Ch. 8: When is a System Broken?
We have one more thing to consider before moving on, how to determine when a timing/trading system is “broken”. Accordingly, this chapter explores how to determine when a timing system is broken.
Turns out I already wrote on this subject in my Market Meditations publication so, rather than reinvent the wheel, I have reproduced portions of the original post below.
One of the most difficult things with trading systems is knowing when to stick with a trading system versus making changes or calling it quits.
Of everything I’ve ever read on when to throw in the towel on a system, I like Tom Basso’s thoughts on the subject the most. The following Q & A comes from a recent interview.
Q: How do you know when your strategy may be broken versus just being out of favour with the current market?
A: Broken strategies are found when they do something that you didn't design it to do…For example if you are buy and hold long stocks and the stock market goes down 50%, and you lose 45%-60% of your equity, that would be expected and the strategy is not broken. Nothing to fix there. If you are timing using a 20/100 day moving average and the stock market goes through a sideways period of 1 year and ends up unchanged for the year and you are down 10-15%, that's also to be expected with the whipsaws. It's not broken, so don't try fixing it…If [the trading system] is doing what you expected during the conditions that have existed, then it is not broken, so don't be fixing it.
To summarize, just because a trading system loses money does not mean that it is broken.
A trend system in a choppy market will almost certainly lose money just like a mean reversion system will lose money during trending markets. This is a function of the wrong market environment for the system, not any inherent flaw in the system’s design. Conversely, if you have a system that intends to benefit from a rising stock market and it loses money despite the stock market rising, you likely have a truly broken system since it isn’t doing what it is supposed to be doing.
The key determinant in declaring a system broken comes down to if the system does what you expect it to do, not whether or not it makes money in any given time period.
In the next chapter, I will review the things we’ve covered in chapters 5 - 8. After that I will get into what I do and why.
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George, Thanks for mention. Good summary.