Trading Rules : If Only it Was This Simple

Every few weeks I tour the internet in search for articles related to forex trading and the advice otherĀ  experienced traders give to newbies on their websites. I find this interesting to do as it shows me the pitfalls within new traders’ online forex education, allowing me to see what is missing and fill the gap with some of my own insights into the subject. Last week I was doing a review of forex articles to find out the most common advice given to new traders and none was as common as the advice to have “rules”. I often find the advice online – as I did when I started trading – very vague, pointless and misleading and this idea that the only thing you need to do to succeed is “have rules” and “stick to them” is definitely not the exception. On today’s post I am going to talk a little bit about trading rules and the dangers new traders face when they attempt to develop a profitable trading outcome from this simple precept. If the only thing required to succeed was to have a set of rules then without a doubt a large majority of traders would be profitable, much more is absolutely required.

If you browse the internet for a few hours you will definitely find that all new trader websites advice you to build some clear rules and trade according to them. The idea here is that having some type of mechanical guide will allow you to remain on your tracks, stay away from risking large amounts of money and overall make money in the long term from your trading setups. It is therefore pretty simple, you design some rules to make up a trading system, trade it without modifying your rules or risking to much money and you will be making a ton of cash in the longer term. This simplification of the mechanical trading process and the creation of rules is a very efficient way to make traders fail, telling them to develop rules (which they don’t know how to develop) and trade them without ever deviating from their outcome.

What is the problem then ? I don’t have any problem with the notion that successful trading can arise from discipline and a given set of rules, my problem with the approach offered by most websites is that they don’t stress enough the importance to do long term evaluations of rules before executing them in demo or live trading. Most traders who attempt to develop rules never evaluate them because they either lack the knowledge to program or they simply do not have the time to do so.

Running some rules with only a simple visual backtest of a few weeks or months or because short term forward testing on a demo account has turned positive is an incredibly dangerous and destructive thing to do. For me running anything without a prior 10 year analysis is crazy since I cannot run a set of rules for which the existence of a “trading edge” is unknown. When I began trading I attempted to develop many “rule sets” but I ended up second guessing the rules and changing them because I had no idea if in the long term they would work or fail. This is the exact same thing that happens to the large majority of beginning traders. They design some rules and then following them becomes impossible because they simply ignore the quality of their rules. Even more dangerous, traders will often trade rules which are simply not profitable in the long term and the failure to perform evaluations ends with them changing from system to system without ever achieving success in trading.

Sadly this very bad approach to mechanical trading leads many people to say “rules don’t work” when in fact what doesn’t work is an approach to rules without long term evaluation and accurate knowledge about the rules long term statistical characteristics. For new traders this tip to “develop rules” is a deadly trap since they will attempt to develop a system without any knowledge about its possibilities for success and this will make trading the rules extremely hard – if not impossible – from a psychological point of view. Since the profit and draw down targets are ignored the trader will constantly doubt the rules when a draw down period comes, leading to endless modification and “adaptation” that ends up with another set of rules which has statistical characteristics as well known as the first one.

I personally do not believe that new traders are lazy regarding system development and the effort that needs to be put up. However I believe that most lack the necessary tools and knowledge to perform adequate system evaluation, mechanical system development requires large amounts of time, a good basic programming knowledge (even if the system is not to be completely automated) and knowledge about profitable system characteristics, the limitations of simulations, etc.

Long story short, new traders lack the necessary knowledge to develop rules and advising them to do so without carefully explaining what needs to be done from an evaluation and analysis perspective is simply going to cause the trader to lose his or her money. When rules are created without the necessary knowledge you end up with systems that don’t have any statistical edge which will be extremely hard to execute and will bring no reward in the longer term. This is especially dangerous when you consider that short term results are more or less random so a trader may get excited about a system that lacks any long term profitability, merely due to some short term results. After a draw down period comes the trader may then continue trading the system towards a wipe-out merely because it worked for a short time before. In the end, knowing about the trading edge of your system and its long term characteristics is VITAL, failure to do so will only bring problems to your live trading experience.

If you would like to know more about mechanical trading system development and how you can gain a true education regarding system development and analysis please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach to automated trading in general . I hope you enjoyed this article ! :o)

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2 Responses to “Trading Rules : If Only it Was This Simple”

  1. Chris says:

    Hi Daniel-

    I finally got a look at your Currency Trader magazine article for October, 2010. Nice work and very interesting to find out that the double-doji by itself doesn’t work (which I found out first hand through my own research). But when you add the tick volume, it becomes a long-term profitable system!

    Looking forward to seeing that work added as another system on Asirikuy, or potentially added to an existing Candle-based system such as WA #2.

    Combining this into an existing system might make sense since its unlikely that you will see a 3 candle expansion and a Doji together although you could easily see one followed by the other. I would be in favor of combining them together because as you know, i’m NFA-challenged. :-).

    Again nice work and take care,

    Chris

    • admin says:

      Hello Chris,

      Thank you very much for your comment :o) I definitely thought about your efforts while developing the article ! I thought you would find this particularly interesting since you found out -as you said – that the double doji doesn’t work by itself first hand. Interestingly enough most pattens that are signs of uncertainty do not translate very well into systems unless volume is taken into consideration since – especially on the lower time frames – they can easily happen due to a general lack of trading activity. This explains a little bit why these patterns have much more predictive power on higher (daily or weekly) time frames as within this time frames volume is inherently high by definition.

      Well, certainly this will be a candidate for a future Asirikuy system but probably I will develop a more complex candlestick-volume pattern library before this happens. Thankfully we now have a ton of systems that could potentially become Asirikuy long term profitable strategies so I am looking at all of them and choosing the ones that are more diversified and robust as Asirikuy additions. Watukushay No.6 will be released soon and probably 7 and 8 will come before the year ends. Right now my objectives for these three systems will be to trade several pairs – for those that need to trade under NFA conditions – and to build a system for the USD/JPY and JPY crosses (something which has eluded me for quite a long time !). Robustness and diversification are the main goals I want to achieve.

      As always, a lot of work to do and millions of things to try but we’ll get there slowly :o) Thank you very much again for your comment Chris,

      Best Regards,

      Daniel

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