q. Can a trader be successful with only a few indicators?

A. Yes. As long as you have a few indicators that have historical validity you can do very well. Remember that indicators are valid as a function of their history and NOT necessarily as a function of their logic or apparent validity. Simply stated, if it works, use it!

Conclusion: I have barely scratched the surface of this subject. The final outcome of any approach is the true indicator of what works best. Every trader must find his or her own niche in terms of signal, indicator or trading system or method, please know the affects as well as the realistic limits of what such approaches can do for you. And remember - THERE IS A RISK OF LOSS IN FUTURES TRADING

Jake

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