Commentaries by Bruce Babcock for New and Experienced Traders

Implementing A Mechanical Approach to Trading Commodities

In my article in the last issue of Trader's World, I argued that "The average person has the best chance to be a profitable trader if he or she adopts a 100-percent mechanical approach." This is the only surefire way to minimize the emotional influences that inevitably destroy nearly every trader. I know that in my own case, the more mechanical I am, the better my results are. Assuming you have decided to try the 100-percent mechanical approach, how exactly should you proceed? You would think that the most important step would be to find the perfect system. Strangely, finding the system is only a small part of the job. In the first place, you must abandon the idea that you will ever find the "perfect" system. The perfect system this month may be lousy next month. It will definitely have many difficult periods. A system can only exploit one time frame at a time. (What traders think of as a non-trending market is really a trending market in a shorter time frame.) There is no indicator now, and there never will be one, that can predict what type of market you will have in the future. You can never know which time frame will be optimal to trade in the near future. The best an indicator can do is tell you what type of market you are in now. You should pick a system that has done a good job historically over a long period of time. You hope and expect that if you trade it long enough in the future, you will eventually achieve approximately the same level of profitability.

One key to success is to diversify as much as your capital will allow in markets and (perhaps) time frames. Up to about $50,000 in capital, I suggest you pick a relatively long-term system and use your diversification power to diversify in markets only. One system should be enough, but there is nothing wrong with trading several systems using different markets. If you have more than $50,000, you can begin to think about adding additional systems to diversify into shorter-term time frames.

Long-term trading is the most efficient. In long-term trading, you hold winning trades longer, so your average profit per trade will necessarily be larger than in short-term trading. As your time frame becomes shorter, your holding period becomes shorter and your average profit per trade becomes smaller and smaller. However, your costs of trading (slippage, commissions and the bid/asked spread) stay the same. Thus, your system has less margin for error. A long-term system may give you an average trade of $500 to $2,000. A short-term system may yield an average trade down to $50. If, because of adverse market conditions, your system's efficiency decreases by $500 per trade, your long-term system may still make money, but your short-term system will be in big trouble. [To the extent that you may need intraday quote equipment for very short-term trading, your general overhead increases as well. This may or may not be offset by an increased number of trades creating additional profit.]

The purpose of diversifying into a shorter-term time frame is to smooth out the equity curve by being able to take advantage of periods when the markets are congesting in your long-term time frame. Trading shorter-term can also make better use of capital if your system can move from market to market seeking the best opportunities.

Depending on your trading personality, you may prefer to use additional capital to diversify in long-term systems or just add additional contracts in the markets you are already trading. I believe this approach offers the highest probability of making long-term profits and the highest expected value of profits earned. The key to benefitting from the long-term statistical advantage is to trade a well-selected group of diversified markets and to have the discipline and courage to keep trading your system until you reach the long-term.

Almost all traders fail to exploit the statistical advantage of following trends in the futures markets. They do not trade their system religiously, they choose a poor group of markets to trade or they overtrade their capital and are forced to quit too soon. An essential thing to avoid is trading with an over-curve-fitted system. Nearly every system is curve-fitted to some extent. The minute you test an idea and then change it at all to improve performance, you have engaged in curve-fitting. The more you bend your system around to improve performance on past data, the less likely it is your system will trade profitably in the future. This is very hard for inexperienced traders to accept. They expect that methods which worked well in the past will probably work well in the future. Past performance will only approximate (and I emphasize approximate) future performance to the extent the system is not over-curve-fitted.

The best way I know to guard effectively against over-curve-fitting is to make sure your system works in
many markets using the same parameters. Successful system traders use the same system parameters for each market no matter how counter-intuitive this seems. The more markets and the longer the historical time period your system can trade profitably, the more robust it is. But don't expect your system to trade all markets and all time frames profitably. This will not happen. I trade one of my systems in fourteen markets using the same parameters for each. So long as a system tests well over a large number of markets, there is no requirement that you trade it in all of them to diversify. You could have ten systems that all tested profitably in fifteen markets over the last six years and choose to trade each of them in only one market. That would allow you to trade ten diverse markets using a non-curve-fitted system in each. It would be just as acceptable theoretically as trading one of those systems in the same ten markets.

For myself, I am not concerned about finding the perfect system. I want to trade a good system, an adequate system that is not over-curve-fitted. I then spend considerable time choosing a good portfolio of markets to trade. I will discuss that process in my next article.

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TRADING IN COMMODITY FUTURES OR OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS.
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

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