Evaluating Automated Trading Systems
Automated trading with services such as ZuluTrade, Collective2 and FX-Auto requires that you pick profitable, robust trading systems with an acceptable degree of risk. It is also important to exercise prudent money management, which means not trading too much of your balance at one time, and maintaining small lot sizes.
Most newcomers to automated trading automatically choose signal providers with the largest profits and then are taken by surprise when a large loss takes out a big chunk of their account. This is due to a lack of understanding of risk, drawdown and leverage. This tutorial hopes to educate traders on these risks.
Although this tutorial is intended for the automated forex trading services listed above, these principles can be applied to evaluate any trading system.
Equity Curves and Drawdown
The first thing you'll look at when browsing trading systems is the equity curve. A linear curve is most desirable, with profits increasing from the lower left corner to the top right corner of the chart. Things to watch out for are equity curves with sharp peaks and valleys, signifying large losses or unusually large gains.
The most important statistic to look at is the maximum drawdown. This is the largest peak to valley equity drawdown in the system's trade history. This can be specified as a percentage of equity (Collective2), or as the total number of pips (ZuluTrade, FX-Auto).
A high maximum drawdown means that trades are going well into the red before they are closed. So even if most trades ultimately end up as winners, they likely had to go through an extended drawdown before returning to profitability. This can lead to a margin call if your account is over-leveraged, or to disastrous losses if the market turns against the system.
The second thing to look at is the trade history. Look for winning trades with large negative drawdowns and losing trades that are unusually large. This indicates that the system is taking on a high degree of risk, leaving trades open too long or using very wide stops.
When dealing with losses and drawdowns in your automated trading account, the maximum drawdown is a good measure of the amount of negative equity you can expect. Don't trash a perfectly good trading system because of drawdown - as long as those losses are within the amount of risk indicated by the maximum drawdown and the equity curve.
High risk systems can offer significant profits, but at the risk of large drawdowns and a sudden loss of trading equity. If you do decide to add a high risk system to your portfolio, be aware of the risks and use appropriate money management. Otherwise, choose systems with consistency and reasonable drawdowns.
Other Statistics
A few more things to look for when evaluating trading systems:
- Length of trading history - A system with months or even years of trading history is more reliable than one with just a few weeks worth of trades.
- Live trades - Zulutrade will indicate trades that have been placed on live accounts. These results will be more reliable than hypothetical forward-tested results. Collective2 also allows you to browse live trades for a system.
- Popularity - The wisdom of crowds is one advantage of automated trading services. The profitable systems will rise to the top quickly. You'll still need to evaluate them to see if they fit your risk profile, though.
- Profit factor - A ratio of wins to losses. Anything above 1 is profitable, and the higher, the better. Collective2 and FX-Auto both display this statistic.
- Win percentage - A very high win percentage can indicate systems that leaves trade open until they are profitable, sustaining large drawdowns along the way.
Money Management & Diversification
Using appropriate lot sizing and limiting your maximum risk is critical if you want to avoid large drawdowns and margin calls. The number one cause of failure for traders is taking on too much risk due to large lot sizes and too many trades.
It's important to keep lot sizes small, no more than 1-2% of your account per trade. Zulutrade features the Margin Call-o-Meter, which indicates whether you are taking on too much risk. If the meter is in the red, the possibility of a large loss or margin call increases. FX-Auto's leverage reading displays a similar statistic.
Many trading systems open several trades at once, as many as 10 at a time! You'll want to be aware of how many trades a system can open at one time. You can glean this information by looking at the trade history. Look for several trades that have the same closing time. FX-Auto shows the maximum number of trades on the Performance screen.
You can manually limit the maximum number of trades or lots that can be placed at the same time. ZuluTrade allows you to limit lot sizes by trade, by currency or for the whole account. Collective2 allows you to limit trades by system. FX-Auto does not have a mechanism for limiting trades.
If your account balance is large enough to permit it, trade as many different systems as you can without over-leveraging your account. Be sure to include as many different currencies as possible in your portfolio to diversify risk. Having several systems that primarily trade the EURUSD is a bad idea if the euro starts racking up trade losses across multiple systems.
Be sure to sign up for a free demo account at any of the automated trading services listed on this site, and practice selecting profitable trading systems before you trade with real money. We hope this information will make you a more profitable trader!