How to choose the right trading strategy

If you don’t have the time or inclination to create your own trading systems … but you want to be pro-active with your financial future … then you’re going to need to follow someone else’s trading strategy …

That’s fine.

But there’s a problem – there are so many different systems out there, all claiming to be the best, how on earth are you supposed to know which one is right for you?

It’s a lament I hear from Bulletin readers all the time: “Which is the best strategy?”

And while I do try to pick out in my newsletters what I believe are the best of the bunch, there are some key things that I look for in a strategy, and I hope that this checklist will help you to do the same for yourself …

Is it right for you?

First of all, there are a few questions you can ask yourself. If you answer “no” to any of these, you can safely walk away …

– Can I make the time commitment? If a trading system requires that you spend 8am–midday glued to your computer screen, and you have a day job, chances are that it’s not for you.

Likewise, if it involves placing a trade at 6am each morning, and you’re more of a night owl – it’s unlikely that you’ll manage to stick with it.

– Do I have the necessary funds? Some systems require a large initial investment, especially if they use wide stop losses and require you to hold multiple positions at one time. Check what funds are required.

– Does it come with any guarantee? If the person or company selling this system doesn’t have enough faith in it to offer you a guarantee, then I can’t see any reason why you should have any faith in it.

– Do I trust the source of this strategy? Do the sellers include full contact details? Are they a registered UK company? If you can’t track down the company, then you may have problems fulfilling the guarantee.

So, if you’re happy with your answers to these questions … let’s move on to the interesting bit – the profits!

Are the profits achievable?

£300,000 by the end of the year …? £1,500 by tomorrow morning …?

Anybody who wants to sell something, will want to show it in its best light – that’s fair enough. BUT we shouldn’t have our heads turned by big, shouty numbers.

In fact, I’ve been accused of doing exactly this recently, when I got very excited about the £23k that one trading strategy had racked up for me in just 9 weeks, and started showing off about how much I was making. The thing is, that most traders wouldn’t be jumping in with a starting fund of £42k, which is what I was trading with.

What would have been more useful is if I’d said that I’d made 56% gains in 9 weeks. But (I admit it) I got excited about the big bucks!

But even percentage gains don’t tell you everything … because they don’t tell you how much you need to risk to make those profits …

Sure, you might have £1,500 by tomorrow morning if you were prepared to risk 50% of your trading fund – and you won! Yes, you may have made £300,000 in the next six months if you’re prepared to take some crazy risks, and you get lucky.

These big numbers sound very tempting, but taken alone, they tell you very little about the profitability of a trading technique.

You’re better off paying attention to the percentage gains that you can make – and keeping an eye on the kind of risks that are being taken to achieve this.

Risks, drawdowns and success rates

Drawdown is the reduction of your trading fund after a series of losing trades. A large drawdown is not a pleasant thing, but it’s worth remembering that some of the most profitable trading strategies ever have drawdown levels that would give most traders a nosebleed.

But profitability is only a fraction of the story when you’re considering risk, drawdowns and success rates. These three factors have a huge psychological impact on a trader, and many traders only learn what works and doesn’t work for them through painful trial and error.

Drawdowns are an important and inevitable part of any trading strategy. No system can win all the time. And when they hit a run of losses (which they will do), it can be an uncomfortable experience.

To stomach hefty drawdowns, you need to have a decent-sized trading fund (this means that you can keep your risk-per-trade nice and low) and you need strong nerve.

If you lack these things, then look for a system that hasn’t suffered bad drawdowns (although this is never a guarantee for the future), but a respectable success rate and risk reward ratio will help.

A good success rate can also be a great psychological boost to a trader, even if overall profitability is mediocre. Likewise, taking small, steady risks is a good way to keep trading consistently. Whereas pushing risk too far will give you that gnawing feeling in your gut that quickly turns into neglected trades … unclosed positions … and other bad habits.

Past performance

No doubt you’ve heard the saying that “hindsight is always 20:20” – and nowhere is it more true than in trading histories!

Back testing is a dark and murky area of trading records, and I’d like to throw some light on it here …

Back testing is the process of applying a trading technique to historical data in order to verify how it would have performed in that period.

Sounds fair enough, and like a very sensible thing to do – but the simple fact is that because of the knowledge we have about the past, it’s far easier to create a profitable system that will work on historical data than one that’ll work in the future.

In fact, if I plugged some numbers into the software I have on my computer and applied the “optimization” feature – I could probably come up with a trading strategy that would look like a great little earner – based on purely back-tested results.

How would I do that?

I’d run through the charts, and find the optimum trading times, I could hone my profits targets, fiddle my stop losses – and miraculously score again and again.
In fact, I can even introduce some new trading rules to explain away the days when the market misbehaved. (Like “Never trade on a Tuesday when there’s a letter ‘r’ in the month”!)

I’m not suggesting that there’s no place for back testing – but it is no substitute for testing a trading strategy in the real market.

Even if I apply the strictest rules to my back testing, it’s hard to ignore the things I know about the timeframe – the general bearish or bullish nature of the markets … or the volatility of those months.

Nothing beats strict forward testing of trading results.

If I see someone flogging a trading strategy with a handful of months worth of backtested results – I run a mile. And I’d suggest that you do too.

Of course, even with meticulous back-testing, and rigorous live testing – we cannot have any guarantee of whether a strategy will be profitable in the future. If you want guaranteed returns, then trading isn’t the place for you.

But if you’re prepared to take some measured risks, and in return have the opportunity to significantly out-perform the market – then you’re in the right place.

Related posts:

How to test a trading strategy The 10 tests of a good trading strategy