Knowledge on Mechanical Trading

Currency traders use different approaches in their trading. Some use discrete trading system and others use mechanical trading systems. Majority of successful traders use self developed mechanical trading systems that they developed themselves. There are always advantages and disadvantages of different trading systems. The majority of unsuccessful traders depend on discrete trading method that depends on their experience and technical knowledge.

Many traders develop their own trading systems. There are many actively developed trading systems also known as Expert Advisors or Robots for sale. Theses robots are basically computer programs that are based on some mechanical trading system. It can vary widely in prices. The prices can be from a few hundred dollars to a few hundred thousand dollars. The significant advantage of these computer programs is that they generate signals. These signals can be used by the trader for trading. Sometimes these computer programs are developed for a certain bank or a corporation.

The discrete trading method is used by many traders. They depend on their experience and instincts in trading. It is like an artist trying to adapt to different market conditions and using flexibility and tactics corresponding to the particular market condition. In case of a discrete trading method, the trader’s mood and health can greatly affect the outcome of each trade. The main disadvantage of the discrete trading approach is due to the stress factor influencing the trader, the unstable trade results.

A mechanical trading system prevents the trader from quick adjustment of trade tactics and strategies under changing market conditions. However, it almost completely removes the influences of the stress factor. It also reduces the negative pressure on a trader which is obviously a big plus. There are eight requirements that any ideal trading systems should fulfill. A mechanical trading system also doesn’t allow the quick customization of the trading system in cases like the change of the account size. These conditions are:

1. A good trading system should allow to any trader for the maximum adjustment according to his/her psychological character and makeup.

2. The trading system should depend on trading methods that are universal. It should not depend on a particular market condition at any moment of time.

3. It should be simple and logical. It should depend on understandable ready to use elements and units.

4. The trading system should provide specific price signals for the trader for entry and exit positions some time in advance.

5. The trading system must allow some room for the trader’s creativity. He/she should have the ability to tweak the system.

6. Without violating its main principles and elements of the trading system, there should be some flexibility to modernize. The trading system should adjust in accordance with the changing market conditions.

7. The trading system should relieve the trader from emotions. It should remove psychological stress in trading and should be ruled based that do not depend on emotions.

8. It should be customizable. Different traders can use the same method with different account sizes and different risk/reward appetites.

A previously effective trade system could lead to negative results from change of market conditions. No one trading system can fulfill all these requirements. Trade systems based on these requirements could be complex and adjustable. The only way of satisfying these conditions is through developing a diversified trading system. It can consist of a set of systems. These systems can be used as the basis for specific trade tactics at any given moment.

Kelly Ratio
There are many factors to consider while testing and evaluating a mechanical trading system. The important question is how to develop a trading system, evaluate it and then apply it with real money. We need to not only know that the trading system is profitable for each trading system that we test. But we should also know whether it is profitable with limited equity swings. We should know does the trading system have excessive drawdown periods? Three of the most important elements of mechanical trading systems are:

1) Rules for exiting at profit targets.
2) Rules for exiting at loss targets or how much loss is permissible and
3) Clear cut rules for entry and exit for each trade.

Do losses exceed gains more than what is tolerable in the long run? Does the trading system experience periods of time that result in significant losses that give back those gains when a string of multiple winners and substantial profits accrue? John Kelly while working at AT&T Bell Labs had developed the formula in 1956 now known by his name. A money management tool used by system traders is the Kelly Formula or Ratio. Most traders do not know when to correctly add on a trading position.

Gamblers realized its potential as an optimal betting system in horse racing. It soon became popular with the gamblers. This formula enabled gamblers to maximize the size of their bets on consecutive races. Gamblers would use the Kelly Formula to determine how much to parlay winnings into the next bet. Kelly Formula is used by many traders to determine how much money to place on the next trade taking into account the historical performance of the trading system.

Kelly Ratio is given by the formula: K=W-[(1-W)/R] where K is the Kelly Ratio in percentage. W is the winning probability and it is the probability that any given trade that you make will return a positive amount. R is the Win/Loss Ratio and it is the total positive trade amounts divided by the total negative trade amount. Suppose K is 25% then you can risk 25% of your account on each trade. Kelly Ratio tells you what you should ideally be willing to risk on each trade to maximize your total returns in terms of the percent of your total account.

To be on the safe side you should half the ratio. Suppose K is 25%. You should half it to 12.5%. What it means is that you should not risk more than 12.5% of your account on a single trade. Many traders argue that the Kelly Formula gives too high a figure so half it to be on the safe side. You can use it in deciding which trading system is better in the long run. Kelly Formula can help you in comparing two trading systems. You should look for a trading system that has the highest Kelly Ratio.