Sunday, March 21, 2010

Explaining a Mechanical System

Nirav asks:
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Earlier in this blog I asked you about mechanical systems, and you said that mechanical systems work in this markets. But right now i am reading a named The Intelligent Investor- Benjamin Graham. And in that it is written that All mechanical formulas for earning higher stock performance are “a kind of self-destructive process—akin to the law of diminishing returns.” So, how will you justify this. Please reply.
UnQuote

My Notes:

A mechanical system is a set of rules that can be backtested. For example: A four week breakout rule is: Buy when th Nifty closes at the highest of the last four weeks close. Exit the long position when the Nifty closes below the last four weeks lowest close. This rule is then tested over the past 8 years. It makes money. Then, it is taken as a mechanical system, because the results could be proved over past data.

This is not so bad, is it?

What is the alternative?

Hunch? Mr X says "I feel abc is going to go up. You should buy it". Now, there is no way of knowing if such calls will make money consistently. One call may be a multibagger - the reason could be luck. But unless the methodology is not systematic and tested, there is no way of saying that trading calls coming from Mr X will finally make money.

Chart Patterns? Much better than Hunch. These patterns could and are converted into mechanical systems. Rules are well defined, and, a lot of patterns can be tested with such rules. When you trade patterns based on systematic rules you are really a mechanical trader. That sounds fine, doesnt it?

What can go wrong in mechnical systems? When rules are created, based on wrong principles. But this applies to all methods of analysis - fundamental, technical, .... . So, the problem may lie in execution, but not in the basic principles.

Now I will ask a question.

If you do not know that your trading ideas have performed profitably in the past, can you trust the ideas with your money?  It is possible that you can rely on third party research if you trust them, but there must be some basis. Reader feedback is requested.

8 comments:

men said...

Mr. Sudarshan, the 4 week breakout/breakdown is it an example given or real? Hope you could share some similar live experiences. Thanking you in advance.

Jazz said...

how can one rely on past performance, when each day of market is different in absolute terms.If that was the case , then there would have been many bot traders

Niftic said...

Hi Sir,
I have some query on the 4 weeks breakout theory which you have mentioned.
1. After we get a close above 4 weeks highest price when and at what price should we buy?Is it true for every day or after we get a breakout from a trading range?
2. The calculation is based on 28 trading days or 4 calendar weeks?
Thanks in advance...

sam advisors said...

yes sir ji,
i m very much convinced with you, i m taking services only in nifty i, have returen in the blog earlier,abut pivot levels sdwd!

now could we track by wich study this individual is performing the task sdwd!!

men said...

Mr. Sudarshan, how does one determine the trend in general. The market recovered from the day low at the time of writing, while my expectation was a test of 5180. Could you please help.

anshul said...

lot of traders trades only few patterns..why?? because they have mastered them self in few chart patterns ...trading mechanical system is always better than trading on hope... @jazz --yes market r different each day but it is different for me and you not for history..history repeats itself..thats why chart patterns works..chart pattern r foot prints of history...

Nirav said...

Sir,

I got your point. But as I am in a learning phase, one more question is raised in my mind and that is if I have a system and that I have back tested for say 10 years. And in past it has given a nice profit. But suppose now I am starting to trade with this system and if it starts to give me decreasing profit and in future year it will give negative return then how long should I continue with that system? Or what to do next if this happens?

Nitin Gupta said...

Good evening sir, my name is nitin s gupta.....as u told i have taken up a job as u said trading will not give stability and i have a loan to repay...... i have some questions regarding automating trading systems to make money......and wanted to know whether a moving averages system would be an elementary system and how it make it more advanced....