Six Cardinal Rules in trading system design
Once you identify your strongly held trading beliefs, you can switch to the task of building a trading system around those beliefs. The six rules listed below are important considerations in trading system design. You should consider this list a starting point for your own trading system design. You may add other rules based on your experiences and preferences.
- The trading system must have a positive expectation, so that it is “likely to be profitable.”
- The trading system must use a small number of rules, perhaps ten rules or less.
- The trading system must have robust parameter values, usable ^ over many different time periods and markets.
- The trading system must permit trading multiple contracts, if possible.
- The trading system must use risk control, money management, and portfolio design.
- The trading system must be fully mechanical.
There is a seventh, unwritten rule: you must believe in the trading principles governing the trading system. Even as the system reflects your trading beliefs, it must satisfy other rules to be workable. For example, if you want to day-trade, then your short-term, day-trading system must also follow the six rules.
You can easily modify this list. For example, rule 3 suggests that the system must be valid on many markets. You may modify this rule to say the system must work on related markets. For example, you may have a system that trades the currency markets. This system should “work” on all currency markets, such as the Japanese yen, deutsche mark, British pound, and Swiss franc. However, you will not mandate that the system must also work on the grain markets, such as wheat and soybeans. In general, such market-specific systems are more vulnerable to design failures. Hence, you should be careful when you relax the scope of any of the six cardinal rules.
Another way to modify the rules is to look at rule 6, which says that the system must be fully mechanical. For example, you may wish to put in a volatility-based rule that allows you to override the signals. Be as specific as possible in defining the conditions that will permit you to deviate from the system. You can likely test these exceptional situations on past market data, and then directly include the exception rules in your mechanical system design.
In summary, these rules should help you develop sound trading systems. You can add more rules, or modify the existing ones, to build a consistent framework for system design. The following sections discuss these rules in greater detail.