Quantitative Trading Systems

A trading system is a combination of logic and data.

The logic specifies the rules and the parameters. For a trend following system, for example, the rules might be to enter and exit as two moving averages cross. The parameters are the lengths of the two moving averages.

The data is the price history of the issue being traded, perhaps augmented by other data series. The data consists of two components — signal and noise. The signal has the patterns we hope to identify. Everything that is not signal is noise.

A trading system is profitable as long as the logic identifies patterns in the data that precede profitable trading opportunities. That is, as long as the logic and data remain synchronized.

The logic of a typical trading system is relatively fixed. It is designed to detect a particular set of patterns.

The data change, following changes in areas that affect the issue — economics, politics, weather, etc.

As the data changes, the patterns in the data move in and out of synchronization with the logic. When synchronized, the system is healthy, it is profitable, gains are steady, drawdowns are low; when unsynchronized, the system is broken, it is unprofitable, gains are sporadic, drawdowns are high. The profit potential and drawdown risk of a system is determined by the accuracy with which the system identifies the patterns.

During periods of close synchronization, the system is healthy and large positions may safely be taken. As synchronization weakens, position size must be reduced. If the system breaks down completely, it must not be traded.

Methods for selecting entry points include:
• Trend following. Enter after a trend has been established, anticipating that it will continue.
• Mean reverting. Enter after prices have deviated from their average, anticipating that they will return to normal.
• Pattern. Enter when a pattern that has preceded price changes in the past appears again.
• Seasonality. Enter at a time, such as the beginning of a month, that has historically been profitable.
• Cycle. Assuming that prices rise and fall in reliable cycles, enter at a point where the time is right and price is likely to change.

Regardless of the method chosen to enter a trade, every profitable trade is a trend following trade while you are in it. You want to sell at a higher price than you buy.

The characteristics of the trading system are determined by many factors:
• System Logic, and its adaptability.
• Issue being traded.
• Bar length.
• Entry method.
• Exit method.
• Trading frequency.
• Holding period.
• Position size.
• Account size.
• Commission.
• Slippage.
• Winning percentage.
• Win to Loss ratio.
• Trader’s risk tolerance.
• Intra-trade drawdown.

The analysis methods I describe help traders identify the health of their system, its profit potential, its risk, and the position size that will achieve maximum account growth while keeping drawdown within acceptable limits.