Create a Trading System & Test It


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:
  • It should identify trends, preferably at an early stage
  • It should protect, or avoid you from whipsaw
  • It should compromise between the two above goals.  What does this mean?  If you trade at an early stage of a trend, you'll be subjected to whipsaw more.
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:
  1. What's your trading style? Day, Swing or Position Trader?   You will still use multi-time frame analysis, but this step focuses your time frame when looking for trading signals.  
  2. Define your Trading Set Up
    1. Identify your Chart Period you'll use.  eg. 15 min for day trade, or daily for swing trader, etc...
    2. Use Multi-time frame analysis to Identify long-term trend
    3. Use Technical Indicators to identify the trading trend.  Whether it's ADX, moving averages or some other indicator, these tools are a fundamental part of any system.  In it's most simplest form moving average crossovers will help traders I.D. a trend. 
    4. Use Technical Indicators to confirm the trend.  One of our trend trading goals is to avoid whipsaw, so we need to be able to confirm the trend by using indicators.  Oscillators are the technical indicators needed here - Stochastics, %R Williams etc...
  3. Define Entry and Exit Rules.  Do you enter when all your signals line up, no matter what?  Or do you wait until the periods candle has closed after the signal?  It depends on how aggressive you're going to be.  Review some systems out there to decide.  For exits, do you trail your stops, have a price target, what's your reward to risk ratio?  The target can be time, support and resistance levels, number of pips or when indicators tell you to sell.  Whatever you choose you must stick to it!
  4. Define your Money Management Rules - You must define what your risk to capital ratio will be and stick to it. Your stop/loss orders and position size depend on this.  Bad money management can mean even a good system can fail.
  5. The number one thing to remember is discipline - follow 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:
  • Historical walk-through trading
  • Live Demo-Account Testing
Be honest when recording your systems trading record. If you're not you'll lose money! When you're happy with your strategy, move it to a live demo-account until you are happy you are getting consistent results. This will take at least 2 months under different market conditions. This part is vital. It puts you in the mindset of what it will be like to deal with real money. If your system has stood up to 2 months of rigorous testing, it's time to trade for real!!

Below we have a simple back test example as defined by our below Trend Trading Example:

EUR/USD - Simple Back Test Example

To back test:
  • Dress your charts with your setup - i.e. weekly, daily etc... with moving averages, indicators, support and resistance levels. 
  • Record at what price you would've entered - 1.0660
  • Record your stop loss - 1.0560
  • Record your exit strategy. As below
  • Move the chart one candle at a time to see how the trade unfolds. 
  • What price you exited - 1.1020
  • Record your profit or loss - 360 pips
  • Do this over and over again for different markets and at different times - For at least 100 trades.  Software will help you back test your results quicker (most trading packages have historical testing facilities).  Record averages, position sizes, why the trade went right or wrong, everything!!!
  • Move to a live demo-account for 2 months
  • Go Live!!!
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:
  1. Trading Style - Swing Trader
  2. Trading Set Up
    1. Charting period - Daily
    2. Multi-time frame analysis will determine out long term trend - only trade in the direction of the long term trend
    3. Indicators to I.D. our trading time frame trend - 5-period and 10-period simple moving averages.  The crossover will identify an up trend or down trend.  We're using these two periods because they cover our swing time frame
    4. Trend confirmation will be by using RSI (9-period) and a slow Stochastic (14,3,3).
  3. Entry and Exit Rules
    1. Enter Long when Long term trend is up; 5 sma crosses above the 10 sma; both stochastic and it's moving average are moving up (but not in overbought) and RSI is greater than 50
    2. Enter Short when lng term trend is down; 5 sma crosses below the 10sma; both stochastic and it's moving average are moving down (but not in oversold) and RSI is less than 50
    3. Exit when the sma's re-cross, when RSI crosses back to 50 or when stop/loss hits 100 points.
  4. Money Management Rules.  Usually the longer our time frame then the more pips we should risk to let our trade breathe.  Also the higher our profit target will usually be.  I've not calculated reward to risk ratio here.  You know your set up has a stop/loss of 100 pips, so from this and your 1.5% capital risk you can determine your position size.
  5. Discipline - Follow it rigidly
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.