Getting the 'edge'

It's no secret most day-trading profits are made by floor traders. They not only have the advantages of low commissions and ease of execution, but they have the "edge" or the ability to buy at the bid price and sell at the ask price. Although day-trading off the floor is a completely different game, traders also must have some sort of advantage that will give them a trading edge.

Certainly live, tick-by-tick quoting equipment is necessary, along with charting and technical analysis software. Most novice day-traders watch prices, analyze various intraday charts and indicators, thinking they can assimilate this flow of information and make profitable trades. They often hope for some sort of "sixth sense" to give them an advantage. Unfortunately, the market usually demonstrates it has more of a sixth sense and soon separates the trader from his money.

Something concrete is needed to give a trader the confidence and commitment to "pull the trigger." There are so many examples in books and magazine articles isolating some guru's favorite chart formation or technical indicator that shows where to buy or sell. New traders follow this advice based on "trust" that the author or guru knows from experience what he is talking about. But doesn't it make sense to ask, "How many times in the past when this indicator signaled a buy, did the price actually go up?" Or, "If we use a close $200 stop as suggested, how many times did we get stopped out for a loss, only to have the market turn around and produce what would have been a profitable trade?" Or, "If we buy a breakout of the previous day's high, how many ticks in profits can we expect, given various market conditions?"

Knowing the answers to such questions will give you an "edge" to win at day-trading. With all the computing power and historical data available today at relatively inexpensive prices, you have no excuse to day-trade without hard statistical facts.

Results of historical testing on technical indicators, chart formations or price patterns can be combined with a "signal generator" to form a trading system. Actual buy and sell signals are generated throughout the day based on trading models developed with historical testing. If you have a limited degree of computer knowledge, use TradeStation or SuperCharts RT by Omega Research or MetaStock RT by Equis International to test a myriad of day-trading strategies and create trading systems. Expert computer users can develop more advanced strategies using Microsoft Visual Basic or C++.

To develop a day-trading system, you must obtain historical data and one of the "toolbox" software programs that can test trading ideas.

There are five main rules to follow when developing a day-trading system:

1.Use long test periods Novice traders often test a strategy back over several contracts, or even several years, and think they have a tradable method. Unfortunately, day-trading based on this limited testing will end in disaster. Any trading method must be tested for a minimum of five years and preferably 10 years or longer. Then, the reality of more down-to-earth performance statistics appear.

2.Robust variables When testing, or incrementing variables for a system, it is important that wide ranges of values generate favorable results. If just a few variable increments produce acceptable results, the trading rule is fragile. Future results will be poor.

3.Limited number of rules Any trading method could be 100% accurate and display impressive profits if an unlimited number of rules were used, however the method will almost certainly fail in real-time trading with new data. Keep the number of rules or conditions a system uses to less than five or six for a 10-year period or slightly higher if the number of trades or occurrences is high.

4.Real-time or out-of-sample testing After historical tests have been completed over reasonably long time periods, and variable values have been selected, the trading method should then be tested over new or "real-time" data. This "out-of-sample" test is usually over current data, using a shorter period of one to two years. The results will give a good idea of system performance, just as if the trader were using it in the market during this time period. Out-of-sample tests on periods prior to the historical testing period also are acceptable but not as useful as tests over more recent data.

5.Walk-forward testing Most testing programs do not have this advanced feature, which is really an automated way of generating a whole series of out-of-sample tests. This approach increments or optimizes system variables over a moderate time period, such as two years. The variable values that produce the best results over this "learning" period are then used on the next quarter (three months), which is new or "real-time" data. The results should be profitable. Then, the first quarter of the learning period is eliminated, and the next quarter in the database is added to the multi-year learning period. Variables again are incremented and the best ones are selected for use in the next out-of-sample quarter. Testing continues like this all the way through the database. The net performance of all out-of-sample tests is summarized. Overall, the results should be profitable to consider the system valid for trading with real funds. If the system doesn't hold up to this testing method, it won't make money in the future...period!

Purchasing a system After new traders discover developing their own system is not that easy, they may consider purchasing a trading method from a system developer. But how do you decide which system to purchase?

First, all the rules given previously for developing your own system should have been used by the vendor. Ask him how the method was developed. Were long test periods used? Does the system have robust variables? Are only a limited number of rules or conditions used? Was walk-forward-testing employed, etc.?

Then, once you receive the program, you must be able to verify the vendor's marketing material with the software itself. Don't just buy a "signal-generator." The system you purchase should duplicate the results advertised. You should be able to run historical tests over data and see for yourself the simulated performance of the system.

Don't just rely on the vendor's brochure or performance numbers. Go back and run long historical tests over the data. Increment the variables and check for robustness. Change the system variables, and do some out-of-sample tests. Then, if the method holds up to the five rules for developing a system, it can be relied upon for real trading.

Capital Next you need to determine the right amount of capital to use. This is where the results of historical testing are helpful.

The account size should be large enough to cover the largest maximum drawdown (largest historical account equity decrease) of the system, plus margin amounts. Again, this is where the importance of using long test periods shows up. If the maximum drawdown for the last two years was only $1,800, and you don't realize a big drawdown of $5,000 occurred six years ago, you are not aware of the potential risks of trading the method and will not allocate enough trading capital.

Plan for drawdowns. Assume the maximum drawdown will start on the day you start trading the program. Also, be aware that future drawdowns can exceed previous historical maximum drawdowns.

Knowing the maximum drawdown also can be used to improve day-trading performance -- one technique is to wait for a good-sized drawdown to occur on paper before starting to trade the system.

Another technique is to keep an eye on systems and variable sets that are not performing well and are in a drawdown. Start trading them with a small profit objective. If the trades are profitable immediately, take the profits and stand aside, and wait for another drawdown. If the trades go against you, continue trading the system until the profit objectives are reached. However, you need to have the additional capital available to stay with the system until it begins to recover from the drawdown.

You also must have a high level of confidence in a system to start trading when it is in a drawdown. Systems tend to run in cycles. Most traders will hop on and start trading a system after it has had a very profitable period, only to catch the next down cycle. Then, when it is in a losing period, they start tinkering with it, trying to second guess the system, instead of just sticking with it. Often they end up missing the next big profitable cycle. Following the five rules for historical testing will give you the confidence to start trading a system when it is in a drawdown.

Many traders also try to add additional filters or rules during drawdowns. However, this breaks one of the primary rules of developing a system. Adding additional conditions or rules just makes the method less reliable in the future. Accept the drawdown as part of a necessary risk of trading with a stock broker. Let the system run its course and stick with it. Execute your plan...that's your "edge!"

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