We've talked about a trading plan and different types of trading in this module and hopefully you're well on your way to putting your plan down onto paper. To help you with your plan, let's now talk about trading systems, their goals and how to build one from all that you've learned in this course. We'll look at the most popular one below - The Trend Identifying System
Developing Trading Systems
Most trading systems are based on mechanics. Meaning, mechanical trading systems are systems that generates trade signals for a trader to take. They are called mechanical because a trader will take the trade regardless of what is happening in the markets. This should eliminate all emotion and uncertainty from any trade. However, as you develop your own systems, you may start to add more discretionary elements to your systems, i.e. You're system may still be based on mechanics, but you'll use your knowledge and experience allowing you to make trading judgements - i.e am I too close to resistance to take that long trade. One example of a discretionary system is here, built from our trading system flowchart
There are thousands of systems out there - You'll have notice if you search the internet. Not all of them work all of the time, so you must make sure you back-test and dry trade your chosen systems first. Be wary of any system that claims to be the holy grail and even if the system is the holy grail, most traders lack the discipline to follow the rules through. Try developing your own system first - it's FREE, fun and fairly easy. It's Following the rules of the system that's the hard part. Below we'll look at developing a trend following system, but much the same applies for reversal, break-out systems etc...
Developing your Trend Trading System
There are a few goals to any successful trading system:
Now that we have the goals, we need to develop our system and write it into our plan. Developing a system shouldn't take too long, but the testing of it can take time. Make sure you thoroughly test your system, it's worth it in the long run. Below are the main steps in developing your system:
Testing a Trading System
We've already taken an extensive look at system testing in Module 4 - Charting Tools in our module Tool box - Software, Scanning and Testing. But, let's talk about it some more. The fastest way to test your system is by using charting software where you can go back in time and move the chart forward period by period.
There are 2 stages to testing your system:
Below we have a simple back test example as defined by our below Trend Trading Example:
To back test:
For the 10 commandments of back testing see Module 4 - Charting Tools in our module Tool box - Software, Scanning and Testing. Also see Manually Testing your System in the next module for the mechanics of historically testing manually.
Example of a Trend Trading System
Let's look at a real example of a trend trading system using what we've learned above. After extensive soul searching we've decided that Swing Trading is more suited to our style of trading. We also feel comfortable using moving averages and oscillators for our technical analysis and we're willing to risk 1.5% of our capital on each open position. We can calculate our position size from this 1.5% risk position and our stop/loss order, which we'll examine below.
It looks like this:
You can see the result of our system in the above chart - EUR/USD - Simple Back Test Example.
It's also a good idea to keep in mind benchmark markets especially when entering into a trend trade in individual stocks. I.e if our market scanning suggests Glaxo-SmithKlien is a good buy opportunity, we'd look at how the FTSE 100 market is doing. Is GSK going to follow the FTSE 100 trend, or is it fighting it? A trend trader will tend to make sure the trends are correlated. Break-out traders may also look at the main index, i.e. does the main index break resistance or support - it could indicate that the individual stock is about to do so too.
If trading an index, some say that if 85% of it's components are trending, then this will suggest that momentum in the index as a whole will gain momentum - something to ponder...
To Sum Up
Of course many trades will go against you! Remember this is a simple system. Yours may incorporate reward to risk factors and support and resistance etc... See the Trading Flowchart for more ideas. But you may want to keep it simple - Simple systems do make money. Visit some blogs and sites to view some other systems.
Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.
Manually Testing your System <<<<<<< HEAD