What is a Trading System? By, Van K. Tharp, PhD

[vc_row][vc_column][vc_column_text]van tharp bkA note to readers: While Dr. Tharp’s content is timeless, this article is from our newsletter archive and may contain outdated information, missing links or images.

Traders often ask, “What exactly is a system?” In this article, we’ll go through some background information to help you understand what a system is outside of the context of trading. We will focus on clearly defining what a trading system is and then looking at the broader picture of your system—your trading plan. Finally, we’ll focus on some key elements in system development.


Business Systems

In Robert Kiyosaki’s book, Cash-Flow Quadrant, he distinguishes two types of people who work for money and two types of people who have money working for them. In each case, one of the major distinguishing characteristics is how they deal with systems.

First, let’s look at the idea of business systems. McDonald’s, as a major franchise, is basically a large set of systems that one buys. In fact, a person who buys a McDonald’s franchise must go to Hamburger University for about six months (I believe that’s the length of it) to learn the systems for operating the franchise. There are systems for food delivery, preparing food, greeting customers, serving them within a minute, cleanup, etc. And all of these systems can easily be carried out by a manager who has a college degree and employees who might even be high school dropouts. In other words, a system is something that is repeatable, simple enough to be run by a 16-year-old who might not be that bright, and works well enough to keep many people returning as customers.

Now, knowing that definition of a system, let’s look at how people in the four cash flow quadrants relate to systems.

The Employee: Employees are basically motivated by security. They have a job and they do their work to get money. Employees basically run the systems. They don’t necessarily know that they are running a system, but that is their function. For example, one employee at McDonald’s will greet customers and take their order. This employee is basically running the “customer-greeting” system.

Most employees do not understand systems. Instead, they just know what their job is. And this is typical of employees who become traders or employees who work as traders. They typically ask questions such as “What stocks should I buy?” “What is the market going to do?” Or “How do I go about doing this?” We see it all the time in the questions we get. For example, a gentleman just called into CNBC, as I’m writing this, and asked the guest, “What direction do you think the market may go with respect to ‘the war’ and how might one profit from it?” These are typically employee questions. And they amount to saying, “I don’t really understand anything, please tell me what to do!” The financial media thrives by answering the questions of the employee investor/trader.

The Self-Employed Person: The self-employed person is basically motivated by control and doing it right. Notice that I have often talked about how these motivations constitute some of the biases that most traders have—the need to be right and the need to control the markets. The self-employed person is the entire system. They are basically running on a treadmill only they don’t know it. And the more they work, the more tired they get.

Like the employee, the self-employed are working for money. However, they like it a little better, because they are in charge. They think working harder will make them more money—and to a certain extent, it does. But mostly, working harder gets them tired. Nevertheless, they continue to plow forward thinking that they are the only ones who can do it right.

As I said earlier, the self-employed person basically is the system. And quite often they cannot see the system because they are so much a part of it. They are stuck in all the details. In addition, they have a strong tendency to want to “complexify” things. They are always looking for perfectionism and they believe that the perfect system must be complex. They are always asking, “What will make my system perfect?”

A lot of people come into trading from the self-employed mentality—doctors, dentists, and other professionals who had their own small business in which they were basically all of the systems in one. This is all they tend to know and they approach trading the same way. They keep adding complexity “until it works,” even though this strategy seldom works. The self-employed person would be likely to have a discretionary system that is constantly being changed.

The Business Owner: A good business owner should be able to walk away from the business for a year and come back to find it running better than before. While this is an ideal type of statement, it has some theoretical truth to it. This should occur because the job of the business owner is to design a group of systems to run the business so well that his employees can do the job by themselves (or at least with a manager in place). In other words, the business owner is someone who designs systems and these are usually simple systems.

The business owner usually does very well in the trading arena if they approach the process the same way that they’ve run a business before. And, of course, the business owner would usually hire someone to run their trading system, at a much lower wage.

When Tom Basso,1 who is interviewed in The New Market Wizards, did workshops with me, he always described himself as a businessman first and a trader second. Part of Tom’s perspective was to look for repetitive tasks that a human being in his organization has to repeat over and over again. When he found such tasks, his job was to develop a program to take that task out of human hands. Routine computer programs are great examples of simple systems.

The Investor: The last person on the quadrant is the investor. The investor is someone who invests in businesses and his/her most important criterion should be, “What is the rate of return of the business?” In other words, this person is continuing to ask, “If I put money in this investment, what kind of return will I get on it?” High return investments (e.g., high returns on equity) are typically good businesses in which to put your money.

Robert Kiyosaki describes this as the quadrant in which money is converted to wealth. Rich people, according to Kiyosaki, derive 70% of their income from investments and 30% or less of their income from wages.

Most traders are probably not investors by this definition. They buy low or sell high, trading stocks. As a result, there is something they must do to generate their money. Investors, in contrast, are people who typically look for places where they can put their money that generate rates of returns of 25% or higher without them doing anything. If you know how to get those types of returns, then you want to hold onto those investments as long as possible. Many high tech stocks were showing earnings growth rates of well over 25%, and when they did, the prices went up dramatically because this is what investors want. The problem with such investments is they are not guaranteed to continue forever. Many of you have probably discovered that in the last few years.


System vs. Strategy

What most people think of as a trading system, I would call a trading strategy. A system would consist of eight parts:

  1. Market filter
  2. Set up conditions
  3. Entry signal
  4. Worst-case stop loss
  5. Re-entry (when it is appropriate)
  6. Profit-taking exits
  7. Position sizing algorithm, and
  8. Multiple systems for different market conditions.

A market filter is a way of looking at the market to determine if the market is appropriate for your system. For example, we can have quiet trending markets, volatile trending markets, flat quiet markets, and flat volatile markets. And, of course, the trending markets can either be bullish or bearish. Your system might only work well in one of those market conditions. As a result, you need a filter to determine whether your system has a high probability of working. Should you trade your system or not?

The setup conditions amount to your screening criteria. For example, if you trade stocks, there are 7,000+ stocks that you might decide to invest in at any time. As a result, most people employ a series of screening criteria to reduce that number down to 50 stocks or less. Examples of screens might include William O’Neil’s CANSLIM criteria or a value screen for stocks with good PERs or a good PEG ratio or a fundamental screen having to do with management and its return on assets. You might also have a technical setup, just prior to entry, such as watching for the stock to go down for seven straight days.

The entry signal would be a unique signal that you’d use on stocks that meet your initial screen to determine when you might enter a position—either long or short. There are all sorts of signals one might use for entry, but it typically involves some sort of move in your direction that occurs after a particular setup occurs.

The next component of your trading system is your protective stop. This is the worst-case loss that you would want to experience and it is defined as 1R (or your initial risk) for you. Your stop might be some value that will keep you in the stock for a long time (e.g., a 5% drop in the price of the stock) or something that will get you out quickly if the market turns against you (e.g., a 25-cent drop). Protective stops are absolutely essential. Markets don’t go up forever and they don’t go down forever. You need stops to protect yourself. As I said in my first book, Trade Your Way… (To Financial Freedom), entering the market without a protective stop is like driving through town ignoring red lights. You might get to your destination eventually, but your chances of doing so successfully and safely are very slim.

The fifth component of a trading system is your re-entry strategy. Quite often when you get stopped out of a position, the stock will turn around in the direction that favors your old position. When this happens, you might have a perfect chance for profits that is not covered by your original set-up and entry conditions. As a result, you also need to think about re-entry criteria. When might you want to get back into a closed-out position? Under what conditions would this be feasible and what criteria would trigger your re-entry?

The sixth component of a trading system is your exit strategy. The exit strategy could be very simple. For example, it might simply be a 25% trailing stop where you adjust the stop to 75% of the closing price whenever a stock makes a new high. The stop is always adjusted up, never down.

However, you may have many possible exits in addition to a trailing stop. For example, a large volatility move (e.g., 1.5 times the average daily volatility) against you in a single day is a good exit. Crossing a significant moving average (e.g., the 50-day) might be a great exit. Technical signals are good exits (e.g., breaking a significant trend line.)

Exits are one of the more critical parts of your system. It is one factor in your trading of which you have total control. And it is your exits that control whether or not you make money in the market or have small losses. You should spend a great deal of time and thought on your exit strategies.

The seventh component of your system is your position sizing algorithm. Position sizing is that part of your system that controls how much you trade. It determines how many shares of a stock you should buy. A general recommendation would be to continually risk 1% of your portfolio. Thus, if you have a $25,000 portfolio, you wouldn’t want to risk more than $250.

Let’s say you wanted to buy a stock at $10. You decided to keep a 25% trailing stop, meaning if the stock dropped 25% to $7.50 you would exit your position. Since your stop is your risk per share, you would divide that $2.50 risk into $250 to determine the number of shares to purchase. Since $2.50 goes into $250 100 times, you would purchase 100 shares of stock. Notice that you would be buying $1,000 worth of stock (100 shares @ $10.00 each) or four times your risk of $250. This makes sense since your stop is 25% of the purchase price. Thus, your risk would be 25% of your total investment. If you want to know more about position sizing, I’d suggest that you review the books Trade Your Way to Financial Freedom and The Definitive Guide to Position Sizing (available on Amazon).

Finally, you need multiple trading systems for each type of market. At a minimum, you might need one system for trending markets and another system for flat markets.

The Entire Trading System: Your Business Plan for Tradingwriting by window 1

Remember that I said that what most people consider a trading system, is simply a trading strategy that should be part of an overall business plan. Without the overall business plan, many people would still lose money.

Let’s look at the overall context in which a trading strategy should be made—your business plan. I have written extensively on this subject, therefore for the purpose of this article, the following is just a brief overview.

Here is a summary of what we consider to be essential for a good trading plan:

1) The Executive Summary. This is usually the last section written. It reviews all of the material of the plan and presents it in summary form. It should describe in detail the objective of the plan and then briefly describe, without a lot of detail, how the objectives will be achieved.

2) A Business Description. The business description should include the mission of the business, an overview of the business and its history, the products and services you provide (which is growth of capital and risk control as a trader), your operations, operational considerations such as equipment needed and site location, and your organization and management of employees (if any). All of these topics are fairly self-explanatory, but you should take the time to write them out as part of your plan.

3) An Industry Overview and Competition. In the industry overview, you need to look at the factors influencing the market. For example, Ed Yardeni in his website lists ten major factors influencing the market. These include a globally competitive economy, a revolution in innovation, wireless access to the internet, low tech companies having access to high tech tools and changing their businesses as a result, the need to outsource to increase productivity, and many other themes. See www.yardeni.com for more information. In addition, you also need to know who/what is your competition. Who are you trading against? What are their beliefs? What advantages do they have that you don’t? What advantages do you have that they don’t?

4) Self-Knowledge Section. You need to know your strengths and your weaknesses and list them in this section. You need to know how to capitalize on your strengths and avoid (or overcome) your weaknesses.

5) Your Trading Plan Itself. The tactical trading plan should be a part of your trading plan, but it should also include (a) your trading beliefs that form the basis of your plan, (b) any strategic alliances you may have, and (c) what you plan to do in terms of education and coaching.

6) Your Trading Edges. I believe your trading plan should also include a listing of all the trading edges that you have in the market. When you list your edges, you can review them often and be sure that you capitalize upon them. For example, your edges might include a) the fact that you don’t have to trade, b) your understanding of R-multiples and position sizing (which give people a huge edge over those who have no idea about these concepts), c) your ability to read a level II screen to get excellent stock trades, d) your sources of information, e) your ability to plan well in advance so that you have a game plan each day, f) your skill in following the ten tasks of trading, g) your knowledge of yourself and your strengths and weaknesses. This is just a sample of the possible edges that you might have over the average trader/investor.

7) Financial Information. This section should include three parts. The first part is your budget. How much money do you have? What will the trading process cost you? The second part will be your cash flow statement. Does your plan make sense in terms of cash flow? And finally, the third part will include profit and loss statements. If you have no trading record, you need to make estimates based on historical testing and based on paper trading.

8) Worst Case Contingency Planning. Things always happen that you have not accounted for or planned for in your trading plan. How will you deal with these elements? What will you do if any of these things come up? How will you make decisions when these elements come up?

Developing a SystemWhat is Your Goal 1

I am revisiting an interview I did years ago with LTC Ken Long, a systems expert with the U.S. Army.

Here’s what Ken said about developing a system:

Define Who You Are: “Before you conduct any planning or system design, you must have a thorough understanding of who you are and what your objectives are. Individual investors, private hedge fund managers, public mutual fund managers, and trust managers will have different dynamics, time frames, and risk profiles. This relates to system design in that the final product must fit the circumstances and dynamics of the group or individual. If you jump into system design without considering these basics, you will sow the seeds of future problems.”

Objectives: “In trading system design, the problem is to define what you want the system to accomplish. With as many ideas, events, circumstances, and adjustments that occur in system development, you have to have your objectives crystal clear in your mind. If you don’t know where you are going, then any old road will do.”

“Objectives give you the basis for making choices and prioritizing actions. This is not to say that objectives are static. In fact, they can change as you discover either unexpected limitations or advantages in your system as it matures. But before you start you must have an initial set of goals and objectives to guide you.”

Calibration: “After the system is deployed and operational, part of the process of calibrating the system is checking to see if the objectives still fit the person or organization that you have become. That’s a very exciting part of system design. I can’t tell you how often I’ve been part of a design team that started with a limited set of objectives and discovered in the “imagineering” phase that by adjusting our sights we were able to accomplish far more for much less. But you have to start somewhere. If you don’t start with objectives, you are spinning your wheels.”

I posed this question to Ken: “This section is critical. How will you know if your system is working or not? What are your performance benchmarks? What are your criteria for knowing that your system is not working? How will you make decisions when these criteria are met? Will you scrap everything or just make position sizing adjustments?” All of these questions are critical to developing and operating a good trading system.

“In general system development then, we look for robust, simple plans that can cover a wide range of conditions. When you preplan like this, you don’t try to force the world to adapt to your plan. If you fall in love with a strategy and become emotionally invested in making it work no matter what the market or the world says, you lose the ability to adapt and learn.” —Ken Long.

Having a trading system that fits you is one of the most important elements of successful trading. Understanding what a trading system IS, is the first step. Even if you want to use a system created by someone else who is like-minded, understanding the parts of a great system will help you adapt their system to better fit your style.[/vc_column_text][/vc_column][/vc_row]

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