Develop The Perfect Trading System--Nelson Freeburg Tells You How

Editor's Note:
The following is an interview done by Dave Goodboy in conjunction with RealWorldTrading.com. After you read the interview, talk about it here.
Brice

Hi, My name is Dave Goodboy, I am executive producer of Real World Trading. This week I had the pleasure of interviewing, Nelson Freeburg. Nelson is a renowned trading systems designer who counts many world-class systematic money managers as clients, including, Paul Tudor Jones. He publishes the popular Formula Research letter that focusing on trading system development and is truly on the cutting edge of this field. This interview will step inside his mind to see what we can learn. Let’s get started!

Dave: Welcome to Real World Trading, Nelson

Nelson: Thanks, it’s a pleasure!

Dave: Let’s start at the beginning. What first got you interested in trading system development?

Nelson: Almost no one in the field of systematic trading started out as a trader. Even some of the best known names in the profession began in different fields. Gerald Appel was a psychiatric social worker. Martin Zweig was a professor of academic finance. The late Bruce Babcock, who popularized dozens of mechanical timing strategies, was an assistant district attorney (who helped prosecute Charles Manson).

Dave: Wow, that's a shocker. I would have never guessed that is the case. Charlie Manson, the market? More similarities than we would like to admit! (laughter all around). Seriously, did researchers from these diverse fields reach any common conclusions?

Nelson: When all of these people eventually turned their attention to money management, they reached a common conclusion. Buy-and-hold investing simply does not work. There may be periods when the stock market goes straight up. But the good times are offset by frequent bear markets.

Dave: How do the systematic traders earn more than simple buy-and-hold strategies?

Nelson: One way to capture the gains and avoid the risks is to use conventional technical analysis—familiar tools like charting, candlesticks, trend line analysis, etc. But there is a lot of subjectivity involved in interpreting chart formations, breakouts, volume patterns, and so forth. This puts a lot of negative psychological pressure on the trader. Furthermore, there is no easy way to back test trading methods that rely on intuition and judgment.

Dave: Correct, technical analysis is generally very subjective, often an art instead of a science.

Nelson: Yes, so the alternative is mechanical timing methods. Explicit trading rules can be reliably tested in great historical depth. If they don’t work, all you’ve lost is time and effort. You don’t lose real money. Furthermore, much of the doubt and fear inherent in subjective trading is eliminated when the entry and exit rules are specified in advance and rest on sound principles of price behavior.

Dave: How did you start being interested in systematic trading?

Nelson: I was working on a Ph.D. in world politics at Columbia University in the late 1970s. My specialty was strategic arms control. I would use formulas and models to simulate the effects of thermonuclear war. (Please understand, I was trying to REDUCE the odds of such catastrophe.) Around that time, gold and silver were on a historic bull run. My cousin, a professional commodity trader, introduced me to the joys and passion of trading. And I was hooked…just like that.

Dave: You were a scientist, I see. Did you give up on the world politics studies?

Nelson: I quit researching world politics and shifted to the study of price behavior. Like many of us, I had my ups and downs as a chartist. Sometimes the chart patterns worked, other times they didn’t. Meanwhile, around this same time, the personal computer made its appearance. It became much easier to develop and test mechanical timing strategies. For ten years I researched computerized timing methods, trading all along. In 1991 I started Formula Research to share my quantitative findings. We started out with a small but discerning group (including Zweig, Appel and Paul Jones). Today we serve institutional money managers and private investors in 27 countries.

Dave: Let's give systematic trading a clear definition. How exactly do you define systematic trading?

Nelson: It’s simply rule-based trading. Investment decisions are based on specified entry and exit conditions defined in advance. With a systematic timing model, if we all have access the same price data, we should generate identical signal histories—a feat not possible with trading by judgment.

Dave: What are the basic components of a trading system?

Nelson: As is often (correctly) pointed out, some of the best trading systems are the simplest. You just need an entry rule to get you in the market and an exit rule to get you out.

Dave: Interesting, particularly in light of all the "quant shops" opening up.

Nelson: By the way, all things being equal, simpler is indeed better. But I would not exclude in principle trading strategies which embrace more nuance and are therefore more complex.

Dave: Are all trading systems basically the same?

Nelson: Most trend-following systems are surprisingly similar in their governing logic. They will feature distinctive stops, filters, and other individual variations But over a test period going back decades, the equity curves will track each other closely.