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TraderInterviews.com: Hi, this is Tim Bourquin, cofounder of traderinterviews.com. Thanks for joining me for highlights of interview number four. If you've heard about automated trading systems that find trades for you, you'll love this interview. Kevin Davey recently won a worldwide trading contest three years in a row. In the fourth year, he placed second. Now that proof that someone knows what he's doing. Kevin writes automated trading systems and is very candid about how it all works. The first thing I wanted to ask him was how do you know when a black box trading system works in the real world, not just paper trading, and how do you know when you need to make a few adjustments or pitch it out and start again? He begins by talking about drawdowns and then gets into how he knows when a system is working properly. The audio quality on this interview isn't as quite as good as the other ones we normally have, but I think you'll still be able to get a lot out of it just from the highlights.

Kevin Davey: The way I typically trade is by developing systems and then rigidly adhering to those systems. Right now, I'm trading about six different systems for my personal account, and four of those are semi-automated where I will get signals but I'll still have to enter them myself. And then the other two systems are completely automated where I don't even have to be at the computer although I usually still am just to make sure everything works right. What I found is to reduce the drawdowns that occur, I like to diversify and try some different things. So, for example, I'm trading six different systems, so a couple of them are different types of systems with the stock indices, the mini S&P, the mini Russell, mini Nasdaq, so there are a couple systems there. And then I'm also trading some of the agricultural-type commodities and doing some spread trading. So, really what I found was the best way to reduce drawdown is obviously to have a good system in the first place, but drawdowns are kind of inevitable in any system. And so, by combining a couple of systems, what you get is you can use your capital a little bit better and also it kind of takes some of the sting out of some of those drawdowns.

TraderInterviews.com: Yeah. That's a good point, too because I was going to ask you how do you know when it's just a temporary drawdown and it's just maybe four or five trades in a row that have gone bad, and historically maybe you don't have that many but it's still within the parameters. And when it's completely off the tracks like you said, it needs to be revamped completely.

Kevin Davey: Right. And I'll give you an example of a system I started trading last fall. And right away when I started trading with real money, and this probably has happened to a lot of people, it started losing and had pretty significant drawdown right off the bat. And of course, when you're just starting to trade a new system and it immediately doesn't go your way, you start to think, "Well, maybe I did something wrong. Maybe, it's over-optimized. Maybe, the market's changed." And you think of all these things. And so what I did was I went back and looked at the previous history. I did some simulations. I used Monte Carlo simulations to predict a range of the expected performance in the future, and what I found is even this significant drawdown that there was a chance of this happening. It wasn't a big chance, but it was say 10% or 20% chance of this type drawdown happening in this shorter period of time. So knowing that, I felt comfortable that there's nothing wrong with this system. This is doing what it could do. It's not of the range. And so I continued to trade it and sure enough within a couple weeks, it turned around and then just kind of took off.

TraderInterviews.com: Kevin then goes on to talk about some of the adjustments he made to what the system was looking for that made it turn around. I was also curious as to how he gets his new ideas for automated trading systems.

Kevin Davey: Sometimes it's as simple as reading a magazine article. So, for example, reading something out of Futures Magazine that something somebody has tried. And I probably won't test the exact idea that they had but maybe something in that article will spur me to think, "Wow, what if I did this?" Another example of some systems that I just created and just kind of went alive with in the last month. There was this system where probably a couple years ago, I had read an article somewhere about something called the prisoner's dilemma which is kind of like a game theory type situation. I won't go into details about it, but it was about a game theory. And I just kind of found that when I come across these things, I kind of follow them away and I might have, at that time, run a small test on it and didn't really see anything there. But I came with it about a month ago and kind of approached it a different way and lo and behold it turned out to work out pretty well, and it's something I'm trading with real money right now. So, really it can come from a lot of different sources. One of the things I try to do is when I'm not thinking about trading or trading, I try to read books or do things that are kind of, I would say, on the creative side or something totally different than trading. So what I'm trying to do is to get input from, maybe, the other side of my brain, not the thinking part but the artistic part. And what ends up happening is sometimes these ideas just kind of pop in my head and then I'll go and test it. And usually, unfortunately, probably for every 100 to 200 ideas I can come up with little variations, it takes 100 to 200 ideas to actually come up with a system that will work. Most of the stuff just ends up getting thrown in the garbage.

TraderInterviews.com: Now, that's patience. Even trading system programers have to try a lot of different things in order to find something that works. Next, we discussed the types of systems he programs and which ones he likes best. So, could it be a system as simple as you noticed that every year on July first if you buy corn in the morning and sell it the next day at the close, you make 15%. I mean could that be a system in and of itself?

Kevin Davey: Yeah. It could be. Obviously, what I look for is try to do something the simpler the better, but that doesn't always work out that way. Sometimes I start out with some pretty complexed models and then try to make them simpler, so I go both ways. I actually, take simple things and make them more complicated, and take complicated things and make them more simple. But if things like seasonals, some of the systems in trading have some of that in them where they're pretty simple systems, but they seem to work. And part of the reason, I think, some of these work is some of the ways that I control risk isn't necessarily...I like tight stops, for example, but unfortunately, for me, at least the markets I trade doesn't seem, at least the markets I trade doesn't seem to like tight stops in the long run. It seems just to be a way to slowly grind away your money. If you a two-point stop in the mini S&P, for example, you'll probably get stopped out a whole lot. So what I found it's better to go with pretty wide stops, and I think that's where some of the edge in my trading comes from is I take risks that probably a lot of other people don't feel comfortable with. But in the long run, it works out better because you...there's this noise level in the market and I kind of tried to put some of my targets outside of this noise level so that the market will just do what it wants to do and it won't necessarily kick me out.

TraderInterviews.com: Kevin goes on to talk about he software he uses to program his trading systems which is trade station and now he starts with his simple theory and tests it to see if it will work. He then talks about how me makes adjustments to get signals that are just for the most profitable trades. Finally, we talked about why he trades systems rather than just making discretionary trades as sees them happen. With those three years that you were in first or second place and doing really well this year, what does this say about mechanical trading? Does it say that all these computerized-based trading systems will, in the long run, always beat discretionary traders who are trading on gut feel?

Kevin Davey: I guess, I'm not so sure about that. I happen to know a few of the people who won the world cup in years passed were more of discretionary traders and could actually do that. And I know for me personally, there's no way I could discretionary trade because I've tried it, and I'm really good at doing the opposite of what would be a good trader. I sell at the low buy at the peak and if you did the exact opposite, I mean, maybe you could fade out my discretionary trading, so I don't do that anymore. But it really depends on the person, and I think you have to end up doing something you're comfortable with. So, for example, I'm very comfortable with numbers, with statistics, with data, with rigid rules, and I have enough confidence in my abilities to do that that once I come up with the system, I have the confidence to trade it.

TraderInterviews.com: So it's all about knowing your strengths and then concentrating on being the best trader you can be, and knowing your own personality. Kevin's figured that out, and he's hugely successful because of it, and I think that's one of the great things about traderinterviews.com. You get to hear from all kinds of different traders with different methods and different personalities. It's a great way to help you figure out on your own, what your strengths are, and focus on those strategies you're most comfortable with. I spent 45 minutes with Kevin talking more about his systems and of course the full interview and transcripts are available to you as a member. We'll see you tomorrow for highlights of my interview with a business owner, turned trader who talks about how he uses simple candlestick charts to make a lot of money trade in the markets. See you tomorrow.