| Most people invest in the stock market but only a | | | | Inevitably, a mechanically traded stock system will |
| very few go to the effort of designing their own | | | | produce a fairly significant drawdown. This is where |
| stock trading system. By "system", I mean a piece | | | | emotion comes into play. It is very easy to study a |
| of software that automatically tells the trader when | | | | backtest simulation and come to the conclusion that |
| to buy and sell stocks. There are several advantages | | | | you can tolerate a 25% drawdown. It is a completely |
| to mechanical stock trading systems. One of the big | | | | different situation when you are down 25% with real |
| advantages is that it removes the emotion from the | | | | money invested. In this situation traders typically |
| trading activities. Or should I say, a mechanical stock | | | | begin to question whether their system still works. |
| trading system should remove the emotion from | | | | With enough stress the trader will liquidate his (or |
| trading. | | | | her) holdings. This is how traders end up buying high |
| In fact, most system traders tend to seek the | | | | and selling low. It complete cycle is greed and fear. |
| highest possible return on capital without accounting | | | | Greed comes into play because too much capital is |
| for the emotions experienced when real money is on | | | | put into the stock positions initially. Fear comes into |
| the line. As a result, many traders make fundamental | | | | play when the positions move against the stock |
| mistakes including underdiversification, | | | | holder. The root cause is typically deployment of too |
| undercapitalization and overtrading. | | | | high a percentage of one's trading capital on |
| One significant issue that novice system developers | | | | non-diversified positions. This is often compounded by |
| face is the assumption that live performance of a | | | | use of capital that one cannot afford to lose. |
| trading system will mimic system backtest | | | | Before embarking on the design of your own |
| performance. It is very unusual to achieve similar | | | | personal trading system you should first assess your |
| performance live as was achieved in simulation. A | | | | personality, lifestyle and financial means. There is no |
| good rule of thumb is to expect 50% of the profit | | | | point in putting a great deal of effort into a trading |
| and 50% higher drawdown in live trading as opposed | | | | system that is ultimately unsuitable for your life's |
| to backtest simulation. | | | | situation. |