Trading Systems: Buy Or Build?

The debate over whether to buy or build a trading system has been ongoing among investors for years. While some experts argue that commercial systems are too volatile and unpredictable, others see them as a viable option for making money in the market.

One of the most commonly cited examples of a successful trading system is John Hill's "Futures Truth" program. As president of Futures Truth Inc., Hill has been independently testing and developing trading systems for decades, and his company has become synonymous with quality commercial trading software.

However, not all third-party trading systems are created equal. Some may generate profit solely through luck, while others may be based on flawed assumptions or lack any discernible logic. This raises the question: do investors really need to buy a trading system if they have already mastered the art of systematic trading?

The Hidden Cost of Volatility Drag

One of the primary reasons why most traders miss out on potential gains from commercial systems is due to the inherent volatility in the market. As seen in recent events, markets are prone to sudden and unpredictable fluctuations, making it challenging for even the best-developed systems to maintain their performance.

This volatility can be attributed to a range of factors, including market conditions, economic indicators, and individual investor psychology. To mitigate these risks, some traders resort to employing more conservative strategies or adopting strategies that involve risk management techniques.

Why Most Investors Miss This Pattern

While it's true that some traders have had success with commercial systems, many others fail to take advantage of this opportunity due to various reasons. One common pitfall is the tendency for new users to give up quickly when faced with a system that generates losing trades out of the box.

Gutmann notes that "often, the new user gives up quickly, disgusted that they spent hard-earned money on something so opaque as an automated system whose inner workings they took for granted." Similarly, King observes that "there is no benefit that I can see" in purchasing a third-party system, stating that "if you have the skills to evaluate a ready-made system, then you have the skills to develop your own."

A 10-Year Backtest Reveals...

One of the most compelling reasons why traders should consider buying a trading system is through a backtesting exercise. This involves analyzing historical data to determine the performance of different strategies and systems over a period of time.

A 10-year backtest reveals that commercial systems can indeed be highly effective, with some even outperforming their benchmarks. However, this success comes at a cost: investors must carefully evaluate each system's underlying logic and risk profile before making an investment decision.

What the Data Actually Shows

Numerous studies have shown that commercial trading systems can be highly effective in generating returns over the long term. For instance, research by Stanley Haar has demonstrated that certain types of trades, such as those involving grains or commodities, can be profitable even in volatile market conditions.

Another example is the performance of managed funds, which often employ sophisticated trading strategies to generate consistent returns for investors. According to recent data from Futures Magazine, managed funds have consistently outperformed individual traders over the past decade.

Three Scenarios to Consider

When evaluating a trading system, investors should consider the following three scenarios:

1. Conservative Scenario: In this scenario, the investor aims to minimize risk while still generating returns. This can be achieved through strategies such as hedging or diversification. 2. Moderate Scenario: In this scenario, the investor seeks to balance risk and return by employing a combination of conservative and aggressive strategies. 3. Aggressive Scenario: In this scenario, the investor aims to maximize gains while minimizing losses. This can be achieved through more aggressive trading strategies.

The Beauty of Trading Systematically

Trading systematically requires following all rules religiously. Successful system traders avoid the temptation of bypassing the rules, whether that comes in the form of holding a loser too long or being too quick to take profits. The beauty of trading systematically is that it allows investors to focus on making informed decisions rather than reacting impulsively to market fluctuations.

To achieve this, investors should carefully evaluate each strategy's underlying logic and risk profile before implementing it. Additionally, they should consider the potential consequences of their actions, such as holding a losing trade for an extended period or giving up quickly when faced with a system that generates losing trades out of the box.

What Does This Mean for Portfolios?

The implications of trading systems on portfolios are significant. For investors who have mastered the art of systematic trading, commercial systems can be a valuable tool for generating consistent returns over the long term. However, this requires careful evaluation and implementation to ensure that the system is aligned with their individual investment goals.

What Does This Mean for Investors?

For investors who do not have extensive experience in trading or system development, buying a commercial system may not be the most effective approach. Instead, they should focus on developing their own trading strategies using publicly available data and market research.

Ultimately, the key to success in trading is finding a strategy that aligns with your individual investment goals and risk tolerance. Whether you choose to buy or build a trading system, it's essential to carefully evaluate each option before making an investment decision.

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