Over the next few weeks I would like to focus on the steps and processes involved in designing a trading system. Whilst by no means an exhaustive list, it will provide an insight into the process for those interested in designing their own trading system and for those who are weighing up whether to develop their own system or purchase an existing mechanical system with a positive edge over the market.

I will provide a practicable insight into designing, developing and building a trading system or more correctly, a trading methodology. This is a general overview rather than an exhaustive coverage of the subject but should be sufficient for a potential system designer to get a good idea of the processes involved. I trust it will assist you in either embarking on the journey or accepting that it is one that you would rather not make. For those of you who already know that designing a system is not for you then this chapter will give you a greater understanding of how to evaluate any system when you are considering a purchase. My goal is that regardless of whether you choose to pursue the development of your own trading system or purchase a proven methodology from a reputable system vendor you will be more knowledgeable about avenues for profitable trading by grasping the content of the blog over the next few weeks.

Generally the purpose of developing an edge is to trade the edge in order to make money with it. Whilst this statement may seem obvious, the majority of people who embark on the system development journey don’t complete the journey and hence don’t achieve the purpose.

The system design paradox

Before getting into any detail I must uncover a paradox that is one of the main reasons why most who start the journey of system design do not complete it.

Most people generally wish to avoid the pain associated with losing. Unfortunately this paradigm (avoiding loss) will, by default, be used to evaluate the edge the individual is attempting to design. This is a Catch 22 situation as the system designer needs to have learned to think in probabilities with a market paradigm in order to evaluate and hence complete the design of a system. I covered many of these topics in last year’s weekly blogs. You may wish to refer back to them to refresh your knowledge or to read them for the first time if you are unsure of some of these terms.

The operative word in system design is ‘complete’. If some degree of a consistent mindset has not been achieved, then the designer will not know when to stop researching and start trading. Typically the results of the research will continue to be evaluated from the paradigm of trying through analysis and further research to eliminate losing. This means that the individual will be thinking like an analyst rather than a trader.

The analyst’s mindset attempts to analyse away losing. Even though the analyst will admit (using the logical left brain) that analysing away these situations is impossible, his/her subconscious, having been trained by society to avoid these situations, will rule the roost and lead the analyst to continue research, attempting to analyse the following out of the system: losing, being wrong, missing out and leaving profits in the trade.

The trader’s mindset, achieved through reprogramming the subconscious, is to trade an edge and totally accept the losses an edge generates. Therefore, if you have an analyst’s mindset when trying to design an edge, the probability of completing the development, let alone trading it successfully, is very low. In fact, an analyst will have a difficult time trading any edge, let alone one they have developed themselves.

The successful researcher must have a degree of successful trader in him/her, and must know what a practicably profitable system looks like to know when he/she has completed the research journey and can begin the trading journey.

By definition, an edge will make money over a large sample of trades.

I know that my comments on this paradox may be contentious amongst readers but successful system designers and system traders who have completed the journey or part thereof will agree with me. In next week’s blog I will take a look at the tools and resources required to begin the journey of designing your own trading system.

After a well earned break following a busy year, we are now back to business in 2010. As the year ahead begins to unfold I would like to take this opportunity to reflect on the events of 2009 and how this may help us with our trading plan this year.

The first few months of 2009 saw the downtrend, that had been the feature of 2008, continue into early March. The press was awash with every doomsday theorist and almost every economist on the planet predicted the potential end of the financial system and equity markets. Many so-called experts were making wild and outrageous predictions on how low the major world equity indexes would go – some even predicting the Dow Jones to drop to less than 500 points. With American company’s going broke left, right and centre, (including some large and well recognised brand names), hundreds of thousands of American’s losing their jobs, and home foreclosures happening every few minutes the naysayers and doomsday theorists were having a wonderful time, especially those that had been calling a major bear market for over 15 years!

But, lurking quietly in the shadows of all this doom and gloom were equity markets that were slowly and cautiously starting to rise off their lows. Once again, as has happened throughout history, equity markets lead the economy out of the mire. Despite the negative noise of the financial media, those with a trading plan and money management rules were able to begin re-investing in a rising stock market. As a result these investors and traders were able to take advantage of some wonderful opportunities that combined to see the major world equity markets experience some very significant rises and returns between March and September of 2009.

There are a number of important issues that arise from the events of 2009.

• Whilst many investors without a trading plan or rules to exit their positions or lighten their portfolio’s were severely savaged by the events of the Global Financial Crisis in 2008 / 2009, those with a plan followed the rules and sold, hedged or lightened their equity exposure as the markets collapsed.
• These same investors who held onto losing positions were then either too afraid, or too easily influenced by the negative press to re-enter the market as it turned around. They subsequently missed out on a bull market that saw gains of 50% or more in some markets, and even greater on an individual stock basis in some instances.
• ‘Experts’ are quite often wrong. Whilst predictions and theories sell newspapers and make for spectacular headlines, they don’t make you money.
• The pre and post GFC periods prove to us yet again that you MUST have a trading plan for engaging the markets. Regardless of whether you are a trader or an investor, you must have a clear and unambiguous set of rules that allow you to participate in the markets free of the mumbo jumbo, noise and opinions of others.
• Money Management, position sizing, and risk management tools are crucial to your success (or otherwise) in the markets. Without an understanding of these principals and the discipline to implement them, your investing activities will forever be influenced by the opinions and conjecture of others.
• Success can be achieved in the markets through a disciplined and consistent approach and the application of a rigorous and robust trading system.

2010 will present us with a new set of market conditions to deal with. Will the market keep rising? Or will it retrace? Or will it drift sideways? Will volatility increase or decrease? Will inflation raise its head, or will economies deflate? The list of questions, events and variables that may or may not impact on the markets is endless.

As active and educated investors and traders our ‘job’ is simply to manage what happens and not hypothesize about what may happen. Trade what is, not what you think may or may not happen. Listen to the market and trade what is in front of you in the ‘now’ moment. Eradicate the ‘noise’ that surrounds the market which will make you drift from your trading plan.

To achieve this, we need to have processes to follow the rules of our trading system or methodology in a disciplined manner, free of any emotional attachment to the outcome of any individual trade. Through application of a robust system with a positive equity curve over the long term, our investing activities can be rewarding and positive, despite what the media may try and have you believe.

This will liberate you from conjecture, prejudice, opinion, fear, uncertainty and doubt and keep you focused on your processes.

I wish you all a successful and prosperous 2010.

We firstly need to understand what knowledge actually is. Many spruikers spruik that all you need is knowledge and they have the knowledge that you need to get ahead. Well I have some bad news for you, knowledge alone will not do the trick for you. There are thousands of well educated derelict people around the world.

Knowledge is the difference between being unaware of some information and being aware of it. It is merely the comprehension of some information that you didn’t comprehend before. In a sense, you create some information that is new to you by experiencing it through any of, or combination of your five senses.

This doesn’t mean that it is new to the universe or to everybody else on the planet. It has most probably existed in the universe since year dot, but you will have needed to go through the creative process to gain this knowledge for the first time, which makes it new for you.

When a new idea is created by a human being for the first time in the history of the Earth, this is an invention. There clearly have been thousands or even millions of occurrences of this over the centuries. Even so, investors merely uncover truths or combinations of truths that already exist but were not seen or known by them before.

But here comes the catch—being aware of something and applying it in your life are two very different things. It’s the application bit that causes the greatest trouble to the majority of human beings.

This is the gap between knowing and applying, or put differently, between knowing what to do and doing what you know.

The fact is that most people don’t apply new knowledge. To themselves and others around them, they appear to ‘give up’, when, in fact, they never even started in the first place. All they were doing was applying their existing knowledge—information that existed before the new knowledge came along. This is the way that our minds work. Our current beliefs, which are the caretakers or our current habits which, in turn, are the application of our current knowledge, will defend themselves to the hilt. It takes effort to change.

Being aware occurs in the conscious mind; applying awareness or knowledge occurs in the subconscious mind. The challenge for us all is to get new knowledge from our conscious to our unconscious minds at which stage it becomes a habit. Only then will new knowledge become an ongoing working part of our being. To develop a habit we must step through a process that embeds the new knowledge into us as a part of our personality, that is first nature, so it becomes effortless to use the new knowledge to achieve our objectives.

This is where sayings come from such as: ‘I tried that once and it didn’t work.’ Because it was tried a few times, people perceive that they have covered that ground and there is no need to revisit whatever they tried. Their current, maybe dysfunctional, beliefs even convince them that because they tried it once (or twice) before, they are an expert as to why it didn’t work and hence why they shouldn’t use it any more and just carry on doing what they were doing before. And carry on getting the same results as before! With the same old bad habits, beliefs and thinking patterns.

From there they move on and try the next thing that is novel to them. And so the endless loop of failure continues. Nothing will work not because there is necessarily a problem with the new knowledge but because there is a problem with the process of embedding the new knowledge into their being.

Embedding new knowledge to the habit stage requires repetition of experiences via our five senses, and this involves disciplined effort until the habit stage is reached.

Maybe you can now understand that there is more to investing than just making money. It is an ongoing journey and transition process of acquiring new skills and improving them.

Sure, you could say that the same applies to golf, gardening or stamp collection but few other environments provide the magnified pressure cauldron such as the markets in which to execute learned mental skills under the pressure of losing money. The pressure is self induced by magnifying the perceived importance of money. Perceived or not, when you mix people and money the pressure is on.

One of the most satisfying outcomes of providing trading methodologies to and coaching active investors for many years is the feedback that has been provided by many that have successfully transitioned their active investing paradigm. Just about every person that comes to the markets does so to make more money, their primary motivation is growing their money.

However, when I have long discussions with customers that have become and then remained mechanical active investors for many years the most important things to them in hindsight is not the making of money through outperforming the market indices, the important things to them are:

• overcoming fear through trust (in an edge),
• creating investment processes and then surrendering to those processes,
• accepting and being at peace with outcomes of individual trades through focussing on the process,
• having no expectations for individual trades,
• believing in probabilities and thereby overcoming the uncertainty of individual trades,
• overcoming their biases that are harmful to investing in the markets, instilled through many years of living    in society,
• overcoming the “noise” that surrounds the markets propagated through newspapers, newsletters, TV shows,    radio shows, advertising, spruiking and many other sources.

These investors have learnt that you cannot trust and fear at the same time. If you are fearing you are not trusting and if you are trusting you are not fearing.

There is more to it than just money. The benefits of transitioning how you think, feel, say and do go way beyond just making money.

Not everyone knows that a universal philosophy actually exists in the business of trading. Importantly, in order to be successful in the long run, this needs to be clearly understood and firmly burnt into the trader’s psyche.

Anybody can place a few profitable trades—randomness will take of that. But to maintain that run of success requires more. It requires a consistent step-by-step approach and the ability to remain firm and confident in your approach, especially when you are going through tough market periods.

Being ‘successful on an ongoing basis’ means running a portfolio (equities, shares) that continues to rise at a faster rate than the market accumulation indices (managed funds), while experiencing acceptable troughs along the journey.

Depending on your perception of investing in the market, you will have a different view of what it takes to continue to be successful. Whatever it is, it is likely to be encompassed in the following 12 Point Trading Philosophy:

1. Develop well defined trading processes that are part of a plan.
2. Create an edge with a positive mathematical expectancy.
3. Undertake the necessary preparation and research.
4. Become empathetic, especially with the way the market moves.
5. Trust your trading processes and your edge.
6. Resist “noise” outside your processes.
7. Overcome fear, hesitation, indecision and reservation.
8. Execute with confidence.
9. Successfully manage both the euphoria of success and the despair of failure when something does not go the      way you planned.
10. Continue to engage according to your processes, regardless of your outcomes.
11. Transition your processes and your thinking into habits so that they become a natural part of who you are.
12. Become consistent and objective in your decision making.

Importantly, point Number 12, ‘becoming consistent and objective’ is the ultimate aim, the by-product of your processes, your endeavour and how you think.

Along the way you will need to deploy certain techniques, tools and skills to achieve the various parts of the trading philosophy. These may include:

• discipline
• technical analysis
• fundamental analysis
• research capabilities
• money management principles
• risk management principles
• mental, physical and execution exercises

At the end of the day, the trading philosophy can be simplified into this equation:

Edge in the Market + Trader’s Mindset = Consistently Successful Trader

Pretty simple, hey?