Beginners become emotional when they trade, but if you want to survive and succeed, you must develop discipline. The moment you become aware of feeling fear or joy, use that as a signal to tighten your discipline and follow your system. You developed that system when the markets were closed and you felt calm. Now it gives you your only chance of survival and success in the markets.

The idea of an automatic trading system is fundamentally flawed. If those systems could work, then the smartest guy with the biggest computer would have cornered the market long ago. Automatic systems do not work because the market is not a mechanical or electronic entity that follows the laws of physics. It is a huge crowd of people acting in accordance with the imperfect laws of mass psychology. Physics and mathematics can help, but trading decisions must take psychology into account.

When you talk with a pro, one of the first questions he'll ask-or not even ask because he'll know the answer from a few of your comments-is whether you are a discretionary trader or a system trader.

A discretionary trader takes in market information and analyzes it using several technical tools. He is likely to shift and apply somewhat different tools to different markets at different times. His decision-making tree has many branches, and he follows them at different times as market condi-tions change. All branches are connected to the sturdy trunk of his deci-sion-making tree, an inviolate set of rules for risk control.

A system trader develops a mechanical set of rules for entering and exiting trades. He backtests them and puts them on autopilot. At that point, an amateur and a pro go in opposite directions. An amateur, frightened by the market, feels relieved that a system, either his own or bought from someone else, will free him from worry. Market con-ditions always change and all systems self-destruct, which is why every amateur with a mechanical system must lose money in the end. A pro who puts his system on autopilot continues to monitor it like a hawk. He knows the difference between a normal drawdown period and a time when a system deteriorates and has to be shelved and replaced. A professional system trader can afford to use a mechanical system pre-cisely because he is capable of discretionary trading!

In my experience, system traders tend to achieve more consistent results, but the best and most successful traders use the discretionary approach. The choice depends on your temperament rather than a cold business decision. Some people feel attracted to system trading, others to discretionary trading. Much of what you read in this book deals with discretionary trading. All of these components can be used in systematic trading. This book is written to help both types of traders.

A trading system is an action plan for the market, but no plan can anticipate everything. A degree of judgment is always required, even with the best and most reliable plans.

Think of any other plan or system in your life. For example, you probably have a system for taking your car out of the garage. You need to open the garage door, start the car, warm up the engine, and pull the car out into the street without bumping into walls, running over tricycles, or getting hit by passing trucks.

You have a system in the sense that you perform the same actions each time in the same sequence, not thinking of the routine but paying attention to what is important-watching out for dangers, such as kids on bicycles, or freshly fallen snow, or a neighbor crossing the sidewalk. When you detect an obstacle, you deviate from your system, and return to it after the situation returns to normal. You would not try to design a complete system, which would include dealing with the snow, and the bicyclists, and the neighbors because that system would be too complex and still could never be complete-a neighbor could come into your car's path from another angle. A system automates routine actions and allows you to exercise discretion when needed.

And that's what you need in the markets-a system for finding trades, setting stops, establishing profit targets-all the while paying attention to a heavy truck headed toward you in the shape of a Federal Reserve announcement or a kid on a tricycle in the form of a disappointing earnings report. Many beginners set themselves the impossible task of designing or buying a complete trading system, which is just as impossible as a complete system for pulling your car out of the garage.

I have two friends who earn a good living testing systems for traders. Both are expert programmers. One of them laughed as he told me how he gets at least one phone call a week from yet another amateur who thinks he has discovered the Holy Grail. He wants his automatic set of rules backtested to find the best parameters, and his only concern is that the programmer should not steal his secret! I asked my friend how many profitable automatic systems he found during several years of backtesting.

Not one.

Not one? Doesn't he get discouraged doing this kind of work?

Well, what keeps him going is that he has a handful of steady clients who are successful professional traders. They bring him snippets of trading methods for testing. They may test their parameters for placing stops, the length of MACD, and so on. Then they use their own judg ment to bind those snippets into a decision-making tree.

An intelligent trading system includes components that have been backtested, but the trader retains control over his actions. He has sev eral inviolate rules, mostly having to do with risk control and money management, but allows himself latitude in combining those compo nents to reach trading decisions.

An intelligent trading system is an action plan for entering and exiting markets that spells out several specific functions, such as finding trades or protecting capital. Most actions, such as entries, exits, and adjusting stops, can be partly but not fully automated. Thinking is a hard job; a mechanical trading system tempts you by promising you won't have to think any more, but that's a false promise. To be a successful trader you need to use your judgment. A trading system is a style of trading, not an automatic turnkey operation.

SYSTEM TESTING

You must test each indicator, rule, and method before including them in your trading system. Many traders do this by dumping historical data into testing software and obtaining a printout of their system's param eters. The profit-loss ratio, the biggest and the smallest profit or loss, the average profit and loss, the longest winning and losing streaks, the average profit, and the average or the maximum drawdowns give the appearance of objectivity and solidity.

Those printouts provide a false sense of security.

You may have a very nice printout, but what if the system delivers five losses in a row, while you trade real money? Nothing in your test ing has prepared you for that, but it happens all the time. You grit your teeth and put on another trade. Another loss. Your drawdown is get ting deeper. Will you put on the next trade? Suddenly, an impressive printout looks like a very thin reed on which to hang your future, while your account is being whittled away.

The attraction of electronic testing is such that there is now a small cottage industry of programmers who test systems for a fee. Some traders spend months, if not years, learning to use testing software. A loser who cannot admit he's afraid to trade has a wonderful excuse that he is learning new software. He's like a swimmer who is afraid of water and keeps himself busy ironing his swimsuit.

Only one kind of system testing makes sense. It is slow, it is timeconsuming, and it does not lend itself to testing a hundred markets at once, but it's the only method that prepares you for trading. It consists of going through historical data one day at a time, scrupulously writing down your trading signals for the day ahead, then clicking your chart forward and recording the trades and signals for the next day.

Begin by downloading your stock or futures data for a minimum of two years. Swing to the left side of the file, without looking at what happened next. Open your technical analysis program and a spreadsheet. The two most important keys for traders on a computer are Alt and Tab because they let you switch between two programs. Open two windows in your analytic program-one for your long-term chart with its indicators, the other for the short-term chart. Open a spreadsheet, write down your system's rules at the top of the page and create columns for the date, entry date and price, and the exit date and price.

Turn to the weekly chart and note its signal, if any. If it gives you a buy or sell signal, go to the daily chart ending on the same date to see whether it gives you a buy or a sell signal as well. If it does, record the order you have to place in your spreadsheet. Now return to the daily chart and click one day forward. See whether your buy or sell order was triggered. If so, return to the spreadsheet and record the result. Track your trade day by day, calculating stops and deciding where to take profits.

Follow this process throughout your entire data file, advancing a week at a time on the weekly chart, a day at a time on the daily chart. At every click write down your system's signals and your actions.

As you click forward, one day at a time, the market history will slowly unfold and challenge you. You click and a buy signal comes into view. Will you take it? Record your decision in a spreadsheet. Will you take profits at a set target, on a sell signal, or on the basis of price action? You are doing much more than testing a set of rigid rules. Moving ahead day by day, you develop your decision-making skills. This one-bar-at-a-time forward testing is vastly superior to what you get from backtesting software.

How will you deal with gap openings when prices open above your buy level or below your stop? What about limit moves in futures? Should the system be adjusted, changed, or scrapped? Clicking forward one day at a time gets you as close to the real experience of trading as you can ever get without putting on a trade. It puts you in touch with the raw edge of the market, which you can never experience through an orderly printout from a professional system tester.

Manual testing will improve your ability to think, recognize events, and act in the foggy environment of the market. Your trading plans must include certain absolute rules, most of them concerning money management. As long as you stay within those rules, you have much freedom in trading the markets. Your growing levels of knowledge, maturity, judgment, and skill are much more important assets than any computerized testing.

Paper Trading

Paper trading means recording your decision to trade and tracking it as if it were a real trade, only without money. Most of those who paper trade have lost their nerve after getting beat up by the markets. Some people alternate between real trades and paper trades and cannot understand why they seem to make money on paper but lose when ever they put on a real trade.

This happens for two reasons. First, people tend to be less emotional with paper. Good decisions are easier to make when your money is not on the line. Second, good trades often look murky at entry time. The easy-looking ones are more likely to lead to problems. A nervous beginner jumps into obvious-looking trades but paper trades the more promising ones. It goes without saying that hopping between real trading and paper trading is sheer nonsense. You either do one or the other.

There is only one good reason to paper trade-to test your discipline.

If you can download your data at the end of each day, do your homework, write down your orders for the day ahead, watch the open ing and record your entries, and then track your market each day, adjusting your profit targets and stops-if you can do all of this for sev eral months in a row, recording your actions, without skipping a day- then you probably have the discipline to trade that market. Someone who is in it for entertainment will not be able to paper trade this way because it requires work.

To paper trade your system, download your data at the end of each day. Apply your tools and techniques, reach trading decisions, calculate stops and profit targets, and write them down for tomorrow. Do not place your orders with a broker, but check whether they would have been triggered and write down those fills. Enter paper trades in your spreadsheet and your trading diary (see Chapter 8, "The Organized Trader"). If you have the willpower to repeat this process daily for several months, then you have the discipline for successful trading with real money.

Still, there is no substitute for trading with real money, because it engages emotions more than any paper trade. It is better to learn by putting on very small real trades than paper trades.