Assess Your Needs Before Starting

Before embarking on the design of a trading system you should first assess your personality, lifestyle and financial means.  There is no point in putting a great deal of effort into a trading system that is ultimately unsuitable for your life's situation.

Most traders dream of having an automatic stock picking system that makes tons of money - all you have to do is sit in front of a computer and buy when the S/W tells you to buy and sell when your PC tells you to sell.  Easy Right?? 

Well, even if you had such a program it wouldn't be easy.  And there are several reasons.  The first being that you probably need a large amount of trading capital to start off with.  Are you willing to risk a large amount of capital on something that may or may not perform into the future? 

Do you have the ability to sit in front of a computer screen all day long waiting for a signal that may occur once or twice a day.  Will this make you happy?  The answer for most people will be NO.  But you may have to if you run a day-trading system.

What happens when the system goes on a losing streak?  Do you have the courage to continue when your trading capital is down 25% or will you pull the plug?  It is one thing to run backtests on a trading system where it shows a 25% worst case drawdown.  It is quite another when you are down 25% with real money, not knowing when or if the trading system will recover.

What securities are you comfortable trading?  Can you stomach the potential for unlimited losses by trading highly leveraged futures markets or FOREX?

The point I am making is that you have to assess your personality, financial means and lifestyle before you embark on this long journey.  I say "long journey" because there is no instant success.  No one designs a trading system and instantly starts making outrageous amounts of money right off the bat.  It has taken me 15 years to realize there is no holy grail.  If you believe there is then run out and subscribe to the trading robot or whatever.

For this assessment I ask myself a series of questions.  My answers are in blue.

How much trading capital do you have?  $100K

How much time do you wish to spend per week maintaining your system?  1-2 hour

What is your maximum drawdown tolerance?  15%

What securities do you wish to trade?  U.S. stocks only

Will you trade in a margin account?  No

What is your profit objective?   25% per annum

I would like to note here that one's profit objective has to be consistent with one's tolerance for drawdown.  It is silly to write down a profit objective of 250% per year with a maximum drawdown of 5%.  Neither are plausible.  In any case, after doing some research you will likely refine your answers to be more consistent with what is achievable.

So from the above answers I conclude that I have $100K to deploy on a weekly stock trading system.  I am looking for 25% profit (or $25K first year) per annum with a maximum drawdown of 15%.  I should add that my personality type cannot allow me to be in the red for long periods of time and every year should be profitable.

Comments

[Jerrod]

Excellent approach, Steve. I've also been doing a lot of fussing with the notion of tolerable subpar performance, or "risk" in shorthand. Here's a novel approach from Mungofitch on the Motleyfool Mechanical Investing board (Post #212586).
" For risk, I use a metric called a downside deviation.
This is based on the ideas that (1) you really want to make
a certain amount of money every single year---I assumed
10% per year, (2) that any twelve month period which is lower
than that is a "failure" because it had a shortfall from your goal, and
(3) that a shortfall of twice as much is four times as bad. i.e., getting
2% return (which is 8% less than your 10% per year goal) is four times
as bad as getting a 6% return (which is a shortfall of only 4%).
So, each doubling of the shortfall from your goal is given four times the penalty.
You can ignore the details, but what it means is that I've
come up with a single number representing risk: it's the
average of the penalties from (a) 3 month periods that didn't
even break even, from (b) 1 year periods that didn't make 10%,
and from (c) 2 year periods that didn't make 21% (which is 10%
per year compounded)."

I like this, because it addresses three time periods -- 3 month, 1 year, 2 year. For my own case, I'd probably put a shorter term leash on the calculations -- 1, 3, 12 month.