WHAT IS A COMPLETE, MECHANICAL TRADING SYSTEM?

One of the problems witb Katz’s early trading was that his “system” only provided

entry signals, leaving the determination of exits to subjective judgment; it was not,

therefore, a complete, mechanical trading system. A complete, mechanical trading

system, one that can be tested and deployed in a totally objective fashion, without

requiring human judgment, must provide both entries and exits. To be truly complete,

a mechanical system must explicitly provide the following information:

1. When and how, and possibly at what price, to enter the market

2. When and how, and possibly at what price, to exit the market with a loss

3. When and how, and possibly at what price, to exit the market with a profit

The entry signals of a mechanical trading system can be as simple as explicit

orders to buy or sell at the next day’s open. The orders might be slightly more

elaborate, e.g., to enter tomorrow (or on the next bar) using either a limit or stop.

Then again, very complex contingent orders, which are executed during certain

periods only if specified conditions are met, may be required-for example, orders

to buy or sell the market on a stop if the market gaps up or down more than so

many points at the open.

A trading system’s exits may also be implemented using any of a range of

orders, from the simple to the complex. Exiting a bad trade at a loss is frequently

achieved using a money management stop, which tertninates the trade that has

gone wrong before the loss becomes seriously damaging. A money management

stop, which is simply a stop order employed to prevent runaway losses, performs

one of the functions that must be achieved in some manner by a system’s exit strategy;

the function is that of risk control. Exiting on a profit may be accomplished

in any of several different ways, including by the use of pm@ targets, which are

simply limit orders placed in such a way that they end the trade once the market

moves a certain amount in the trader’s favor; trailing stops, which are stop orders

used to exit with a profit when the market begins to reverse direction; and a wide

variety of other orders or combinations of orders.

In Katz’s early trading attempts, the only signals available were of probable

direction or turning points. These signals were responded to by placing buy-atmarket

or sell-at-market orders, orders that are often associated with poor fills and

lots of slippage. Although the signals were often accurate, not every turning point

was caught. Therefore, Katz could not simply reverse his position at each signal.

Separate exits were necessary. The software Katz was using only served as a partially

mechanical entry model; i.e., it did not provide exit signals. As such, it was

not a complete mechanical trading system that provided both entries and exits.

Since there were no mechanically generated exit signals, all exits had to be determined

subjectively, which was one of the factors responsible for his trading problems

at that time. Another factor that contributed to his lack of success was the

inability to properly assess, in a rigorous and objective manner, the behavior of the

trading regime over a sufficiently long period of historical data. He had been flying

blind! Without having a complete system, that is, exits as well as entries, not

to mention good system-testing software, how could such things as net profitability,

maximum drawdown, or the Sharpe Ratio be estimated, the historical equity

curve be studied, and other important characteristics of the system (such as the

likelihood of its being profitable in the future) be investigated? To do these things,

it became clear-a system was needed that completed the full circle, providing

complete “round-turns,” each consisting of an entry followed by an exit.

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