November 16, 2005

Name: Mike Seery
Company: Manduca Trading
Years Trading: 11
Favorite Movie: Parenthood

Steps to Developing a System

Read more about the author.

Complimentary "21 Proven Trading Strategies for Trading Options" Booklet courtesy of Manduca Trading

Receive your complimentary booklet which illustrates 21 option trading strategies, detailing when to use each strategy, the profit and loss characteristics of each strategy, and the effects of time decay. With each strategy comes a chart that quickly distinguishes breakeven properties. Useful in determining which option spreads should be considered relative to your opinion of a market's direction. Helpful pattern evolution charts exhibit the manner in which the profit or loss characteristics of a strategy change over time. Get it here.

Steps to Developing a System

There must be a map or model of the data which shows the zone to be navigated and upon which is marked the best route.

It is very useful to believe that if several people can do something well, then the same skill can be copied, or modeled, and taught to someone else. To develop a good model, you need to find several people who can do the task well. You then need to interview those people to find out what they do in common. These are the key tasks involved in the model. It's very important to find out what they do in common. If you don't, you'll simply discover the idiosyncrasies of the people involved, which usually are not that important.

Here are some of the characteristics top traders share in doing their system research, trading research and taking personal inventory of themselves;

1. Take an Inventory

The first key step is to take an inventory of yourself - your strengths and weaknesses. To have market success you must develop a system that is right for you. In order to develop such a system, you must take such a self-inventory of your skills, your temperament, your time, your resources, your strengths, and your weaknesses. Without taking such an inventory, you cannot possible develop a methodology that's right for you.
Among the questions you need to consider:

- Do you have strong computer skills? If not, then do you have the resources to hire someone who does or who can help you to become computer proficient?

- How much capital do you have? How much of that is risk capital? You must have enough money to trade with the system you develop. Lack of sufficient funds is a major problem for many traders. If you don't have sufficient funds, then you cannot practice adequate position sizing. This is one of the essential ingredients of a successful system and yet it is one that most people ignore.

- How well can you tolerate losses?

- How are your math skills?

There are many important issues that you should contemplate. For example, consider what time constraints you have. If you have a full-time job, think about using a long term system that only requires you to spend about a half hour each night looking at end-of-day data.

2. Develop an Open Mind and Gather Market Information

The first part in system development modeling is to develop a completely open mind. Here are some suggestions for doing that.

First you need to understand that just about everything you've ever been taught-including every sentence you've read so far- consists of beliefs. "The world is flat" is a belief, just as is the statement "The world is round." You might say, "No, the second statement is a fact." Perhaps, but it is also a belief- with a lot of important meaning in individual words. For example, what does "round" mean? Or for that matter, what does "world" mean?

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Anything that seems to be a fact is still relative and depends upon the semantics of the situation. It depends upon some assumptions you are making and the perspective you are bringing to the situation- all of which are also beliefs. You'll become a lot less rigid and much more flexible and open in your thinking if you just consider "facts" to be "useful beliefs" that you've made up.

The reality that we know consists solely of our beliefs. As soon as you change your beliefs, then your reality will change. Of course, what I've just said is also a belief. However, when you adopt this belief for yourself, you can begin to admit that you don't really know what is real. Instead, you just have a model of the world by which you live your life. As a result, you can evaluate each new belief in terms of "utility." When something conflicts with what you know or believe, think to yourself, "Is there any chance that this is a more useful belief?" You'd be surprised at how open you'll suddenly become to new ideas and new input. Keep in mind the following: You don't trade or invest in markets - you trade or invest according to your beliefs about the markets.

3. Determine your Objectives

You cannot develop an adequate system for making money in the market unless you totally understand what you are trying to accomplish in the markets. Thinking about your objectives and getting them clearly in mind should be a major task in system development. In fact, it probably should occupy 20 to 50 percent of your time in designing a system. Yet most people totally ignore this task or spend just a few minutes doing it.

4. Determine your Time Frame for Trading

Your fourth task is to determine how active you want to be in the market. What is your time frame for trading? Do you want to have a very long-term outlook, probably only making a change in your portfolio once a quarter? Do you want to be a long term trader where your positions last 1 to 6 months? Do you want to be a swing trader who might make several trades each day with one lasting more than a day or two? Or do you want the ultimate in action - being a day trader who makes three to ten trades each day and is always out by the close of the market?

This question should be adequately addressed before you begin trading.
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5. Determine the Best Historical Moves in that Time Frame and Notice what thoseMoves have in Common

Once you decide upon the time frame that you want to trade, determine what the best possible moves are within that time frame. Find many of them, in many markets, so that you have a large sample. Probably you want to collect a minimum of 50 to 100 sample market moves. Also be sure you include both up moves and down moves.

For example, if you subscribe to "Daily Graphs", there is typically an example of a commodity in a pattern from which it moved more than 100 percent. You could collect many examples from past issues. You will be much better off if you can make money from both good up moves and good down moves, so be sure to collect and research both.

Once you have a collection of great moves, notice what they have in common. You might observe that all of them show a strong move up, establish a base, and then break out of that base. However be willing to look at a lot more than just price conditions. For example you might notice important volume conditions that occur with moves. Are there any fundamental conditions that seem to be necessary for such moves to occur? Are there certain timing relationships present? Many of these are set-up conditions that are important for you to notice.

6. Look for Huge Reward Trades

Look to capture huge rewards in comparison with the size of your losses. Another way of stating this is to look for huge R-multiple trades, where your payoff is many times the size of the potential loss you will suffer if you are stopped out at your initial risk (called R).

Let's say there is a long, narrow consolidation period before the market starts to move. Let's say you entered the market three times during that consolidation period. Each time you are stopped out at a loss of about $0.75 per position. You now get into the market and make a $10.00 profit (a 12.5-R multiple) per position. Would you like that kind of system?

Most people would hate it because they are "wrong" too many times. In fact, in the example, we assume you are only "right" one time out of four times, or 25% of the time. Yet look at your bottom line. You have a $10 profit from which you must subtract three $0.75 losses, or $2.25. The net result is a profit of $7.75 - or over three times the size of your total losses. This kind of trading can be very profitable. It is not easy for most people, however, because they would typically give up after three or four losses.

7. Determine how you can improve your System

The next task in developing your system is to determine how you can improve it. Market research is an ongoing process. Markets tend to change, according to the character of the people who are playing them. For example, the futures market is dominated by professional CTAs- most of whom have trend following strategies that they employ using very large amounts of money. In another 10 to 20 years, the markets might have quite different participants and thus take on different character.

Any system with a good, positive expectancy generally will improve it's performance if more trades are taken in a given period of time. Thus, you can usually improve performance by adding independent markets, so adding many markets simply gives you more opportunity.

In addition, performance can usually be improved by adding non-correlated systems - each with its own unique position sizing model. For example, if you have a major trend following system with a very short term system that takes advantage of consolidating markets, then you'll probably do very well when you combine them.

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The hope is that your short term system will make money when there are no trending markets. This will lessen the impact of any draw-downs produced by the trending system during these periods, or perhaps you might even make money overall. In either case, your performance will be better because you will move into trends with a higher capital base.

8. Worst-Case Scenario Mental Planning

It's important to think about what your system could do under a variety of circumstances. How will you expect your system to perform in all types of market conditions - highly volatile markets, consolidating markets, strong trending markets, very thin markets with no interest? You won't really know what to expect from your system unless you understand how it's likely to perform under each possible market condition.

Imagine what it's like to take the other side of each trade. Pretend you just bought it (instead of sold it) or pretend that you just sold it (instead of bought it). How would you feel? What would your thinking be like?

This exercise is one of the most important exercises you can do. I strongly recommend that you take it seriously.

You also need to plan for any catastrophe that might come up. Brainstorm and determine every possible scenario you can think of that would be disastrous for your system. For example, how would you your system perform should the market have a 1- or 2-day price shock (very large move) against you? Think about how you could tolerate an unexpected, once in a lifetime move in the market, such as a 500 point drop in the Dow (it has happened twice in 10 years) or another Crude oil disaster like the one we saw during the Gulf War in Kuwait. What would happen to your system?

When you have your list of disasters, develop several plans that you can implement for each one. Plan your responses in your mind and rehearse them. Once you've established your actions in the event of a calamity, your system is complete.

Complimentary" 21 Proven Trading Strategies for Trading Options" Booklet courtesy of Manduca Trading

Receive your complimentary booklet which illustrates 21 option trading strategies, detailing when to use each strategy, the profit and loss characteristics of each strategy, and the effects of time decay. With each strategy comes a chart that quickly distinguishes breakeven properties. Useful in determining which option spreads should be considered relative to your opinion of a market's direction. Helpful pattern evolution charts exhibit the manner in which the profit or loss characteristics of a strategy change over time. Get it here.

About Today's Author
Mike Seery began his tenure in the agricultural complex at the Chicago Board of Trade. He then transitioned off the floor to pursue an ambition of becoming a full service broker, which he succeeded in doing. Mike had been a regularly featured speaker on WCIU's Ask an Expert where he fielded questions about the markets from viewers and shared his trading philosophy. Mr. Seery brings not only his experience to his customers, but also his increased awareness in the value of Customer Service. Using a disciplined trading approach with a strong emphasis on risk and money management, Mr. Seery incorporates a mixture of fundamental and technical analysis, and is comfortable trading any markets his customers are interested in trading. Mr. Seery has the knowledge, discipline, and experience to help his customers maximize their trading potential. Forward This Email To a Friend