Gold vs. Garbage

Evaluating Trading Systems

Anyone who has even casual experience trading is aware of the plethora of trading systems available. From simple to complex, the sheer number of available trading methods can make the task of evaluation & deciding upon which system to use more than a bit confusing to the average person.

How is one to find a really good trading system? Is there a way to quickly eliminate the many flawed systems from those that deserve more investigation?

Thankfully, there are a few things which one should focus on to determine if a potential system is worthy of further consideration. In fact, by the time you finish reading this article you’ll have enough information to eliminate 90% of the trading systems frequently advertised.

Naturally, any presentation of a trading system which you may see on a website or at a seminar is going to be a sales presentation. And there's nothing wrong with that. But no system provider is going to reveal EVERY detail of the system, after all, there would be little left for you to purchase.

However, by looking closely at what IS being presented and what IS NOT being presented, one can quickly cull the potential diamonds from the broken glass. The following are tips which will enable you to better critically evaluate potential trading systems.

TIP #1: Remember What You Are Seeking.

Unless you trade for the sheer excitement of placing a trade, you want a trading method which offers superior performance on a consistent basis. If you agree with this statement, then you are seeking two critical functions from a trading system: 1) superior performance and 2) consistent performance.

Keep these 2 critical functions in mind as you read or listen to the presentation. Begin with the view that you want 1 question answered, and until this question is answered, you'll not pay attention to anything else which is presented. This question is, of course...

"Does this system provide superior and consistent performance?"

Until this question is answered, consider everything else as an attempt to mislead you. Afterall, without superior and consistent performance, does anything else really matter?

Sounds like a rather stern approach?

Maybe, but we're talking about YOUR MONEY!

Not only the money you may spend by purchasing the trading system or service, but the money you'll lose on poor performance as a result of making an unnecessary wrong choice!

Also, there are many people who are selling highly inferior systems and will indeed provide a lot of information WITHOUT answering our main question. They know that as you read through or listen to the presentation it is often easy to get excited and be misled by skillful marketing. It is, therefore, critical that one keeps in mind what one is really seeking.

The tips which follow reveal some of the common marketing tactics. These will help you better seperate "hype" from real information. Real information directly helps us answer our main question. Hype makes the product sound great, but doesn't truly provide the information needed to answer our question.

TIP #2: How It Works Doesn’t Matter.

Sound strange? It isn’t really. Some system providers will spend a lot of web space explaining the basic mechanics of their system. They may explain Japanese Candlesticks, moving averages, pattern formations, indicators and oscillators, or even some new (or old) magic trading secret which only they will reveal to you.

The idea with this marketing concept is to connect with either the logical or emotional part of your brain. It is intended to make you say to yourself,

“Hey, that sounds reasonable. It really sounds like it will work!”

The problem is, understanding “how” a system operates says nothing about it’s performance. Knowing how it works doesn't answer our primary question of whether or not the trading system will provide superior and consistent performance.

Just because a method seems like it should work, doesn’t mean it will.

Let me provide a simple but profound example. Some systems issue trades when the stock price crosses a specific moving average. These systems are frequently explained in varying detail which makes them seem almost fool-proof.

However, the price crosses a moving average almost everyday. Take any chart and place a 500 day MA and a 1 day MA on it. All that space between those two lines can be accounted for with a moving average between 1 day and 500 days.

So the simple fact that the price crosses “X” moving average doesn’t mean that the system provides superior performance and consistent performance.

It doesn’t really matter "HOW" the system operates, what we want to know is "HOW WELL" the system operates. Will it provide the two critical functions we seek?

Only when we are satisfied that the system will indeed provide superior performance and consistent performance should we consider further investigation, including perhaps understanding how the system works.

So don’t get caught in the marketing trap of trying to understand the actual operation of a system. If it doesn’t perform, it doesn’t matter how it works. Our first priority is to determine performance.

TIP #3: Look At The Historical Performance.

Amazingly, there are some system providers who do not even show how well their system has performed in the past. They may offer claims about how much you can make, but fail to show how much it has made.

As you can probably guess, any presentation which fails to disclose historical performance should automatically be eliminated from further consideration. You simply have no way of knowing what you’re buying; gold or garbage.

Odds are, if the system had a good track record, they would be anxious to show it.

In fact, when you are presented with a potential trading system, the first thing you should look for is the historical performance. Unless you can see the historical performance, consider everything else as nothing more than marketing hype.

There are several little tricks which are often seen in connection with the historical performance. One trick is to provide what appears to be an historical performance record, but without truly reflecting the results of ALL the signals which the system produced during the time represented.

For example, if the site provides stock trades over the past year, do these trades represent EVERY trade signal given during that time, or just a few selected examples? It is very easy to create a false impression when one only reveals "selected" examples.

The important point to remember is to look for the historical performance and verify that the record reflects all the signals the system produced. You may need to contact the system provider to verify this, especially if he was not thorough enough to state it on the website.

TIP #4: Overall Performance = Average Percentage.

Some system providers will try to impress you with historical performance expressed as dollar amounts. This can be very misleading. Let me explain by way of example:

“Here are the results of our last 3 trades:

1) $2 per share profit,

2) $1 per share loss and

3) $3 per share profit.”

Wow… sounds like you should have a total of $4 per share profit, doesn’t it? Sounds great, right?

Suppose you had started with $3,000 and traded $1,000 on each of these trades. The first trade was on a $20 stock. This means you were able to trade 50 shares (forget broker fees for this example). At $2 profit per share, you made $100.

The second trade was on a $5 stock. So your $1,000 position allowed you to trade 200 shares. The $1 loss per share would then result in a loss of $200.

The third trade was on a $40 stock.. So your $1,000 position allowed you to trade 25 shares. You made $3 per share profit for a total profit on this trade of $75.

In the end, you lost $25 from your account (again, not including broker fees). You experienced a $100 profit, a $200 loss and a $75 profit. You do the math.

Far cry from the $4 per share profit isn't it?

The point is, performance is not expressed in dollar amounts. That may be how performance is realized, but it can not be expressed this way. Performance should ALWAYS be expressed as a percentage of the amount invested.

Performance is a return on your investment, so performance can ONLY be expressed in a manner which compares the return to the amount invested. The $2 profit per share is actually 10% of the initial price ($20). So the actual performance is 10%. Likewise, the $1 loss on a $5 stock is a performance of -20%.

So remember, if you see historical performance expressed in dollar amounts, there should be all sorts of bells, whistles and alerts going off in your mind. You could kindly ask the provider to revise the data, but don't be surprised if he won't. Often, results are presented in dollar amounts to hide a poor overall performance record.

TIP #5: Overall Performance Is Averaged:

Another marketing trick which some use to inflate the perceived performance of a system is to add the returns of the trades rather than averaging them. Here is an example of how these numbers are frequently presented:

• Trade #1: 15% Profit
• Trade #2: 10% Profit
• Trade #3: 5% Loss
• Trade #4: 10% Profit
• Trade #5: 15% Loss
• Trade #6: 10% Profit
  ---------------------------
  Total: 25% Profit!!

If you said no, you’re catching on!

The historical performance should provide us with future expectation. We look at how well the system has worked in the past to determine how well it should work in the future.

A trading system which is profitable will have a positive expectation on every trade. If we average the results, then we can not only determine if our expectation is positive, but we can also determine exactly what our profit expectation is on every trade we make using the system!

This is an advanced concept, but a critical one. Not every trade will be profitable, of course. But if we know what our profit expectation is, then we can trade with confidence, knowing that in the long run our return should favorably compare to the system expectation.

Let’s determine the profit expectation for those 6 trades we saw a moment ago:

• Trade #1: 15% Profit
• Trade #2: 10% Profit
• Trade #3: 5% Loss
• Trade #4: 10% Profit
• Trade #5: 15% Loss
• Trade #6: 10% Profit
  ---------------------------
  Total: 25% Profit!!

25% profit divided by the total number of trades (6) equal a profit expectation of 4.1667% per trade. This means that each of those 6 trades worked together to earn 4.1667% on average. Here’s another way of looking at it: we made 4.1667% on every trade we made, INCLUDING those trades which showed a loss.

So the actual performance of this particular trading system is 4.1667% per trade. Since the expectation of 4.1667% per trade is positive, the system appears to be a profitable system. Naturally, no trading system should be evaluated on just 6 trades.

The concept to understand here is that the value of a system lies in it’s performance and the performance comes down to a profit or loss expectation. This expectation is expressed as an average percentage (positive or negative) on a per trade basis.

There's another reason why the profit / loss numbers should not be added together. This is because the result would only be correct if one trades their whole account on each trade. In the example given above, the only way to achieve the 25% return is to invest your entire account on each of the trades. And what happens if a new trade is signaled before your current trade is closed out?

The method simply doesn't work mathmatically or in real life. The essence of performance is found in the system's profit expectation.

Let’s quickly review the 5 tips:

TIP #1: Remember What You Are Seeking.

You are seeking superior performance and consistent performance.

TIP #2: How It Works Doesn’t Matter.

Until we know that a trading method provides superior and consistent performance, the mechanics of the system is meaningless.

TIP #3: Look At The Historical Performance.

Anyone who fails to provide historical performance does not deserve your consideration.

TIP #4: Overall Performance = Average Percentage.

Forget historical performance numbers which are expressed in any manner other than the profit or loss percentage.

TIP #5: Overall Performance Is Averaged.

Forget performance numbers which are added together to provide a total. True performance is expressed as a profit / loss expectation per trade.

I hope you have found this article helpful and will use the information to more critically examine the claims of various trading methodologies. There is one final tip which I believe is absolutely critical to any serious trader, but first...

If you seek a powerful & proven trading system, then let me strongly recommend that you examine the Logical Trades Signal Service. You'll not only find superior and consistent performance (the 2 critical functions), but a trading service which is designed for every serious trader, no matter your level of experience. Logical Trades does ALL the work for you. Check it out now, just click on the following link:

I believe you’ll find everything you’re looking for, and MORE!

Thank You for your time, attention and consideration. If you have any questions, comments or suggestions, please do not hesitate to contact me: