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Mechanical Trading with CFDs

Mechanical Trading
Written by Andy

While there are many trading systems on the market, you want to be sure that the system you use is appropriate for your personality and risk profile, and the best way to do this is to understand how to make or adapt and test a system for yourself. The kind of trading system that is best for this is called a mechanical trading system. In fact, using a mechanical trading system with CFDs is an excellent way of entering the trading field. Both CFDs and the mechanical system have advantages that allow easier and more profitable trading.

While trading CFDs, there is always the temptation to break your own rules. Traders tend to fall prey to shifting stop loss levels based on nothing more than gut feeling that they’re going to see a reversal and recoup their losses, or wait longer than planned before taking profit, wanting to make as much as they can, convinced that the movement still has a way to go. While this can sometimes pay off, more often that not, you can end up watching with your hands over your eyes as the folly of a shifted stop loss wipes out your day’s profits. So maybe a mechanical trading system would be helpful here.

A mechanical trading system takes away the emotion from trading. It is well recognized that the emotions of fear and greed are tremendously powerful, and provided the trader can stick with the system, they can be eliminated from the trading decision making with a mechanical or automated trading system.

What is a Mechanical Trading System?

A mechanical system, at its simplest, is a set of rules to govern how trades will be made. It consists of a set of absolute rules that can be written down or put into a software program, such as the Expert Advisor feature in MetaStock or MetaTrader. There is no subjectivity or choice about the trades to be taken, as they are all laid out, and this type of system can be back tested over a range of historical data to see how well it performs, and to refine it. The system will address entry and exit conditions, including the stop loss exit, and position sizing so that any trades made are consistent. With good design, they will also be profitable. A mechanical trading system does not have to be run by a machine or computer, but quite often it will be. The key is that there is an unambiguous response to whatever the market does, so that a computer could be programmed to respond.

Once you have gathered together some feasible rules for entry, exit (either from a winning position or from a loss), and for position sizing and money management, you can encode these into your program and set the back testing to work, analyzing which rules worked better over the last 10 years for the security that you are interested in. For instance a possible mechanical system could be based on buying when the price breaks through a certain level and the Relative Strength Indicator is below 30 – and it is actually possible back test this system for previous years and see how well it would have performed. In doing this testing, the aim is not merely to finish up with the maximum profit, but to check other factors such as how much drawdown (the most that the account went down on bad trades) the account suffered, to see how it would fare in practice. Looking at these results, and checking that the drawdowns are acceptable, you will probably see room for improvements. The work is never finished, you will always be able to refine your system and go back to check it again, and it’s by keeping on top of this that you keep ahead in the markets.

When you’re back-testing a system like this, together with variations, it’s not sufficient to look at the outcome at the end of the testing period to determine how well it has performed. There are many more factors involved, particularly how large a drawdown the system may experience, and these factors are relevant to your perception of risk, and whether you will find yourself able to continue to trade with the system when things get hard.

It’s also not enough to buy or make a mechanical system and sit back, thinking you are set for life. Markets change, the most obvious change being between uptrend and downtrend or trading in a range, otherwise known is going sideways. A particular system will be best in a certain type of market, and if you continue trading the same system month after month without modification, you will find that it loses its performance. That’s why vendors of mechanical systems are always trying to sell you new ones, or updated to old ones.

Mechanical Trading Systems and CFDs

One of the fundamentals of any mechanical trading system is in defining what types of markets it is best suited for. With a good system, you can use leveraged financial products such as contracts for difference, and this will give you the best return for your money. But even within the field of CFDs, you need to align the type of product and the system used to get the best performance. As CFDs are available on such a wide range of financial instruments, you have a greater choice and flexibility in deciding which will work best.

When used with CFDs, the back-testing can include any margin requirements, so that the trader will know within reason what to expect. Past results are no guarantee of future performance, but they are the best that we have to go on. It is usually reasonable to expect similar performance in the future.

Another advantage of the mechanical system is that, even if you do not program your computer and software to make the trades for you, the computer can run a check on all available CFDs and produce a list of those that comply with your requirements. You can include items in the trading system that eliminate prospects on the basis of, for example, the price being lower than last week’s average. This saves a lot of time manually viewing the charts to find possible trades.

Whether or not it is programmed to do the work for you, a mechanical trading system has the distinct advantage that it will assist the trader to overcome the feelings that often accompany trading. It is always difficult to cut losses when a trade goes the wrong way, and a system that demands you do so provides a push just when you may be thinking that you should wait and see if it will turn around. A mechanical trading system embodies the trading plan which is something that all traders should have, unless they want to learn from their mistakes, and can save you making errors.

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