What Frequency of Trades is Best for a System?

overwhelmed with trades

When evaluating trading systems, how do you decide what frequency of trades is best? It seems like an easy question but there are several factors to consider and many of these decisions can be the difference between a successful trading system and one that’s not worth your time. Here’s my framework for determining the right number of trades for a model.

As Often As Possible? Maybe!

On one hand if your trading system has a significant edge then theoretically you should trade it as often as possible – no filtering at all, right? In practice though there is typically some filtering that needs to take place.

Consider the chart above. You have your trading idea, say, new highs on high relative volume. Most trading systems should start out with a basic trading edge – a strong theory that is supported by looking at a large number of trades in a backtest.

When done properly, the more filtering you do to your trading system the higher the profit per trade but the lower the total profit from the system. This is because proper filtering will filter out the worst trades at each point along the x-axis. (I estimate that 90% of my edge comes from my ability to choose filters that make sense – I’ll write about this soon.)

Imagine you can determine with decent accuracy which trades will be profitable and which will not. If you were really concerned about the win rate (unhealthily so!) then you could reduce the system to just a single trade that was highly likely to be profitable. But at what cost? Total profit of course. So you can see there’s a tension between total profit and profit per trade when you are able to meaningfully filter your trading system.

What’s the Right Balance Between Total Profit and Profit Per Trade?

This is the ultimate question and where most of your work occurs. There is an art to coming up with the right balance and a lot of what you choose will come from experience. Depending on your situation the more conservative approach would be to apply more filtering at first – that is, choose a point nearer to the right side of the chart. The more aggressive approach would be to choose a point nearer to the left side.

There are good arguments to be made for either direction. If you have more trading experience then the more aggressive approach can be quite valuable. The more quickly you gather live feedback from the market the more quickly you’ll be able to iterate and understand more about how your trading system acts in the actual market and how that differs from your theoretical backtest. Of course there are costs associated with this and as I’ve written before there’s always the real temptation to scale a trading system up too quickly (something I’ve done many times) since you’re typically overly optimistic at this point in the system development cycle.

If you choose a point towards the right of the chart you’ll have less risk but that comes with the cost of having to wait potentially a long time before the feedback comes (i.e. trade signals appear). Of course there is no “right” answer – you’ll have to gauge for yourself what makes sense given the nature of the strategy and your personal preferences.

Other Important Factors to Consider

How will this affect the systems you’re already trading?

If you already have a trading system that you’re trading how will these new trades affect it? Will the trade times overlap? Will this new system be a distraction? Is the trade frequency of the new system dramatically different than your current one? If so trading the new system might be a serious distraction from the trading you’re already doing. If you’re mentally burrowed down trading in the zone in one system and then a signal from another comes along you might underestimate just how much of a distraction that can be.

How fast is too fast?

Like the video clip from I Love Lucy above implies, there’s a point where you’ll be overwhelmed by the number of trades. There’s a wide variety of capacities among traders – some can easily handle more trades and others find it difficult. This can be alleviated by automating your entries, your exits, or both – something I highly recommend. Also note that you should err on the side of fewer strategies if given the choice. For example, would you prefer to take 10 trades from a single strategy or one trade from 10 different strategies? It should be obvious that 10 trades from a single strategy is preferable.

How slow is too slow?

Another factor to consider is what’s your threshold for the lowest frequency? I think about this in terms of trades per day. I try to keep my trading systems above 0.5 trades per day if possible. Why? I find that anything less than that and it’s not frequent enough to keep my attention. I need to be focused on the strategies I trade – understanding fully why they should be successful. There’s something about the repetition of trades in a system that keeps this focus in the forefront of your mind. As the frequency of trades drops it’s harder and harder to recall that focus quickly.

What about buying power?

A non-obvious factor when you add a trading system is the buying power that is required. The more trades in the system the more buying power needed. Combine this with systems you’re already trading and this could become a problem quicker than you realize.

It’s quite frustrating to run out of buying power just before some winning trade signals materialize! One thing I do is keep a log of buying power over time. This updates in real time as I’m trading. I can go back and see when I had the least amount of buying power available over a period of time and I can plan accordingly.

Which day had the most trades?

Trades per day is a good benchmark, but that number hides a very important piece of information – what was the day with the highest number of trades? This can vary dramatically between systems even with the same trades per day. It’s really important to plan ahead and visualize what those days would have felt like. Would you have been able to keep up with all the trades? Would you have run out of buying power?

It’s up to you!

It’s clear that once you take all these factors into consideration the choice for trade frequency for a trading strategy is a very personal one and there will not be a one size fits all answer for every trader.

Do you approach things differently? Let me know in the comments.

Exiting Trades Too Early or Late? Here’s Why…

I came across this question on the DayTrading subreddit the other day.

How do you stop exiting positions too early for fear of incurring a loss? from Daytrading

In this case the trader thinks he’s exiting early because he’s worried about a big loss. Big losses, of course, are uncomfortable. You have to be able to tolerate them to catch the profitable trades. The problem is not the occasional big loss – the most difficult part of trading is that you can’t predict when there will be a large concentration of losing trades (a drawdown).

If you find yourself deviating from your plan and exiting your positions too early or too late it could be one of two things that’s occurring:

  1. You are trading too big
  2. You don’t have confidence in your trading plan (or you don’t have one to begin with)

If the trader is mostly comfortable taking losses and is still worried about big losses then he should reduce his trading size to something where he can think more clearly about each trade.

Just as common a situation though is that the trader hasn’t put in the work and research required to understand their exit strategy. If you find yourself second guessing your plan and overriding your pre-planned exit then the best course of action is to test different exit scenarios and see which exit strategy works best over a large number of your trades.

If you don’t know which exit strategies work best for your strategy then you should drop what you’re doing and do the research required to come up with that answer.

Here’s an example from one of my trading strategies. This strategy enters early in the day and holds the trades until the end of the trading day if a stop loss or target isn’t hit. The result is a lot of waiting for positions to play out. Any one trade looks erratic and obvious in hindsight but I know that if I exit earlier than the end of the day I will be leaving money on the table across a large number of trades. There is no guesswork on my part – the numbers don’t lie.

A Trading System that Buys the SPY at 9:31am — What’s Important?

A Trading System that Buys the SPY at 9:31am — What’s Important?

(Interested in trading systems? Check out Trade-Ideas Brokerage+ the smart way to trade the markets.)

Let’s say you’re designing a trading system to trade the SPY every day by buying (or selling short) the open of the second 1 minute bar and holding until the market close. The one thing you can vary is your position size — so you can choose to use large size some days, trade zero shares some days (i.e. don’t take a position at all), or trade a negative number of shares (i.e. sell short).

These are the parameters of the system — you can’t change anything else about the mechanics of the system. Let’s say you have to follow my good friend Sean McLaughlin’s advice and ignore the news:

What information would you look at to inform your decision about what position size to use on a given day? There are a lot of technical indicators and data points you could look at — literally thousands! You can’t look at all of them, so how do you decide which ones are important? One was I will evaluate data points is to look at the correlation. Which indicators are most correlated with the profit of the system. The higher the correlation, the stronger the relationship with profit.

For this system, I picked 4 indicators and posed a question on Twitter asking which one people believed was the most correlated with profit.

Here are the indicators:

% gap from yest close: how big was the gap between yesterday’s daily close price and today’s open.


The Range of the 1st 1 minute bar of the day: the high price minus the low price of the first one minute bar.

Range of the bar

Close of first 1 minute bar in relation to the range: where does the bar close in relation to the range of the first bar? Think of it as a value between 0 and 100 where 0 means it closed at the low and 100 means it closed at the high of the range of the bar.

Close in relation to range

Close of bar in relation to the open of the bar: where did the bar close in relation to the open price? This is related to the overall range but different. The bar could close at the same price as the open but both those prices could be equal to the high of the bar. Think of this as a value between -100 and 100 with 0 being a “doji”, a value of 100 being a solid green bar with no wicks, and a value of -100 being a solid red bar with no wicks. Here’s a good example of bars that close similarly in the range of each bar but quite differently in relation to the open price.

So which do you think is most important for this trading system? Here were the answers given:

Most thought the gap would be the most important. Surprisingly though that is the least important of the 4 variables. It turns out the range of that first bar is the most important factor of the 4.

This makes sense in light of a general rule of thumb when determining the value of a data point: all things equal the recency of the data is more likely to be important. In this case the gap is the least “recent” of the data points — it includes the open of the day and yesterday’s close both of which are in the past compared to the other indicators.

How Do You Fix “Trading on Tilt”?

Mike Bellafiore asked this question on Twitter yesterday. It’s a great question that almost every trader deals with at some point.

There are a lot of thoughtful replies in that thread with some good advice: step away from your trading desk, trade with half your normal position size, stop and go exercise, etc. Of course these are all things you should do if you find yourself in this situation. All of these “solutions,” though, are temporary band-aids for a more permanent problem. If you don’t address the deeper problem you’re likely to continue to find yourself in these difficult trading situations.

The Deeper Problem and How to Fix It

What is the root cause of trading on tilt? It’s really a symptom of a much deeper problem that you should try to solve: you don’t understand your trading system well enough.

If you’re trading on tilt then it likely means that the market has put you in a situation that you didn’t realize could happen ahead of time. “I had no idea this many trades could go against me in one day!” or “Who knew that I could lose so much money in a single trade!” Having these thoughts in the middle of a trading day is a major flaw in your system that must be addressed immediately. How?

The fundamental problem is that you haven’t done enough work outside of the trading day to fully understand your trading system and why it works. What are the best and worst days that your system is going to have? Under what types of markets does your system work well? When does it perform most poorly? You can’t predict the future but you can look in the past and get a really good idea about the range of performance you can reasonably expect from your system. If something surprises you during the trading day, it’s likely that you’ve skipped this arduous but critically important step in preparation.

Peer into the Past

Historical market data is really easy to get access to now. Go back and backtest your system for as long as you can go back. Look at the equity curves — are they smooth or do they have spikes? (And be careful, if you look over a large enough timeframe all curves look smooth!)

Here’s an important step that most traders skip — look at the performance by day of your trading system. What were the best days? The worst days? What days did it trade the most? How many days are there with no trades? Look at the trades it took on those days and truly visualize what trading that day would have felt like with size. Could you have kept up on the days where it traded a ton? What would you have done on the days with the biggest intraday drawdowns?

This is the hard work required to be prepared for any given trading day.

Easy for you to Say, Dave — You’re an Automated Trader — I’m a Discretionary Trader!

What about traders that trade with their instincts? “You can’t backtest my super-duper trading discretion. I trade with my extraordinary feel for the markets.”

I know plenty of traders like this and while it seems like these are fundamentally different styles, they’re really very similar: You get a signal where you’re confident you have a trading edge and you take the trade. Sounds pretty simple and in a lot of ways it is.

How you attain that confidence in your edge varies from trader to trader. Confidence for a discretionary trader comes from experience and trading results over time. This is more valuable than any backtest but it takes time to develop that experience.

If you get into situations where you end up trading on tilt, then you’re probably trading with too much size and you should reduce your size until you gain more experience with your system.

Of course there are no easy answers but if it were easy everyone would do it!

(Like this post? Follow me on Twitter)

Why Trade-Ideas Paper Trading Is Such a Big Deal

(Try out Paper Trading for cheap during the Trade-Ideas Test Drive.)

Here at Trade-Ideas we’re in the process of releasing our paper trading platform. OK, so you can trade fake money — what’s the big deal? As someone who has traded the markets for 15+ years I can say with certainty that when used properly Trade-Ideas Paper Trading can take your trading to the next level. Here’s how to do it.

A Successful Trader’s Worst Habit

I can honestly say that I’m a successful trader having been profitable all but 2 years of the last 15. I’m always doing things to improve my trading which mostly involves brainstorming different strategies to efficiently make money. At any given time I have several strategies in various stages of development.

The biggest mistake I end up making is scaling up size too quickly. I spend too little time paper trading a newer strategy. Backtesting is awesome, but you need to spend time watching trades play out in real time to fully understand the WHY — why your strategy looks great in a backtest, why the strategy makes money, and what is the best way to trade it.

Why is this Stage Hard?

I realized over time that I was spending too little time Paper Trading these ideas. Part of the reason was that I was in a hurry to trade the strategy because I thought it had a limited shelf life — I thought the strategy’s edge would evaporate, so I needed to trade it now while it had edge. I now build strategies from the ground up to have staying power — edges that last for the long term.

The Technical Reason I Didn’t Paper Trade Enough

I slowly realized that the main reason I wasn’t paper trading enough was actually pretty simple technical reason. It’s impossible to have a Paper Trading platform open at the same time as your regular live trading platform — maybe not literally “impossible” but at the least VERY, VERY, VERY awkward. It’s so awkward that I found myself skipping that stage since it required logging into a separate account at Interactive Brokers and having TWO instances of TWS running at the same time. Do you want real time data in both your trading platform and your paper trading environment? That’s hard or impossible in most trading platforms!

Paper Trading should be SIMPLE and easily available alongside your real trading platform. You shouldn’t have to pick and choose whether you’ll be live trading or paper trading on a given day.

Enter Trade-Ideas Paper Trading

We’ve built the Trade-Ideas Paper Trading platform from the ground up to operate seamlessly alongside your actual trades. No awkward convoluted hoops to jump through, no sacrificing real time data, and no picking or choosing which platform to run. It shows up as just another account in Brokerage Plus.

Seamlessly connect to Paper Trading and your live platform simultaneously

Paper Trading Should Work in your Normal Trading Routine

Paper Trading should be available right at your fingertips. When you’re in the middle of a trading day, you need to be able to make split second decisions and fumbling around with another instance of your trading platform just to send a paper trade is unacceptable.

That’s why we put Paper Trading right alongside your real trading — seamlessly available right in your normal trading workflow. Add a strategy in Brokerage Plus like you normally do with all your trading instructions and position sizing predefined and Paper Trading conveniently shows up as another account to point to.

Then when you want to make a paper trade, just right click in almost any window in Trade-Ideas Pro and access the trade menu and choose your strategy. Easy!

Paper trade or live trade right from your chart

Track Paper Trading Performance

When you make paper trades in Brokerage Plus, you’ll see your positions right along side your live trades in the Positions tab. You can monitor performance across all your trades live and paper or you use the Account filter to show just your live trades or just your paper trades.

Paper Trades along side Live Trades or use Account filter

Paper Trading has to be an important part of what you do. As a trader you MUST be continuously learning and adapting and paper trading has to be an important part of your improvement journey.

(Now is the perfect time to give Trade-Ideas Paper Trading a spin in our Test Drive.)

American Presidents, the Stock Market, and Political Bias

(Alternate Title: A Toolkit for Making Political Opponents Look Bad Using Stock Market Data)

This tweet came across my Twitter feed a couple days ago.

The first thing I thought was this was an interesting fact and somewhat counter intuitive — we know how much Trump likes to crow about the stock market when it’s doing well. Quickly my skepticism kicked in and I thought: why did he choose inauguration day and not election day? And also why August 12th and not some other random day? This screamed to me “well chosen example” like a lot of stock market snake oil.

Being a market and data nerd I guessed there was a very good chance you could choose a date like August 12th to make any of these 5 presidents look good compared to the others. I took a look at the data.

It turns out you can use a wide variety of dates to make any one of them look awesome compared to the others (except for one).

Election Day versus Inauguration Day

There’s a lot of time after the election prior to the inauguration of a U.S. President, on average it’s 75.2 days. A lot can happen in that time! Depending on which President you want to look good then you should carefully choose either Election Day or Inauguration Day as this makes a huge difference in the “performance.” A big part of this is that during the time between Obama’s election and inauguration the Dow dropped 17% and during the same time for Trump it rose 8.5%.

I looked at every day for the Dow Jones Industrial Average during these five presidencies. There have been 1009 days since Trump’s election, so I looked at every value 1 though 1009 to see which president’s “score” looked best by comparing the gap between each president and the second best at that point during each presidency. I used either election day or inauguration day as a reference point depending on which one produced the biggest gap between the leader and second place in percentage terms.

The Results

There’s a lot of different ways to look at these results and you’ll want to choose carefully depending on your political bias.

The most days with the largest return among these U.S. Presidents:

Trump: 425 days
Obama: 371 days
George H. W. Bush: 171 days
Bill Clinton: 41 days
George W. Bush: 0 days

That settles it, right?!?! Not really. The average gap between the leader and second place on any given day varies a lot. Looking that that:

Obama: 15.6% difference
Trump: 8.1% difference
George H. W. Bush: 3.4% difference
Bill Clinton: 3.3% difference
George W. Bush: N/A

So as you can see, it’s easy to paint a picture that makes your favorite political party/candidate look good. Eyeballing the chart I think you could even make George W. Bush’s term look good by picking his second term or a particular year as a starting point.

Why August 12th?

So why did the John Harwood choose August 12 for the tweet above? It turns out Clinton had just taken a narrow lead over Trump and then Barack Obama had just taken an even more narrow lead over Clinton. See the area on the right hand side of this chart. Excellent timing indeed!

Logical Conclusion

OK, what’s the logical takeaway from the above chart? My conclusion confirms my prior assumption: you cannot create a trading system that uses the party of the current U.S. President as any sort of meaningful input. In other words, there’s not very much correlation between market performance and political party, as much as either party wishes it were so.

If you think there is (and I often hear many claiming there is!) then your conclusion should be obvious: buy the market when your candidate wins and short the market when the other party’s candidate wins. Should be easy money!

My advice: ignore the news — especially political news and commentary. As Bryan Caplan likes to say: “News is the lie that something important happens every day.”

Should you re-enter trades that have stopped out?

Here’s a difficult trading situation that often confounds new traders or even experienced ones that are experiencing a drawdown: a trade setup occurs, you take the trade according to plan and it quickly hits your stop — but then it immediately sets up again for the same type of trade.

Multiple chances to re-enter a stopped trade

Do you take that second setup? On one hand a setup is a setup and not taking the trade would be a mistake. Though on the other hand the market has already told you you were wrong once — being told you’re wrong twice or three times just seems stupid.

Here are a couple methods you can use to increase your confidence level in this common situation. A large fraction of your trading confidence will come from your research outside of market hours and this situation is no different.

Keep Track of These Situations To Evaluate the Big Picture

As opportunities for re-entering trades occur it’s important to keep track of them to understand what happens over a large number of occurrences. Any individual trade is unimportant — it’s the aggregate that matters.

If you’re having difficulty with this situation you probably are taking some of these re-entry trades and skipping others. That’s understandable but to really gain confidence in these you’ll need to keep track of every one of them. If you’re only trading some then your sample is incomplete and your mind will play tricks on you by easily recalling the big winners or losers but forgetting the bulk of the instances. This is common and why keeping track of all your trades is so important. Your psyche will lie to you but the numbers won’t.

I suggest trading these subsequent setups but with really small size. This allows you to risk a small amount of money so the trade is real rather than theoretical which gives you skin in the game so you’re more likely to pay attention over time. As you trade these re-entries, it’s important to track them separately from the “normal” setup. Tagging your trades in a trading journal is a perfect way to handle these. The re-entries are a subset of the main strategy that these trades come from. For example, use a tag like “Strategy X” for all trades from this strategy whether they’re re-entries or not. For the re-entry trades, use an additional tag “ReEntry”. This allows you to track trades across the entire strategy but also filter on only the re-entry trades to measure their performance separately.

After I accumulated several trades using this method, I realized that the re-entry trades were actually performing better than the system overall. It absolutely made sense to trade these second chance setups — perhaps even with larger size.

Backtest to Get the Longer Term Picture

It takes time to wait to accumulate a lot of real-time trades to keep track of. You should absolutely do that but in the meantime you can do a backtest to understand what happened in similar situations before you started keeping track.

One approach to capture this situation is to have your backtest skip the first N opportunities in your strategy and trade the N+1th one. Of course, there will be fewer trades in the trade set since a lot of times there’s only a single setup, but you should be able to gather a lot of past instances of these re-entry trades to examine closely in a chart. You can start with N=1 and then run another with N=2, etc.

Every strategy is different but these two steps should give you a deeper understanding of your trading strategy overall but also give you confidence to trade the re-entries (or not!) knowing you have data to back you up.

If you like this post, be sure and follow me on Twitter: @davemabe

The “Chase Race” Workout

Once or twice a season we’ll have our distance runners run a time trial on a well known trail in town. Joan hardly ever repeats the same workout, but there are a handful of important ones that we keep track of over time. We can go back and see over time how kids improve on specific workouts throughout their high school careers. This is really important to kids – they can see just how much they’re improving over time – a very motivating thing to do.

Of course for most races and workouts you start everyone at the same time and the finish times end up being naturally staggered. There are plenty of times where runners very quickly get segmented (through ability, current fitness level, pecking order, etc.) – sometimes lots of runners spend the entire workout running alone.

Having done the Medoc Trail Race which staggers start times based on age and gender, I thought a similar approach would be good for the XC team. Instead of using age and gender to stagger the start times, we used a recent mile time trial on the track to determine how to time advantage each runner received.

I ended up creating a spreadsheet to translate the mile time into the predicted time for our 2.4 mile time trial loop. I then figured out the how much of a head start each runner should receive compared to the fastest runner on the team. I printed out the spreadsheet with runner and time advantage. The slowest runner on the team ended up with a 7 minute head start on the fastest runner.

We had never tried anything like this and I was really hoping I did the math right and made good estimations about fitness levels. It would be pretty embarrassing for me to have the fastest runners finish minutes ahead or minutes behind the eventual winner!

What ended up happening was pretty cool. The slowest girls on the team were still leading the race with about a quarter mile to go! The slowest girl ended up in 7th place in the “race.” What really surprised me though was how much faster almost everyone ran! Our top boys beat the all time record for this loop by about 20 seconds – a huge improvement. Up and down the line people had significant course PRs!

It’s easy to see how there would be this kind of improvement. Imagine you’re the fastest guy on a team. In every normal workout you pretty much run alone – nobody passes you and you don’t pass anyone the entire time. Now imagine the “chase race” – the pressure is on the entire time to pass almost 80 people! It’s similar for the slowest runner – every step you feel like you’re getting ready to get passed by 80 kids, but you also feel like there’s a definite chance you can win the time trial!

Here’s some videos of the start and finish of the chase race as well as the top 11 finishers.


Takeaways from Mike Bellafiore’s Discussion on Stopped Out Trades

Mike Bellafiore from SMB Capital wrote a tweet a few days that sparked a lot of replies from the trading community:

The responses ended up being a great discussion on what to do when you get stopped out of a trade, only to see it continue on in the direction of your original trade. Here’s the video of Mike summarizing the discussion and including his take on the responses.

Here’s my take on this frustrating situation which Mike references in the video.

Here I think is the best response to Mike’s original tweet that I think echos what I said in my post:

Any single trade is unimportant! In fact, even with a well defined strategy to re-enter trades like this, you are still guaranteed that these frustrating situations will occur.

To assume that there’s something to learn from every single trade you make is both overly optimistic and pessimistic at the same time. Why? It is absolutely essential that you learn to take losses well. Trying to find fault with every losing trade is foolish since the takeaways from different trades will often conflict with each other. For example, “take profits sooner” versus “give your trades room to run.” Here are two charts with potentially conflicting lessons.

If you’ve done your homework, these seemingly conflicting lessons are irrelevant — you’ll know what works across a large number of trades and you’ll be trading accordingly.

Getting caught up in trying to identify what you did wrong in each losing trade is a sign that you have an irrational need to be right. Do you want to be right or do you want to make money? If this is something you have a problem with then you might want to shift to another strategy with a higher win rate (although that usually comes with a tradeoff of a lower average profit).

If you get caught up in the results of a single trade, then it’s probably a sign that you need to do more preparation away from the trading desk. If you’re fully prepared, you can trade confidently knowing getting stopped out of trades that would have ended up profitable is pretty common.

My Approach to Trading with Bigger Size

Going from an initial trading strategy concept to actually trading it with meaningful size is a long and perilous journey. Having traded for over a decade now, I’ve gone through this process multiple times for dozens of strategies. If you’ve traded for any length of time you realize that, like many aspects of trading, this is far bigger topic and more difficult than it seems on the surface. It’s easy to fall into the trap of barreling down this path instead of carefully tiptoeing. I’ve made a bunch of mistakes in this area over the years (and some I still repeat!) — I’ll go over them here in hopes that you can know the pitfalls ahead of time and not repeat them.

The Most Important Thing to Remember About Scaling Up

If you only take away one thing from this post, let it be this. If you feel pressure for any reason to scale up quickly, you will end up making costly mistakes and you’re going to do it wrong.

Some traders come across a strategy that they feel has a limited shelf life and they need to scale it up quickly before the edge evaporates. If you believe this to be true then I would argue it’s not a strategy worth trading at all. Here’s why: when this strategy has a drawdown it will be impossible to determine whether it’s “normal” or the edge has evaporated.

This is why I always try to cook up strategies with the longest shelf life possible and I think about this from the very beginning of the trade concept stage. A strategy’s edge will fade over time but ones with strong staying power can be tweaked many times to improve their edge. After trading with size in a strategy for a length of time, you may have improved the strategy through what you’ve learned to the point where the strategy is significantly different than the initial concept.

My Stages of Strategy Cultivation

Each strategy goes through several stages of development. Only a few end up making it to the last stage but of course that is the goal.

Stage 1: Concept
This is the very first stage where you have an idea for an edge.

Stage 2: Backtesting
This is such an important step since it involves getting a trade idea from concept to an actual system that can be theoretically traded. You’ll discover a lot about how your system works during this phase without yet risking any money.

Stage 3: Pilot Trading
Especially for new strategies or inexperienced traders, these trades should be paper trades. Over time as I’ve gained more experience I generally spend less time paper trading and instead take what I call “pilot trades” — real trades with very, very small size. No matter what size you think is “small,” go smaller. The point here is not making money, but making your system prove itself to you.

This is the phase where I’m often too optimistic about the trading strategy. You need to be very skeptical at this point. This is the first point where money is on the line and there is probably the most to learn of all the phases. You’ll find out quickly if the system has flaws. Be sure and discover them using as little money as possible.

Many systems won’t make it past the Pilot Trading phase. In some cases you’ll need to make significant adjustments and go back to the Backtesting phase. In others you’ll need to abandon the idea entirely for one reason or another.

Stage 4: Sizing Up
Hopefully some of your strategies make it to this phase. They’ll need to have proven themselves to your skeptical self (the more skeptical you are the better). It’s very tempting at this point to let a strategy loose and put on too much size too soon. This is a mistake I, unfortunately, still make occasionally.

The problem is there are a lot of different types of markets and your system may be more or less robust in some of them. There is also a very real psychological danger here: as you increase size your equity curve could quickly turn negative as new losing trades with larger size overwhelm previous winners that were traded smaller. The system could be acting in a completely “profitable” way but you’re staring at a negative P&L overall. If you size up too quickly it increases the odds that this situation will occur.

This is one of the main strengths of using R Multiples and Expectancy to measure strategy performance — it is consistent regardless of your current position size. So unlike many metrics like Profit Factor, however you’ve varied your position over time you’ll get a consistent measure of performance — very valuable.

Most strategies spend a very long time in this phase. Remember what I mentioned earlier — there should be no sense of urgency to hurry things along. I have a strategy that has been in this phase for 5 years, slowly increasing size!

Stage 5: Max Size
We all want strategies to get to this point and your maximum trading size is likely changing over time. Even when you have a lot of confidence in a system it’s still psychologically difficult to increase size beyond certain points. Of course larger profits are always great, but achieving them will absolutely require tolerating larger drawdowns.

Important Takeaways

If you forget everything about this post, remember these things:

  • Be very skeptical — more skeptical than you think you need to be. Make your strategies prove themselves to you over a long period of time.
  • Don’t be in a hurry, especially when money is on the line.
  • Use a metric like R Multiples that allow you to measure performance regardless of your position size.
  • Get ready for drawdowns because they’ll come.