Mechanical Trading with Ed Seykota: Building Your Own System.

The Case for Mechanical Trading

In a world of information overload and constant market noise, a mechanical trading system can be a trader's most valuable asset. Ed Seykota, a pioneer in this field, understood this better than anyone. He recognized that human emotions are often the biggest obstacle to trading success. A mechanical system, by its very nature, removes the emotional element from decision-making. It provides a set of objective rules for entering and exiting trades, forcing the trader to act with discipline and consistency.

The Building Blocks of a Seykota-Style System

A mechanical trading system in the spirit of Ed Seykota has several key components. First, it needs a way to identify the trend. This could be a moving average crossover, a breakout from a price channel, or any other objective indicator. Second, it needs clear entry and exit rules. When the system signals an entry, the trader must take it. When it signals an exit, the trader must exit. There is no room for discretion. Third, it needs a risk management component. This includes position sizing rules and the use of stop-loss orders to limit losses.

Backtesting: The Key to Confidence

Before trading a mechanical system with real money, it is essential to backtest it on historical data. Backtesting allows a trader to see how the system would have performed in the past. This is not a guarantee of future performance, but it can provide a degree of confidence in the system's edge. If a system has been profitable over a long period of time and across different market conditions, there is a higher probability that it will be profitable in the future. Backtesting also helps a trader to understand the system's characteristics, such as its drawdown profile and its win rate.

An Example System: The Donchian Channel Breakout

Let's consider a simple mechanical system based on the Donchian Channel, a tool favored by the legendary Turtle Traders, who were heavily influenced by Seykota's ideas. The Donchian Channel consists of an upper band and a lower band. The upper band is the highest high over a certain period (e.g., 20 days), and the lower band is the lowest low over the same period. The system would be as follows:

• Entry: Buy when the price breaks above the 20-day Donchian Channel. Sell short when the price breaks below the 20-day Donchian Channel.
• Exit: Exit a long position when the price breaks below the 10-day Donchian Channel. Exit a short position when the price breaks above the 10-day Donchian Channel.
• Stop-Loss: Place a stop-loss at 2 times the Average True Range (ATR) below the entry price for a long position, and 2 times the ATR above the entry price for a short position.

This is just one example of a mechanical system. The possibilities are endless. The key is to find a system that suits your personality and risk tolerance, and then to trade it with unwavering discipline.