Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis

SYSTEM DEVELOPMENT ISSUES: AN OVERVIEW

Mechanical trading systems offer traders a multitude of benefits, including quantification of risk, reward, and assessment of percentage of winning trades prior to entry, along with a host of others. However, for every benefit, there are pitfalls to be avoided and/or (in some instances) accepted as the price paid for enjoyment of such benefits.

The first and most obvious problem in the system development process is that all decisions made regarding trading systems are based on historical data. Future market behavior will never look exactly like the past, and because all models are based on extrapolations from historical data, the best we can hope for is a strong positive correlation between past and future market behavior.

Because decisions regarding indicators and parameter sets for our trading systems are determined through our study of historical data, the methods used to ensure the robustness of our systems must address this limitation in the system development process. Although this statement seems so obvious that it is almost not worth mentioning, the ramifications of this simple truth are far-reaching and underestimation of this flaw leads to a significant number of the errors commonly committed in the system development process.