Model Trading Systems

I consider myself to be a modeler of trading excellence, and as a modeler, I use neuro-linguistic programming to determine how to duplicate trading excellence. To do this, you first have to decide exactly what it is that you want to model.

Next, you need to find a number of people who do what you want to model very well. And last, you need to find the tasks they do to produce that excellence and the ingredients they use to do those tasks with excellence, which are the important beliefs, mental states and strategies.

Early in my career as a modeler and trading coach, I did workshops with two Market Wizard traders, Ed Seykota and Tom Basso. Both agreed that trading success was about 10% systems; 30% money management (or what I call position-sizing); and 60% psychology. I'd already spent a lot of effort in modeling the psychology of trading and position-sizing, so my final task was to look at the part of trading that seemed to be the most technical: System development. Trade Your Way to Financial Freedom was written to be a summary of my research in this area and its purpose was to teach people how to develop a system that would fit them.

In my modeling work, I've come to two important conclusions.

The first is that people generally do the opposite of what's important for trading success, and trading system development is no different. It's full of myths and it generally focuses on the things that do not work. For example, when I first started learning about systems, I discovered that most people equate systems with the entry setup.

Part of that comes from the bias that trading success is all about picking the right investment. For example, William O'Neil's trading system is called CANSLIM, but that word is simply an acronym for the setups (or the stock picking part) of the system. But the success that people enjoy using this system has nothing to do with the stock-picking part and everything to do with the exits and the position-sizing involved.

If you watch the financial news on television or the various gurus who talk about how to make money in stocks or futures or forex, you'll always hear discussions about what investment to pick now. A portfolio manager will be interviewed and the first thing he'll do is talk about the stock picks that he made from the last time he was on television.

The discussion might go like this: "Four months ago, you picked ABC, which is up 10%; BCD, which is up 15%; and CDE, which is down 30%." The manager might give some reason why CDE hasn't done well, but I've never heard one say, "Oh, we sold that stock after it dropped 10% and found something better to trade because we know that we make money on our exits, not on our stock picks." And that's part of the secret to trading success -- "Money is made when you sell, not by what you pick to buy." So that's one of the things that I wanted to convey when I wrote this book.

People also don't understand how important position-sizing is to trading success. Position-sizing is the part of your system that tells you "how much" throughout the course of a trade. And its purpose is to make sure that you can meet your trading objectives. It accounts for over 90% of the variability of one's trading performance, but I almost never hear it discussed in the media. Yet, you can have an excellent system and still lose money if you don't understand how to do position-sizing.

I remember being in a panel with a lot of experts on system design. When it was my turn to talk, I emphasized the importance of position-sizing to trading success. And after I said that, another of the panelists responded, "Oh, I don't worry about money management (that's what he called it). I just use a money-management stop." And to me that meant that he totally did not understand the importance of position-sizing."

Neuro System

The second thing I've discovered through my modeling work is that everything is psychological, including system development.

First, Jack Schwager concluded from his Market Wizard books that a key success ingredient of all the people he'd interviewed is that they'd all found some trading methodology that fitted them. That's certainly the key to system development. People will only trade a system that fits their beliefs and one that they have developed confidence using. And all of this is very psychological. Thus, Trade Your Way to Financial Freedom is often called a psychological book because it tends to deal with one of the holy grails of trading -- the fact that you can only trade a system that fits you. However, I don't consider it a psychological book. I consider it a systems book.