Finding a good trading system is a worthwhile pursuit, but how do you know when you have found one? What should your benchmark be? In the Chartered Market’s Technician’s level 3 curriculum, there is a reference made to Tushar Chande’s book, “Beyond Technical Analysis”. In this book, Chande outlines five key factors that need to be combined in order to constitute a ‘good trading system’. This article will look at each of the five headings Chande identifies.
A positive return
This is the most obvious heading. The system should generate a positive return and Chande suggests that the system should make more than 13% annually.
Less is more when it comes to a trading system. An overly complicated trading system could be either guilty of curve-fitting previous data or running the risk of being too complicated to execute. Chande suggests that fewer than ten rules is best for entry and exit rules.
Can be used across multiple markets
A robust trading system should be able to work across multiple markets. If a system works well for the EURUSD pair, then it should also work across a range of other markets. Be cautious of a trading system that only works well on one market. It could have been heavily curve-fit.
Now remember, there is little practical use of a trading system that generates a positive return but only does so with a large drawdown. Practically, large drawdowns are very hard to bear and many investors will abandon a system when large drawdowns appear. Chande suggests limiting risk to 20% drawdown and that the period of drawdown in a good system should not last more than 9 months.
Finally, for a true technical trading system, Chande suggests it should be a fully mechanical system and that during operation there should be no ‘second guessing’ of how to operate it.
Finding a good trading system is not just about finding a system with a positive return. It also needs to limit drawdown, have as few rules as necessary, and be fully mechanical. Finally, a good trading system should be able to be used across multiple markets. Remember, that a trading system that can only be used in one market could be the sign of curve-fitting for the particular set of market conditions in that one market. Combining Chande’s factors can make it easier to spot a good trading system from one that looks promising but has a fundamental flaw.