Profitable trading systems do not exist

This is, of course, a provocative heading that shoots against successful investors. And it is a thesis, which probably most traders reject. But, in return, we ask the question of the Holy Grail of the trades: Is it really true? If we define this grail as a constantly successful trading system, the consequence is clear: there is no such thing.

Each trade starts with a disadvantage

As a rule, trading costs, spreads and slippages ensure a negative trading start. One can try to minimize the disadvantage, but nevertheless all market participants must accept it. This fact alone ensures that the stock market is less likely than a coin toss.

In 2014, the French stock exchange supervisor AMF concluded within a large-scale investigation of 14.799 accounts that 89 per cent of CFD and forex traders are in the red. This coincides with the general assertion that most investors are losers. The high rate suggests, however, that the statistical disadvantage of trade costs cannot be the sole cause. Technical as well as psychological weaknesses of the investors have probably a negative effect. The author has been dealing with the stock market for many years. He usually converts his trading ideas into program lines. This is the easiest way to perform a back test. Over the years, he has programmed hundreds of trading systems. All systems showed significant fluctuations in the capital curve. The fluctuations could then only be reduced by additional filters. Despite successful back-tests, in reality a trading system never showed the desired consistency, which every trader hopes for. It is true that these systems also have approaches that have functioned. Nevertheless, the claim is that there are no profitable trading systems in the long term. Anyone who believes to have such a thing has just not made enough trades. This thesis is confirmed by the performance of institutional market participants. Under the condition that large funds have almost unlimited financial and professional resources, the services are hardly proportionate. Fund managers with a performance of 20 percent can sometimes be hired as superstars.

This is how successful exchange trading looks

Even if it does not suggest the previous lines, you can operate successful stock market trading. The core of the success lies in the specific application of the trading systems. All systems work well when they fit into the current market phase. This is the key point. Not the system but the market structure should therefore be the central theme of every trader. Good traders are able to choose the right tools at the right time. This is comparable to a craftsman who meets different problems with the appropriate tool. Whoever uses only one tool is limited in his abilities.

The higher the profitability, the deeper the crash

Let us assume that there are no trading-costs, no spread and no slippage. Would then profitable trading be possible permanently? This is also difficult because a trading- advantage becomes a trading disadvantage over a very long time. The greater the advantage, the greater the later disadvantage. Each system has cyclical phases of profit and loss. The larger the gain phase, the stronger the loss phase. A trading system can be assessed in a simplified manner using three statistical terms:

Profit factor = (number of profit trades / number loss trades) x (Average profit / average loss)

Hit rate = number of profit trades / total trades

Payoff ratio = average profit / average loss

In a trading system everything is about the profit factor. A system is only profitable if the profit factor is above 1. This means that the profit trades "weigh" more than the loss trades. In order to increase the profit factor, traders are tinkering with an improved hit rate or looking for trend moves to optimize the payoff ratio. The natural profit factor of each market is just under 1. Without trading costs and so on, it would be exactly 1. If we go from any trading system and try to improve the profit factor, we can first increase the hit rate. The easiest way to do this is by closing the trades faster. However, this is at the expense of the payoff ratio. This effect is often found in short-term traders. They boast a hit rate of 80 percent. The payoff ratio is hardly more than 0.3. This results in a weak profit factor of 1.2. If, then, above-average trade costs are added, the system slides quickly into the loss range below 1. The second way is to increase the payoff ratio. In short, you let the profits run. Unfortunately, this does not harmonize with the hit rate, which is reduced. Because, as soon as the market becomes cyclical, potential losses become real loss trades. In this case, it only helps to limit its losses.

The use of filters

The problem of the interaction between hit rate and payoff ratio can be circumvented with additional system filters. However, the disadvantage of each filter is that the trading frequency is reduced. What are the key figures for a system with strict filters? An example that looks superficial at first sight: Hit ratio 65 percent with a payoff ratio of 3. This gives a profit factor of 5.57. The flaw is however in the detail. Such a super-system does not necessarily lead to a large account increase. The number of trades is reduced by the filters. For example, a system that generates a trading signal every three years, for example, will not yield a sufficient return. As a result, the account remains small, although the key figures are exceptionally good.

 

Lifetime of profitable trading systems

If you are one of the lucky ones who have a functioning trading system, there are different ways of how long your profitability will last. With a system that gives you 100 percent return or more, you should enjoy the great time. Because, sooner or later the corresponding unpleasant loss phase will come. It is the fate of every outstanding profit system. It is just specialized – and the outstanding return is a result of the appropriate market structure combined with optimal system parameters. Pot and lid fit together for a while. Such high-flyer strategies enable incredible returns in a short time. They are often found as a marketed system for exchanges. They provide a short-term return on investment because the system and the market are ideally matched. Such depot boosters unfortunately do not last long. We are not talking about weeks – the system can work for months or years. Somehow, however, comes the tearful end. Just as quickly as it caused for a sprawling rate of return, then come the setbacks.  Almost all institutional market participants are striving for durable long-life burners. This is also understandable because they have to offer constancy over a long period of time. Institutional market participants are committed to their investors. Anyone who cannot keep his promised return is punished mercilessly. A withdrawal of customer deposits must be avoided. Systems with long life have a solid basic idea. They bring you between five and 20 percent return per year. They work very long and you can hardly imagine that the returns are finite. Unfortunately, even such tough-running endurance runners have a life cycle, as the markets are always changing. At some point they do not work well. The trader does not notice it immediately because the deterioration is slow.

 

Conclusion

Do not search for the ultimate trading system. While it is fun to constantly be focused on improvements, the basic idea of the system is crucial. Successful systems follow a compelling profit logic. Once a system has been established, the main task is to look for the best market for the system. You can choose different markets or even a single market. In the latter strategy, it is advisable to segment the market strictly. This can be done, for example, at certain times or rhythms. Whoever understands the market can better choose a suitable trading system. The outstanding ability of a good trader is to recognize the rhythmic movements of the market. Even successful traders cannot predict the markets. But they are masters in reacting to changing market conditions.

 

 

Author

 

Christian Lukas

Christian Lukas is an engineer and has been dealing with the stock market since 1998. His specialty is volume analysis. He is the author of the book "Handbook of Volume Trading". On the website www.trading-ideen.de he gives an insight into his stock exchange trading. www.trading-ideen.de

 

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