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Although discipline and flexibility appear to be mutually exclusive concepts, the most successful traders believe in their strategies and are willing to stick with them through tough periods. Simultaneously, they are always cognizant of the ever-shifting nature of the markets and open to adapting or even abandoning their strategies when market behavior undergoes paradigms shifts.
• Willingness to trade small enough (e.g., not risking over 1 to 5percent of equity under management on any single position) to withstand the drawdowns entailed when employing a trend-following strategy. This problem can stem from two opposite experiences: the breakeven syndrome, where we overleverage ourselves to bounce back from losses more quickly, and a form of the regret/remorse syndrome, where we look at booked profits and decide to increase leverage to capture larger rates of returns.
Psychological reminder to help with this problem:
• Look at the percentage of winning trades in the backtested history along with the worst peak to valley drawdowns in equity. Then remember, if you do not trade small enough to withstand an unprece-
dented drawdown, you will not be around long enough to become profitable.
• Ability to be comfortable with 1 to 5 percent of trades executed generating most profits. This realization is closely linked with one of the primary rules of mechanical trend trading: Never miss a trading signal. This means no vacations from trading ever. Eliminate the top performers from your backtested history (see Table 3.12) and you will quickly recognize that vacations and mechanical trend trading do not mix. Also, since 1 to 5 percent of trades will generate the majority of profits, trading systems must include a reentry mechanism if the trend reasserts itself.
Psychological reminder to help with this problem:
I Examine your system’s historical performance excluding these top-performing trades.
• Willingness to stay with open positions for weeks to months. Trend traders succeed because they know how to let small profits grow large. This entails a willingness to stay with open positions for weeks or even months.
Psychological tools to help with this issue:
| Stay away from the computer screen during trading hours (especially during the early stages of your career as a trend trader).
| Trade around the core position—this helps with the psychological problem of thinking you need to earn your pay by being active while not sacrificing your position. By adding a second contract and/or trading around the core position, you guarantee participation in the trend and can satisfy the psychological need to be active. Of course, the caveat to trading around the core position is that the addition of this second contract should not result in large percentage drawdowns.
• Ability to be comfortable with slower, more analytical trading processes. Many trend trader personality types feel overwhelmed at the prospect of making numerous decisions throughout the trading day. Psychological reminder to help with this problem:
| People with this personality type find holding intermediate or longterm positions less stressful, especially since they can walk away from the screen throughout the trading day.
Mean Reversion Systems
A Matter of Patience
Buy when the cannons are firing and sell when the trumpets sound victory. —Baron Rothschild
CONSIDERATIONS IN ANALYZING INTERMEDIATE-TERM MEAN REVERSION TRADING SYSTEMS
Because markets are range-bound more often than they trend, mean reversion systems tend to enjoy a higher percentage of winning trades than trend-following systems. But because our goal in trading a mean reversion system is entering at temporarily unsustainable levels and exiting at the average, our profit to loss ratios and overall performance often will be inferior to that experienced with successful trend-following systems.
This does not suggest that mean reversion traders are less successful than trend traders; instead, it clues us in to the fact that top-caliber mean reversion traders usually augment basic mechanical trading techniques with discretionary elements. In other words, mean reversion traders may need to incorporate elements that cannot easily be quantified into a mechanical trading, such as unsustainable emotionalism, government reports, wars, and natural disasters.
Achievement of Profit Target and Stop Loss on Same Day
When analyzing backtested results of intermediate-term mean reversion systems, there is a higher probability of the market reaching both the stop
MECHANICAL TRADING SYSTEMS
loss and profit level on the same trading day. Ideally an analysis of intraday data would show whether the trade was a profit or loss, but as of this writing, no data vendors offer 10 to 20 years’ worth of intraday price history. As a result, in such instances I will assume that these trades were stopped out as losses.
In real-time trading the use of stops based on percentage of contract value at time of entry is a sound methodology. Unfortunately, because futures contracts are included in our backtested portfolio and valuation of these assets is based on a continuously adjusted data series, these assets could have a hypothetical value of zero, and percentage-based stops would distort our backtested results.