I wonder how would you rank order market selection, setup/entry timing, protective stop, trailing stops/exit and position sizing in terms of overall importance to the success of a trading system?
A: Each are important, but in analyzing numerous strategies I have not seen a tried-and-true ranking system that fits everything.
The reason I think (and my research proves out) that why strategies fail are directly related to three main things: 1) user error (i.e. failure to act on the signals provided by your system in a consistent manner without trying to outsmart the system, 2) over optimization and use of extensive leverage, and 3) the most important of all – little to no risk management through proper position sizing and stops. All in all, if you really are focused on improving yourself in 2010, the first place to look is risk management as it has more of an impact over your eventual success or failure than anything else.
Successful system trading, in spite of the financial rewards, can be frustrating. A quantified mechanical model will take many decisions off the table. Yet, various issues, particularly the psychological approach to the issues, will always be in play.
Ed Seykota in the book, “Market Wizards,” writes, “Systems trading is ultimately discretionary. The manager still has to decide how much risk to accept, which markets to play, and how aggressively to increase the trading base as a function of equity change. These decisions are quite important, often more important than trade timing.”
It seems most sophisticated traders are aware of the fact that a system needs to be properly quantified and tested before trading. The sample size of the trades needs to be large. These traders are familiar with the terms of curve fitting and optimization. I wonder, however, how many traders continue to study the model as they trade their equity. How many understand the logic behind the entries, stops, exits, and money management techniques. How many are adjusting position size to meet expanding and contracting volatility and changes in market correlation. (more…)