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Types of Trading Systems: Pros and Cons of Each

October 7, 2022
Types of Trading Systems: Pros and Cons of Each
There are various types of trading systems, and all of them deserve to be taken into consideration. This statement alone should suggest the truth behind these tools: they are not magic wands, and there isn't one that can be said to be better than all the others. They are resources, and as such, they should be handled with care, aware of their strengths and weaknesses. It is therefore worthwhile to review the main trading systems and describe their principles, purposes, advantages, and disadvantages. We will do this in this brief but exhaustive guide, where we will take stock of the importance of operating with a trading system, regardless of its type.

Why it is important to operate with a trading system

A trading system is, as the name suggests, a system for trading. In other words, it is a set of rules and "protocols" that suggest:
  • The methods of analysis, as well as the related tools
  • The methods for identifying entry and exit points
  • The techniques for deciding the amount of investments from time to time
  • The techniques for protecting against market risk
  • The methods for reviewing and monitoring results
The trading system can therefore be considered as an instruction manual for traders. It is important as it restores scientific approach, as much as possible, to the investment activity, while at the same time providing systematic action. The real advantage of trading systems, however, is another: it decreases psychological pressure. It does this by reducing the margin of discretion: the trader is led to make fewer decisions, thus having fewer opportunities to act with emotions. Some trading systems are schematized and transformed into robots, which operate in the market in place of traders. Obviously, they must be set up correctly, a phase that could be considered "strategic". Therefore, they only cover the moment of operation, enough to further reduce the influence of one's psychological sphere (with anxieties and fears attached). As already mentioned, there is no best trading system in absolute terms. Indeed, it is always advisable to modify and customize it according to one's needs and trading style. This is especially important with regard to the risk and money management part. For the rest, it is possible to identify some large families of trading systems, each of which tends to offer advantages and disadvantages. Here is an overview.

Trend following: pros and cons

Trend following trading systems aim to identify the trend and always operate in consistency with the latter. When the trend is well-formed and there is no uncertainty in the market, that is, in the absence of predominant lateral phases, trend following appears to be an effective strategy, capable of generating many correct operations. Its advantage is therefore this: in the presence of clear trends, it works very well. Another advantage is that it is relatively simple to design, also because it is normally based on ordinary indicators, such as moving averages. The biggest disadvantage is the extreme difficulty it generally experiences during lateral phases. In this case, the generation of false signals is the order of the day. The advice, to smooth out the defects of trend following, is to prepare a plan B in case of laterality, and to be ready to take command of one's trading action.

Contrarian: pros and cons

Trading systems based on the "contrarian" philosophy are very particular, in some ways even fascinating. They are in fact based on the tendency to go against the trend. One sells when the market appears strong, one buys when the market appears weak. The purpose is in fact to predict new trends, and enter a moment before, so as to capture the maximum in terms of surplus. The greatest advantage of contrarian is that it is able to cope with lateral phases, as it identifies overbought and oversold very well. Its biggest disadvantage is that it is quite difficult to design, as it requires extreme precision. The risk, in fact, is not hitting the right times, and therefore failing the various trades. It should also be said that it is poorly usable during well-formed trends, as it - precisely - is in the opposite direction to the latter.

Volatility Breakout: pros and cons

Volatility Breakout trading systems are judged "extreme" by more cautious traders. In fact, they act by definition in the most volatile phases, even proposing to dominate them, that is, to anticipate price movements when they seem to have gone mad. In a sense, they represent a more exaggerated version of the contrarian. Therefore, they replicate its advantages and disadvantages. The greatest advantage is the ability to act in a condition in which, normally, the trader decides to stay with folded arms, taking advantage of a few but very profitable sessions. The biggest disadvantage is the difficulty of design, which derives from a spasmodic need for precision. Moreover, trading systems based on Volatility Breakout work poorly when the sea is calm, or moves in a precise direction. If the market is flat or there is a well-formed trend, these trading systems may stop generating signals.

Hybrid trading systems: pros and cons

Finally, let's deal with a very peculiar type, but one that has spread like wildfire in recent times, that of hybrid trading systems. As the name suggests, they represent the fusion of multiple approaches. In the vast majority of cases, they are a mixture of trend following and contrarian. Obviously, there is no hybridization between techniques and protocols. Very simply, the system identifies the most suitable moment to deploy one approach or the other. The greatest advantage lies precisely in this, in the ability to operate with fluidity and to react to changed market conditions. After all, they take the best of the various approaches, changing register when the approach currently used shows the ropes or could generate false signals. On the other hand, hybrid trading systems are the most difficult to design, as they are dominated by an additional variable: the description of the market, and the association between the current moment and the right approach.

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