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Cc: eadamy@xxxxxxxxxx, "Mark Brown" <markbrown@xxxxxxxxxxxxx>
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At 9:19 AM -0600 12/8/99, Mark Brown wrote:
>You people saying that a discretionary trader can not be programmed
>are talking about something that is as weird to me ...
At 9:04 PM -0600 12/8/99, Mark Brown wrote:
>Just as the Chess moves would not have been thought possible to be
>programmed to the extent that a computer could beat out a human. Thus
>your skeptical, predictable resistance to belive that it would be
>possible to program a human like response into a trading system.
At 7:20 AM -0700 12/9/99, Earl Adamy wrote:
>Anyone who has attempted to program basic chart patterns in their various
>combinations and permutations is well aware of the tremendous programming
>effort which is required to even begin to approximate the cognitive
>abilities of a practiced human eye/brain. It has been my own experience that
>it's easier to train the human eye/brain through education and constant
>practice than it is to train the computer through programming. Your mileage
>may vary.
I have worked with quite a few very successful discretionary traders who want to convert their "methodology" into a mechanical system so I thought the group might benefit from some of my experiences. This post will summarize some of them. This message turned out to be a lot longer than I had intended but I hope it is useful to others.
Since I often relay this information by answering somebody's email questions, I am writing this as a response to questions in a pseudo "interview" to be able to cut and paste thoughts from past messages.
Keep in mind that this is my experience and may or may not agree with other people's experience on this topic.
Bob Fulks
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Begin "Interview"...
Are the people you have worked with really successful discretionary traders?
Many are. Some have been making a living doing this for 15 to 20 years.
Do they have a method?
Absolutely. The successful ones do.
Why do they want to convert to a mechanical system?
Because discretionary trading is a lot of hard work. Staring at a computer screen all day waiting for a signal is tiring and very stressful.
Why don't they learn to program it themselves?
They usually have little programming experience and do not want to take the time to learn. Some have programmed various custom indicators that they use.
Can they describe their method?
They think they can and spend a lot of time trying. Some have sent charts with patterns marked, some have meticulously logged their impressions at each potential entry and noted why they would and would not take the trade.
Do they live near you? How do you communicate the ideas?
Mostly by email transferring files. "pcAnywhere" has been useful in two cases for the trader to walk me through a process, along with phone calls.
Can you program what they describe as their method?
Usually. I am a pretty good EasyLanguage programmer and can program almost anything that can be precisely described. I cannot program TradeStation to "recognize" subjective patterns such as Head & Shoulders. Computers do not "recognize". The rules must be meticulously precise, which most people find very frustrating.
So what happens when you program their method?
The system gets lousy results. There are usually far too many trades. There are many more entry signals that meet their criteria than they think there will be. We then try to understand how they filter out the bad trades. This usually turns out to be far more subjective than they thought it would be.
So do you end up with anything that works?
It usually is pretty easy to end up with some ShowMe's that will identify potential trade situations. This is often a big help because then they do not have to watch the tube intently all day and can do other things, read a book, watch TV, etc., and wait until an alert is hit. They can then look at the tube and decide whether or not to take the trade. After a period of doing this, they may then begin to see more criteria and we are able to narrow down the number of alerts.
Do you ever end up with a mechanical system?
Sometimes, but not always. But it is not by using what they tell me they use. A good trader will have discovered some characteristic of the market that is repeatable enough to trade. This is clear. Some have very high success rates with well over 90% of their trades being profitable. But they may not exactly know what the characteristic is. In all cases where I have been successful creating their system, I do it by finally understanding what that tradable characteristic is. Once I understand what it is, I can usually design some fancy digital filter, moving average, or oscillator, etc., to find it fairly consistently. This still usually ends up with too many potential trades but most will be profitable, neglecting trading costs. Many small trades become unprofitable when trading costs are added so we then try to eliminate the less profitable ones to get a higher average profit per trade.
How long does the process take?
Usually several months of part-time work. Usually we get some ShowMe's which the trader uses for a while and then we refine the criteria. It seems to take time for the trader to divorce himself from his previous biases of what the computer program should do and just understand what characteristic of the market he is using. A computer cannot think like a person and cannot recognize things. The human brain can process far more complex information in a split second than a computer and can have "judgement". But a computer program is very much more consistent, never gets tired, etc., so once a program works it works consistently.
What about changing market conditions?
Almost all of my systems adapt to changing conditions in some way. Usually, it is possible to "measure" the characteristic you are trading after it has happened (not in real time) to see what its parameters have been running. Then you use these parameters to dynamically adjust the trading system parameters. This adjustment process is also active during back testing so effectively makes a first order correction for market changes, making the system more robust.
What sort of "characteristic" are people trading?
It is often related to some cycle phenomenon or trading a trend of some kind. The set-up can involve a sequence of conditions to indicate that a favorable trading opportunity may be about to occur.
Once you get a system that works, does the trader use it?
They seem to. And they often come back later with improvement ideas. Some call me a year or two later for help on something. The almost always use the Indicators and ShowMe's that we develop as part of the system development. We almost always use the same code for both the system and one or more indicators so that we can monitor how the system is working.
Does the trader really understand what the system does?
I am often amazed at how the trader will check every trade the system makes in excruciating detail to make sure it meets the conditions and that there is not a bug in the code. A typical interchange might start out:
"At 10:50 on 9/8/99, the system went long. It shouldn't have."
At which point I reply one of two ways:
"Sorry, the whatsit was not initialized before the framis kicked in. Try
the attached."
or:
"But that is what you told me should happen."
"Than may be what I told you but it really should be doing ...." I guess
I forgot to tell you about that."
Do they take every trade signaled by the system?
No. They continue to use some judgement. I have used the analogy of an autopilot as a good example. The system might handle 80 to 95% of the situations but there are always situations where the trader feels that the risks outweigh the potential rewards and he will pass a trade. In other words, there is still a pilot in the cockpit to take over in the event of an abnormal event. Stating this on a list such as this one always generates a flurry of messages about how "you should always take every signal of your mechanical system, no matter what". This is hogwash almost always promulgated by people who have never done it. A computer program can handle conditions it was designed to handle. A system that can handle 90% of the cases automatically might require two or three pages of code. One that can handle 95% of the cases might take ten time that amount of code, most of which will never have been tested with real cases since they occur so rarely. A system that can handle 99% of the!
cases might take still another factor of ten more code to cover cases that might occur every 10 years and thus can never be properly backtested with enough occurrences to be statistically significant. Anyway by then the markets would have evolved so much that it wouldn't work well anyway.
So what does the system do when it gets into a situation that it cannot handle?
It exits with a loss, much as with any stop loss technique. I consider stops as something that should rarely be hit, only in situations that the program was not designed to handle. Normal exits should all be programmed. Hitting stops means that something happened in the market that the program did not expect to happen.
Do you use the built-in TradeStation stops?
Sometimes, but not usually. It is very easy to mislead yourself with those stops. For example, you might have an entry condition that is true when XXX <= YYY. The TradeStation stop might take you out but since the condition may still be true, the code would reenter. This is very hard to track during backtesting since it might only occur during some range of values. To prevent this you need to use the "crosses over" kinds of conditions that may not work as you wanted. This is not the fault of the TradeStation stops - they work as advertised. It is the result of trying to do surgery with a blunt instrument.
I am not real sure I understand the difference between what the system can handle and what it cannot handle. Could you give an example?
Assume we get a particular signal to go long and know that typically after such a signal we can expect a move up for 10 to 20 bars. But in some cases this doesn't occur and the price stalls after going up 2 or 3 bars. The trader then might say "reverse now to short" since he recognizes this failed signal as a powerful indication that the market has changed. So now we have three options in the code:
1. Do nothing and watch the small long position profit evaporate
and the losses built up until the TradeStation money management
stop gets us out with, say, a $500 loss.
2. Immediately exit the position with a small $125 loss and go
flat since the market didn't do what we were expecting it to do.
3. Add code to try and recognize that condition and reverse to
short. We try this and it takes a half page of code and it works
fine to reverse this trade. But it also reverses us in eight
other trades where we really wanted to remain long. So now we
look at all nine cases and try to determine why they are
different. They look about the same to me but not to the trader.
And this is only one case of a failed signal, there are lots of
other cases that rarely occur but the trader has them all stored
in his brain and can spot them when they occur. It is rarely
worth trying to code these since it would require a lot of code
for situations that rarely occur. So we default to option 2 and
just exit. In trading the resulting system the trader will be in
the trade and be watching the screen intently. He will spot the
pattern and not exit as the system tells him to but instead will
reverse, muttering something like "stupid computer". When I trade
the system, I will just exit like the system says. His method
results in a higher percentage of wins, obviously.
So how do you measure the success of a system?
I consider a system successful if it has an annualized Sharpe Ratio of about 3 or higher in back testing and has a trading style consistent with what the trader can trade. By trading style, I am referring to things like how closely you have to monitor the system, how long you are in the trade, number of consecutive losses, capital requirements, etc.
What about the statistics of a typical system?
I am not sure there is a typical system but most of the mechanical systems do far poorer in terms of percentage profitable trades than the discretionary trader did. They tend to run about 50%. But the winning trades are much bigger than the losing trades so the Profit Factor should be over 2 to 3 and the Return on Account should be 500% to 1000% or higher in back testing. The most important criterion is the smoothness of the equity curve that I measure with the Sharpe Ratio. (A better measure would be deviation from a straight-line equity curve as proposed by Chande, etc., but Sharpe Ratio does a pretty good job.)
Why is a linear equity curve desirable?
A linear equity curve is very easy to trade. It increases X dollars each week so you have confidence that the system is still working if it is returning about X dollars per week. You also can easily estimate what it will cost you to take a week's vacation, etc. With an equity curve that has lots of losses followed by the "big win" you never know if the system is still working and you cannot take any time off because then you might miss the big win. It takes a lot of confidence to trade such a system.
Can the same system work for many markets?
The trader is almost always trading a single market (sometimes several stocks) and has discovered a characteristic that works on that market. Often the characteristic only exists strongly on that market but may exist to some extent on other markets.
How does the final system compare with what the trader was doing?
As I said there are usually many more trades with a lower percent profitable since the system often just exits quickly on a failed signal whereas the trader might see how to turn a failed signal into a winner. But the system makes a lot more money per month than the trader did because it finds more trades. In real life the trader doesn't take all of the system trades, he stops for lunch, skips a day to go Christmas shopping, quits after a great morning to play golf, etc.
Sound complicated. Don't you run out of memory with the 64K limit on TradeStation 4.0?
Hardly ever. Once you understand the characteristic you are trying to trade, the code for the final system is only three or four pages including comments and debug code. Very complicated code usually indicates that the programmer didn't understand what market characteristic the trader was trying to trade or was trying to include code for lots of special cases.
Do you ever include code to handle special cases?
It is not black and white. There is usually some primary tradable market characteristic that the trader has discovered that works a reasonable percentage of the time. But sometimes it doesn't work. Over time the trader has usually discovered ways to turn what would have been a losing trade into a winner:
> If X happens then reverse the trade
> If Y happens, do not exit yet, this is probably just a pause and the
price will continue going up
> If Z happens wait for the pull-back and add another contract
> Etc.
If there are only a few such special cases and if they can be precisely defined, they can be added to the code. Otherwise it is often better to just trade the primary characteristic and exit quickly with a small loss when it doesn't work. Code for special cases often screws up the primary trading system. Then, to fix these problems, you get into special cases of special cases and this rarely works.
Do you ever start with code the trader developed himself?
If it is available, I usually try to figure out how it works. Most often it is a mess since the trader is usually not a great programmer and the code usually "grew" over time. It is often just bumping into the 64K limit and probably would be bigger if TradeStation 4.0 would have allowed it.
You say TradeStation 4.0. Do you ever use TS2000i?
I have it but it is still in the box. I consider it unusable for real trading in its present state. I have heard that the new PowerEditor has some nice features and that it can be useful in back testing beyond the 13000 bar limit so I might load it on a computer some day soon.
Sounds time consuming and expensive. What do you charge?
I do it for free in return for being able to use the results myself. I only do it if I think the process will end up with something useful. Frequently, we find that the method does not lend itself to a computer program so we discontinue the effort. (p.s.: I am not looking for projects now and am busy with a project.)
Seems like a lot of effort. Why do you do it?
To learn how markets work from people with lots of experience so I can develop trading systems for myself. I do this full time along with my trading. It is quite clear that on-the-job-training on your own can be extremely expensive.
How do you decide what projects to work on?
I try to work with only experienced traders who have been doing it for years. I also look for someone who understands something about what computers can and cannot do. If they understand EasyLanguage, this is a plus since this makes it easier to communicate. I also choose projects related to something I wanted to learn about. For example, I worked on one project that involved point and figure charts since I wanted to learn something about them. I often get messages from people with just an "idea" for a trading system that the person would like help converting to code. I usually pass on these and recommend that the person contact one of the people who do programming for a fee. When I hear words like "the RSI has to be higher than... and the MACD has to be ... and the fast stochastic has to be ... my eyes glaze over and I suggest that the person go someplace else. Likewise on Elliott Waves, Gann angles, astrology, moon phases, etc. Maybe these work for some people but I have not!
seen them work with mechanical systems since they are too subjective.
Do your systems use any "rocket science"?
I am an electrical engineer by training so I understand a lot about digital filters. Such filters are used in essentially all electronic equipment today and are also useful in trading systems. (All moving averages are digital filters.) This is about as close as I get to rocket science. I have a lot of special moving averages I use for various purposes to isolate trading signals from noise.
How long have you been doing this?
About four years. When I "retired" from my last real job, and started looking into ways to learn trading, I found TradeStation and quickly learned that there was no organized way to learn how to use it to trade. Then, by accident, a trader on one of the email trading lists asked me to help him. I quickly realized that he knew a lot more than I would ever know about how the market really worked so I started doing this to learn from him.
How many people have you worked with?
It is hard to define "worked with" but I have probably done a significant work with 20 or 30 people which ended up with probably 10 real projects lasting periods of months.
.. End "Interview"
Bob Fulks
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