 A solid trading system is one of the basic elements needed for a successful trade. It makes you plan ahead before entering a trade with its clearly defined rules so that you don’t let emotions get the best of you during crucial moments. This leaves us to ask the question: What are the ingredients of trading systems that work? Right Level of Complexity Trading systems generally have to have the right level of complexity in its logic. In short, it should not be too simple or too complex. Let’s face it, the market in itself, has complex relationships and movers that drives its price movements. If the trading system is too simple, it might not react adequately to cover market’s complexities. On the other hand, if the system is too complex, the trader may have a hard time implementing it or the trading system could be overly sensitive to little market changes and noises. Clearly Defined Rules An excellent trading system has to have a set of clearly defined rules especially on entry and exit points. Entry points and whether you’re going to take on a buy or sell position are based on a signal. For example, in a support & resistance trading strategy, the entry rules are set at support and resistance levels of a stock. So, based on clearly defined rules of this strategy, you can set a limit order for a long position on support and short position on resistance. As for exit points, closing position may be triggered by any or combination of these: holding time, stop loss, profit target and trailing stop. ● Holding time – it may be that you are running out of time so you have to close your position or place a market on close order. ● Stop loss – every trading system has to have a clearly defined stop loss as part of risk and money management. Say, in a support and resistance trading system, you wish to protect yourself from getting caught in real breakouts, so you may set your stop loss at 5 cents from your last fill or whichever works best during backtesting. ● Profit Target – the price of the stock may have hit your profit target, prompting you to close your position at a profit. ● Trailing Stop – if you believe that the price can go further in your favor, you can set a trailing stop exit so that you can take advantage of the price movement and at the same time, protect the profit that you already earned. One or two indicators can be used to interpret and validate chart data. In the example given above, Slow Stochastics and RSI may be used as indicators in identifying support and resistance levels. Ample Testing Everything works well in theory; however, it is during backtesting where the rules of the trading system are tested. For backtesting purposes, historical data has to be used for a more credible testing. Each element of the rules has to be individually tested. For example, the stop loss has to be set at different levels, with all other elements remaining constant, to arrive at an optimized stop loss level. Same testing has to be done for other elements like entry points, profit target, and trailing stop. Validated The trading system that can give consistent results over the long term is the system that has been validated. It’s not enough that the system has been subjected to backtesting. It’s not enough that the system has been proven to work using in-sample data. More importantly, the system has to be validated using data that have not been used during testing or out-of –sample data. It has to work in different market conditions. Caveats Sometimes, a trading system has to have some caveats for it to work efficiently. For example, news is one of the most powerful driving forces in a stock’s price movement. That’s why some trading system’s caveat is major news update that could impact a stock’s price. Trending stocks could also be a caveat for support and resistance strategy. These are the ingredient of a trading system that work. However, what is most important is the trader who will implement and execute the system. A trading system, for all the importance it plays in successful trading, is still a tool. And tools are only as good as the artist who’s using it. comments powered by Disqus |
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