Do Black Box Trading Systems Really Work?

If you are a trader and you have subscribed to any sort of newsletter or trading magazine, chances are you've been exposed to numerous advertisements regarding black box trading systems. These vary from those that focus on day trading e-mini S&P 500 futures to trading a basket of commodity futures markets to those that focus on trading currencies in the Forex markets. These advertisements come with some wild claims, followed by a required statement that the results indicated are based upon hypothetical trading. In other words, the system was simply back tested on historical data.

The question is, do any of these systems ever work? Well, it really depends upon individual expectations. If you expect to make a 100% return or more every year, these systems won't work. No system will work that well over the long run. If such a system existed, the developer is not selling it to the public!

Unfortunately, new traders fall prey to these businesses that simply sell trading systems, and in some cases charge thousands of dollars for these systems. Traders have no way of knowing whether the system will truly work in the long run.

One way that these system sellers make their product look so good is by curve fitting. They start out with a basic system to test across historical data, and then tweak the parameters to identify the best parameters for the system across the data set. They then advertise the results of those parameters. Unfortunately, those parameters often perform poorly when applied to out-of-sample data sets, or in real time performance. Why? Because the character of markets change.

For example, one of the top trading systems sold over the years has been the Turtle trading system made famous by commodity trader Richard Dennis in the 1980's. He taught a mechanical system to a number of traders, many of whom went on to tremendous success as Commodity Trading Advisors. It should be noted that there was a discretionary component to the system, and none of the traders would blindly follow mechanical trading rules.

Over time, the performance of this system and many similar type trend following systems began to erode. A review of the performance of traders such as John Henry and Dunn Capital Management bears this out. In the last decade, those firms had major drawdowns, which resulted in a significant drop in money under management.

Because of this, these traders were forced to adapt to the ever changing market conditions. There were simply too many traders trying to do the same thing, and this resulted in more choppiness in the trends.

What does this mean for the new trader? Well, it means that you shouldn't blindly purchase a trading system and follow the signals blindly and expect huge profits. It simply won't happen. Instead, a trader should purchase or develop a few strategies that fit their own trading personality, and then learn how to manage trades with real money. In this case, it is imperative that the trader start small and be sure to have another means to pay their bills.

Trading for a living is extremely difficult. However, well capitalized traders with sound strategies do have an opportunity to make a living, even in these current market conditions.


Copyright (c) 2010 Scott Cole