Diary of a System Trader

August 2010 By Jubin Pejman

I placed my first trade in college, buying 100 shares in Information Resources Inc. (IRIC) for $44 each after opening
an account with my life savings of nearly $5,000. I wound up selling IRIC for a substantial loss of 50 percent two
years later.

Despite the loss, by the time I sold my shares, I had developed an extreme interest in the stock market and had
started observing price patterns developing in certain stocks. I began using screening tools and looking for certain
fundamental criteria. I had also started to implement some basic rules, such as never lose more than 10 percent on
a trade, buy into strength and only trade names with high daily volumes.

Slowly but surely, I started doing well and felt confident in my stock picking abilities.

There was only one problem. I had been buying technology stocks in one of the biggest bull markets of the 20th
century. Making money in the technology sector in the late ’90s was no feat.

RULES-BASED TRADING

The dot-com bubble was a great lesson. It illustrated that the vast majority of investors had absolutely no strategy
or qualifications to invest in stocks. Almost all of their decisions were based on data that was already factored into
the market.

Even today, it is extremely rare to find an investor who has a game plan, let alone a strategy, risk-management
techniques or intelligent entry and exit points for a trade. Traders might have a great thesis, but if their timing is
off, they are wrong and often unprofitable.

Even the most knowledgeable market experts must employ strict risk management, cash management and trading
techniques to be successful over the long term.

DEVELOPING A SYSTEM

One way I observed the market was to read crowd psychology. I developed a long-term methodology for picking
stocks and used the reactions of other market participants as trading indicators. I realized that I needed a formal
methodology in place to trade like I were running a successful business and increase my odds of winning.

For this reason, I started documenting the elements that made certain trades successful and others not. I
developed a set of rules—a strategy—for each part of the trading cycle based on these observations.

STRATEGY COMPONENTS

A good trading strategy has three key components: market selection, trade entry and exit criteria, and risk
management.

Market selection: Most traders benefit from monitoring a small basket of uncorrelated markets. Markets can move in
different directions, allowing the trader to capture volatility.

Unless a trader has a software application to help monitor more than 10 markets, it may become extremely difficult
to follow those markets, requiring a large burden of time and manual analysis.

It is also difficult to become an expert in many markets. Although a trading system can increase your odds of
winning and decrease your odds of losing, one must still know the underlying markets well to make intelligent
decisions.

Trade entry and exit criteria: The two most important decisions you can make as a trader are when to enter and
exit trades. This may seem intuitive, but many investors simply do not have any guidance on entries and exits. The
logic behind getting into and out of a trade must be based on the surrounding circumstances of the market and
price movement.

You can use indicators that either interpret or help you visualize price movements along with other market activities
that influence price to identify trade setups.

Indicators can vary from moving averages, the Relative Strength Index, Elliott wave analysis or any of the
innumerable indicators. All of these indicators reflect one thing: specific market psychology. Therefore, you have to
identify the market conditions before executing a trade.
Risk management: Risk management can mean something different to each trader, but the process starts before
you execute a trade. It begins with identifying how much of your working capital will be at risk. You must also set
rules on subsequent entries and know when to add to positions.

Risk management also dictates how much a trade can lose or gain before you exit the position.

MY RULES

I developed a system called Smart Money Signals (SMS). Here are the rules:

• Show no emotion when trading or analyzing the market.

• Ignore news sound bites. Nearly all of the news I read, hear or see is based on post-event commentary. Although
this may be useful to understand what happened in the past, it cannot predict the future of the markets. That said,
I ignore everything that people say about the market unless they have an inside edge. Everything is factored into
the market by the time I hear it.

• Select and monitor five unique markets. Ideally they will be uncorrelated to increase the chances of avoiding
sideways markets that may be common to instruments in a particular sector. This will allow me to capture price
movement and volatility. I look at the S&P 500 futures, crude oil futures, gold futures and several currency pairs
such as euro/dollar and British pound/dollar.

• Determine entry and exit strategies. Smart Money Signals primarily paints inflow and outflow trends of money in a
market. These trends are further defined as either smart money (short-term) or dumb money (long-term). System
1 strategy (S1) focuses on short-term movements for generating buy and sell signals, while System 2 strategy (S2)
generates signals on a longer timeline.

Both S1 and S2 strategies use a blend of known technical indicators, such as average true range, moving averages,
moving average convergence divergence (MACD), and proprietary momentum-generating entries and exits. By its
very nature, the strategy is always putting capital at risk.

INITIAL POSITIONS

When the system signals a buy or sell, an initial position is executed. This initial position usually is one contract in
futures or forex or at least 100 shares of a stock. Of course, each trade has its own set of rules.

The first and most important is to attach a stop market order if the price reverses and crosses over one average
true range value. ATR is used to determine the recent volatility of the last 14 bars of trading history.

When trading a system, you must know the trading range to manage your position risk, regardless of whether you
use daily close or five-minute bars.

ADD TO WINNERS

Allowing a winning trade to pyramid upward by adding to it dictates the degree of long-term success when using
Smart Money Signals. Once the price of the contract has successfully made it through two bars without stopping
out, the system tells me to add one more contract to the initial position.

The system will add one contract for each two bars that continue in the positive direction using a 10-bar exponential
moving average (EMA) to determine the exit point of all pyramid positions. If the price of the contract crosses over
the 10-bar EMA, I must exit all pyramid positions with a market order.

I do not use a limit order because the key here is to exit positions as quickly as possible with limited risk. I hold the
initial position until the exit signal is reached.

MARGIN

The initial capital that I use to trade this system depends on the instruments being traded.

The system needs approximately $10,000 initial margin for trading NYMEX crude oil E-minis. You would need about
$15,000 to trade S&P 500 E-minis. I trade foreign exchange at no more than a 10-to-1 leverage with at least a
$15,000 initial deposit. For stocks I need to trade with at least 120 percent initial margin, which will be enough to
buy 100 shares of the desired stock I follow.

The amount of margin will dictate how many subsequent positions I can pyramid while in winning trades. The Smart
Money System works fine with one position or pyramid positions.

If additional capital is not available, I only trade with an initial position; however, some broker’s margin rules may
allow for further positions to be added.

SOLID RISK MANAGEMENT

My system’s rules are:

• Never enter a trade unless the system gives me a firm signal.

• Always exit a trade when the system gives me an exit signal.

• Never add to a losing position or average down.

• Always place a stop-loss order for each trade based on the ATR of the period I am charting for a specific market.

STRATEGY PERFORMANCE

I have run the S1 strategy against 10 years of the S&P 500 Index for this article to demonstrate the performance
results. I have chosen a simple entry and exit point methodology using 50- and 200-day exponential moving
averages.

For this strategy, I have chosen not to use stop losses to prove the point that if you use systematic entry and exit
points that are tailored to a market, you can beat the market in the long term. I have also decided not to pyramid
positions for this timeframe.

Jan. 3, 2000, to Jan. 1, 2010, gives me 10 years of price data to analyze. The system has clear entry and exit
signals based on moving average crossovers. The system actually waits until Oct. 18, 2000, before generating its
first signal, which is a buy.

The Smart Money Signals system returns 118 percent versus a loss of nearly 30 percent based on a buy-and-hold
strategy during the same period. Please refer to Figures 1-3 to see the first three trade setups. The S&P 500 Index
was at an intraday high of 1,478 Jan. 3, 2000, and closed at 1,115.1 Dec. 31, 2009.

click image for larger view

click image for larger view

By using this 50- and 200-day moving average cross, I have been able to time market entries for long-term
momentum swings in most equity and futures markets. This strategy worked well when used against the S&P 500
Index.

WHICH MARKETS?

I have used this system to trade commodities futures, index futures, spot FX, equities and exchange-traded funds.
But market selection can be a daunting task in a sea of nearly 10,000 tradable instruments.

The most important criteria to follow when selecting markets to trade with a system are liquidity and familiarity. If a
market is not liquid, it will most likely not experience large price fluctuations and may remain stagnant for long
periods.

To properly trade any market, you must be familiar with the way the price moves and how it reacts to other market
conditions. The price movement must trend smoothly to take advantage of the entry and exit points without
creating too many false positive orders.

THINK LIKE A BUSINESS

Trading the markets is a zero-sum (One participant's winnings equal the other participant's losses.) game. The
majority of individual investors (not professionals) who enter the market lose money. Some statistics show as many
as 95 percent of traders lose money in certain markets, such as over-the-counter-traded foreign exchange.

Trading is a business. And as in most businesses, you need to have an understanding of the market and a strategy
or business plan to increase your odds of being successful.

Jubin Pejman is the head of the Environmental Products Group at GFI Group Inc. He has held various senior roles in
the investment business, including positions at Trayport, JP Morgan, Long Term Capital Management and
Oppenheimer & Company. He enjoys studying the financial markets and trading.