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Trading System
A trading system is a specific set of
rules for trading stocks, options, futures, mutual funds, or
other trading vehicles. It tells you what to buy, when to buy,
and when to sell.
Trading systems generally consist of two major
components:
- A market timing component:
Generates trading signals that tell you whether to go long
or short, or to stay in cash. Signals are generally
generated based on a set of rules pertaining to various
technical indicators, critical support and resistance
levels, and other factors;
- Ancillary components: A set of
further rules to define what to trade, what stop loss
strategy to apply, how long to remain in a position, what
profit you expect to take from a trade, what losses are you
comfortable with.
Building a trading system is a
multi-step process that typically involves the following stages:
- Defining your
Trading Style: Many traders use their own specific
trading styles. Some make several trades per day, some only
a few over the course of several months. Some trade only a
single category of options (such as on the QQQQ) or focus on
a few equities while others tend to diversify. Traders
playing mutual funds are restricted to trading during bull
markets. Defining your personal trading parameters allows
you to be more selective in choosing a trading system
appropriate for you;
- Building a
Model: Select the technical indicators to be included in
the system. These might include parameters used to determine
future market trends. Research these indicators. For each
parameter, determine critical levels that may be applied to
generate trading signals (to enter and exit positions). The
signal frequency of your system should match your trading
style: Contrast a system that generates 1 - 5 signals per
day with one that produces only a single signal per month;
- Back-Testing:
Each trading model should be back-tested in order to
assess its probable risk. This step assists in defining an
appropriate stop-loss strategy. It also allows you to adjust
each technical indicator’s critical level, again to minimize
your trading risk;
- Adjusting:
After back-testing, every new trading system or model
requires some adjustments – in some cases even a complete
rebuild. Every adjustment in turn necessitates additional
back-testing. This process ensures that fine-tuning a system
actually lead to tangible improvements;
- Paper Trading:
Once a trading system has been built, paper trade it to
evaluate how well it performs under actual market
conditions;
- Auto-Trading:
If you are satisfied with the paper-trading results, you
are ready to auto-trade the new system. This requires a
broker (and a trading platform) that permits the placement
of auto-trades – based on the signals generated by the
system. Initially investing only a small part of your
portfolio into a newly built trading system is good risk
management;
- Monitoring:
Trading systems require more or less constant
monitoring. Depending on the technical indicators
incorporated, further adjustments may be required. The
market is in constant flux - critical levels that were
appropriate a year ago may now be too risky or too
conservative.
As you can see, building a trading system
is a complicated, time-consuming process that requires constant
monitoring and that may involve frequent fine-tuning. Not nearly
everyone who wishes to trade has the time nor the inclination to
go through the steps outlined above. For most, using a
professional trading advisory service that generates its own
in-house trading signals (based on a mechanical trading system)
is a much better solution.
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Past 13 Months |
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23%
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11%
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QQQ |
QQQ
Buy & Hold |
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as of
02/04/2012 |
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