Friday, March 1, 2013

Autopsy of a rejected trading system

Today I decided to reject the trading system that I've been working on for the last few weeks.
These days I don't feel bad if a potential trading system hits a deadend. Even though it appears that you have nothing to show for your efforts, your understanding of the market only increases.
What made me hopeful for this particular system was the final profit factor that I had calculated, which was 1.16. The backtest and optimisation ultimately involved a little over 400 trades. Both the profit factor and sample size were low, but I was prepared to accept them. I intended to trade this system within a portfolio and let diversification minimise any weakness.
Anyway, the results looked good enough on paper. A profit factor of 1.16 suggested that this system was tradable, at least at first glance.
I then decided to graph the system's equity curve from 2001 to 2012. The result (at 2% risk per trade):


To me, that is one ugly equity "curve". Not only is there massive drawdown in the first five years, but the upside moves are sporadic and extreme. This suggests that the system is very sensitive to market conditions, and not really robust. The system flatlines in the last three to four years.
So while the system looks marginally tradable on paper with a positive profit factor, its equity curve demonstrates a lack of robustness and consistency, leading me to reject the system.

The lessons I learned...


The system is based on the pinbar candlestick pattern. Traditionally, the pinbar is traded on the break of the short wick. However, I wanted to test the break of the long wick to see what would happen.

While a positive profit factor suggests that you will make money, the results suggest strong sensitivity to market conditions. Quite often you'll find pinbar formations at support and resistance levels. If you trade the break of the long wick, you're trading INTO support and resistance. The overall result suggest that trading pinbars this way isn't recommended, at least with my skills.
Multiple signals on the same day
Interestingly, I also decided to examine how the system fared if I only traded pinbars that appeared on multiple pairs on the same day. If I only traded multiple same-day signals, my profit factor ended up being 1.3! A significant improvement. Trading solitary signals gave me a profit factor of 1.1.
This would make sense. If you're seeing the same entry signal on multiple pairs, each signal reinforces the other and you have a type of confluence. A solitary signal on a single pair, however, is less meaningful.
However, while there is a significant improvement in profit factor, the equity curve still looked ugly. Additionally the sample size became far too low to warrant trading (around 100).
I just wanted to share my thoughts on my findings. Failure isn't failure if you can salvage something from your efforts.

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