John Ehlers - Trading System Evaluation (Article)

INTRODUCTION

There are basically two ways to trade using technical analysis – Discretionarily and Systematically. Discretionary traders can, and have, made spectacular amounts of money with their techniques. They integrate their life’s experience, knowledge of the markets, and technical indicators to make their trading decisions. System traders, on the other hand, need know very little about the market or have much experience. Instead, they rely on the trading signals automatically produced by rules implemented by computer programs. They have the confidence to rely on the computerized systems because the performance statistics can be reproduced by backtesting. That is not to say that hypothetical performance is perfect. There can be sharp differences between hypothetical performance and real trading results. For example, hypothetical trading does not involve financial risk, and the ability to withstand losses or to adhere to a particular trading system in the face of these losses is not considered. Implementation issues, such as slippage and commission, can only be included as allowance factors. Further, the trading system can have performance in the future significantly different from its past performance due simply to the randomness of events. Since backtests are always done with the benefit of hindsight, there are all kinds of ways to cheat on reported performance. But this is an article about what you can realistically expect from your trading system rather than how to cheat the statistics.