Trading Systems - Part 1

Trading Systems are simply set of rules that traders use to determine their entry and exit from a position. In an ideal condition, traders should be like machines which have no emotions. But this is an ideal case and there is practically no emotionless human being. Now the question is what stops us from building a machine which trades.

What is a Trading System ?

A trading system is just a strategy which you develop to trade. You might need different trading systems for different markets because the strategy you use to trade in one market may not be applicable to another market. A trading system consists of 8 parts :
1. A Market Filter
2. Set up conditions
3. Time Frame
4. Entry signal
5. Protective Stop
6. Re-entry Strategy
7. Exit Strategy
8. A position sizing algorithm

A Market Filter : 

A market filter is a way of looking at your market to determine whether this market is appropriate for your system. We can have bullish markets, we can bearish markets, we can have flat markets etc. Your trading system might work well only in one of these market conditions. As a result you need a filter to determine whether your trading system should trade in such market conditions.

Set Up Conditions :

This is your screening criteria. For example, if you trade stocks, there would be 10000+ stocks available that you might decide to invest in at a time.As a result, trading systems employ a series of screening criteria to bring this number down to around 100 stocks. You might have a component in trading system to watch the stock to go down for 7 consecutive days before entry. 

Time Frame :

The first thing when you are developing a trading system is to decide what kind of trader you are. Are you a day trader or a swing trader ? Do you look at charts everyday, every week, every month or every year. How long do you want to hold on to your positions ? This will help determine which time frame you will use to trade.Though you still will be looking at multiple time frames, this will be the main time frame you will use when looking for a trade signal.

Entry Signal :

It is signal that tell you when you might enter a position - either long or short. Entry signal depends on entry rules. The simplest way to generate an entry signal is to employ moving average cross over system. The dual moving average crossover (DMAC) is a simple entry rule. If you employ this rule, a 'buy' entry signal is generated when the shorter term moving average crosses the shorter term moving average. Many traders seem to despise such simple procedures and prefer to use more sophisticated rules.

Protective Stop : 

This is one of the most important components of a trading system. This defines the worst case loss that you would want to experience. Your stop might be some value that would keep you in the stock for a long time(e.g. a 25% drop in the price of the stock) or something that will get you out quickly if the market turns against you(e.g. a 25% drop). Without having proper protective stop, your trading system can incur heavy losses. 

Re-entry Strategy :

Quite Often when you get stopped out of a position, the stock will turn around in the direction that favors your old position. When this happens you might have a perfect chance for profits that is not covered by your original set-up and entry conditions. As a result, you need to think about re-entry criteria. When might you want to get back into a closed out position ? Under what conditions would this be feasible and what criteria would trigger your re-entry ?

Exit Strategy : 

Just as we have a rule which generates a signal which tells us when to enter a market, there is a rule which generates a signal which tells us when to exit a market. Sometimes you might have to exit from a winning position and sometimes you might have to exit from a loosing position. In fact in most of the profitable trading systems, only 25 - 30 % of the trades are profitable. This is the most critical part of the trading system. You must spend a great deal of time on exit strategies. For exits, you have different options. You can either trail your stop, or have a set target and exit  when the price hits that target.

Position Sizing Algorithm : 

A position sizing algorithm just tell you 'how much' and 'how big' of a position to take. Position Sizing algorithm is a key factor in whether or not you stay in the game, or whether your gains are huge or minimal. In its simplest form, it boils down to : how many shares to trade, when to increase, when to decrease, when to take profits and so on. 

Advantages of Trading System :

Emotionless :  A trading system takes all emotions out of trading which is often cited as one of the biggest flaws in individual traders. 

Save Time : A trading system saves a lot of time which a trader would spend on analysis. A trading system can even directly place trading orders without the intervention of a trader.

Disadvantages of a Trading System : 

If a trading system would be without any disadvantages, it would be like a money making machine. But this is not the case. Lets look at the other side of the coin.

Complexity : Trading systems are very complex. You require solid technical expertise in the development phase as well as afterwards to make any changes in strategies. 

Transaction Costs : These are the costs incurred when do a transaction through a trading system. These are more than commission costs.

Time consuming in the development phase : It takes a lot of time to develop a trading system. You have to come up with strategies and then code your strategies. While coding you would have to come up with very efficient code since the data that you use to trade can be huge and you have to process the data efficiently. Also you are directly dealing with money, so it needs rigorous testing.