Robust Trading Systems Are the Goal of Trend Followers
You can always find crazy ads promising trading systems with high returns and 100% success rates picking tops and bottoms. These so-called systems achieve their results by using many rules and many exceptions. They were perfectly developed or curve-fit. The rules are always over-optimized. Looking good on paper only is all you get. They won't last or hold up to the real world.
A good trend following trading system must be robust. There are five general criteria for system robustness:
- Sensitivity analysis on system rules (parameters).
- Testing on many markets.
- System-wide risk analysis.
- System consistency.
- Can trend following be described in simple and logical terms?
A trading system with no more than three to five parameters to optimize is ideal. Parameters are the quantitative component of the rules or conditions that must be met.
Test in Many Markets
A significant indication of robustness is to use a system optimized for one market on many different markets without changing any of parameters. If a system optimized on the S&P 500 can trade a Japan fund, a small-cap fund, and an emerging markets fund, the confidence in that system is increased.
System-wide Risk Analysis
System-wide risk analysis imagines all ways system may under-perform its objectives. Think through the options.
Consistent returns show a system, over many trades, is taking advantage of an edge. The word edge is used the same way a casino has an edge at roulette, over a large number of trades, a system with an edge makes money.
Can trend following be described in simple and logical terms?
A system must be explained in simple and logical terms. If a system depends on the phase of the moon or on the exponential moving average of the Fibonacci oscillator, then reject the system. You must understand the basis for a system’s success.