How To Build Your Trading System
If you are considering improving the trading system you are currently trading or want to find a stocks, options or forex trading system that works for you, then, I will assume that you have moved past the search for the holy grail and trading system secrets.
There are many proven trading systems and methods in the world, but most traders continue to lose money in the markets.
If you are struggling, you should first understand what a system is (what I write about below) and start working on a forex trading system that works for you.
You are worried that you are never going to make money with trading. Moreover, you want to fix the areas where you are losing money.
Improving your trading system is the first obvious step.
Where should you start? In this article, I will show you what you the first steps to develop a forex trading system that works.
What Is A Trading System?
While most traders talk a lot about trading systems, and while everyone knows it is of vital importance, there is usually a lack of clarity about what trading system is.
This lack of clarity is troubling because having a clear understanding of the meaning is important, both to make better decisions and, equally important, to take action on them.
Most basically, a trading system is about a decision. Not any kind of decision, but the decision of big turns in the road; those moments where you have to make decisions whether to go long or short, without having the option of turning back the trades do not turn out the way you hope they will.
Decisions in trading are trade-off decisions, which require us to weigh one option against the other. This trade-off is why making and executing trading systems can turn into overwhelming tasks that often lead to failure.
First and foremost, you need to integrate three keywords into your trading: options, rules, and trade-offs. As I discuss below, doing so allows you to make better decisions on what trades to take, gives you confidence why these trades are the right ones and defining how you should be executing the trades.
Step 1. Decide On The “What”
The first essential step of any decision is to think through potential options. Typically, there are two or more options to choose from to achieve specific objectives.
For instance, when thinking about whether to take a trade, you could decide not to take, wait to take it, or you could take action and open the position.
To choose which option to proceed with, you must have clarity around your objectives, trading goals, or rules. Rules give you a sense of what qualities to look for in a particular option.
As an example, a list of rules might include considerations such as income, job security, satisfaction with the job, time with family.
What makes a decision systematic is not only that the decision is important for you and your situation, but also that no “one” option ticks all the boxes.
Instead, different options will score high on some rules and low on others. If this were not the case, the decision would have been clear. When this one clear decision does not exist, you ultimately need to make trade-offs between different options.
For example, quitting your current job and start trading full-time in a volatile market might provide a high income and excitement, but might be challenging from a security view.
Not quitting your job might be safe, but the thought of continuing the same old routine for years to come without much anticipation for development and salary increase is also daunting.
Moreover, what makes this decision so complicated is that it is a decision—meaning: you can not have both, and, once you have decided on one, you cannot easily revert your decision.
Decisions in trading are similar. For instance, investing in a security involves trade-offs made around expected reward and risk. You cannot choose both low risk and high reward.
When you make decisions, it is important to be clear about the trade-offs they involve. You need to ask and challenge yourself if you have thought broadly enough about potential possibilities.
In trading, you will often find yourself stuck with the decision of only a few opportunities, such as trading only breakouts or reversals, both of which might not seem to be overly attractive at the time.
However, if you take the time to explore, there might be other possibilities available.
On the other hand, you also need to gain clarity around the rules that is important, and you need to understand what is important in the particular context you find yourself.
As an example, right now, are you mostly concerned about income or do you want to spend more time with your family; and, what are the minimum threshold levels that we need to fulfill with regards to other rules to make a decision workable?
To gain more clarity around making decisions, you must ask yourself the following questions:
- How do you evaluate whether a particular option would be beneficial? Which rules are most important to you?
- Did you explore different possible options and clearly lay out all possible decisions you could make?
- Are you open concerning the trade-offs that come with each option? What are you going to gain and give up with each one of them?
Step 2. The “Why”
Making a decision is not the end of the story: if poorly implemented in the way you trade, the system is likely to fail.
While there are many reasons why even well thought-out strategies fail, one important issue is that many traders use a trading system that does not suit them yet convince themselves that they are going to trade it.
The underlying problem is that those traders have not participated in the process around exploring options, rules, and weighing trade-offs.
That is why buying trading signals do not work in the long run. Those traders who buy signals are faced with a made decision, and in most cases, they will not understand the thinking that led to the decision, but they nonetheless try to make money on those signals.
So, traders that buy trading signals are most likely to look at the short-term goal (quick profits) instead of the long-term goal (becoming an independent and professional trader).
As a result, these traders often make decisions that maintain their current state over those that would lead to professional trading results, and, in turn, their trading and profits do not evolve as a trader who goes to the process of building the best trading system for them.
Accepting and closing losing trades can be hard, but if you have a trading system that suits you, then, you are more likely to accept the risk in a trade — even if the trade ultimately turns out to be a loss.
Step 3. Define The “How”
Even if you have made clear decisions about what to do and you have the backtesting on why it is the best decision, it is still no guarantee for successful trading.
In particular, if you are deeply entrenched in a specific way of trading, it is challenging to change how you trade.
Then, it is not sufficient just to define what the new trading strategy is, but you will also need to decide on which actions you should drop.
So, which activities will you drop or not permit anymore as a result of the trading system? For instance, if you decide to shift your focus from focusing on day trading to swing trading, you do not just need to know about swing trading, but you also need to have clarity that it is no longer in your best interest to seek quick trades.
If this not made clear and backed up in your trading system and actions, the default option is to revert to the old approach.
Put differently; a trading system is not just about stating what to do, but equally important about defining what not to do.
Here again, going through the process of marking options, setting up and prioritizing rules, and working out trade-offs of different options enables you to eliminate certain decisions and activities, and to do so in an understandable way, backed up by reason.
Step 4. Build Your Forex Trading System
When you develop your trading system, you need to have one or more strategies with an edge.
What Is A Trading Edge?
An edge is defined as “an advantage over other people.” So you understand that having an edge when trading is important.
Trading is a zero-sum game, those with a trading edge win, and those without one lose.
A trader trading a strategy is just like the casino. There is not a single trading strategy in the world that have a probability of hundred percent.
The best ones have a probability of around 80 percent of getting winning trades.
There are many strategies that are below 50 percent.
The reason you can make money on such strategy is that profits are greater than the losses. Use a risk management strategy to control your losses.
Below you will learn the two thins you need to know to understand the profitability of a trading strategy.
It depends on two factors (a good trading strategy have a value above 1 when you multiply these two factors):
- How many winning trades in relation to losing trades you make.
- How big winning trades is in relation to losing trades.
A trading strategy with an edge can be a system with a win ratio of 50 percent (how many – you win one of every two trades) and winning trades is five times larger than loosing trades (how big – $500 win against $100 loss).
A trading strategy with an edge can be a system with a win ratio of 80 percent (how many – you win four out of five trades) and winning trades is half of loosing trades (how big – $600 win against $1.200 loss).
Simple Trading Rule To Improve Your Edge
A simple trading rule you can use is to only trade in the direction of strong candles. Here’s an example in a candlestick chart:
The green arrows point out strong positive candles. The rule is to look for buy opportunities after these until we get a strong negative candle.
Red arrows point out negative candles, look for short opportunities after these.
You can also use this trick to exit your trades, the first red arrow in the chart above was a clear exit signal if you had long positions.
Next step is to build your system around the conditions necessary to make money.
5 Conditions Necessary To Make Money Trading
- High volatility.
- High volume.
- Low commission.
- Small spread.
- Possibility to go short.
It is important that the security has a high volatility so that you can profit from trading the price moves in the security. If a security has an average daily range of less than one percent if will be hard to make money on it. To make money trading, look for security with a daily range of above 3 percent and trade it with a market timing strategy we teach to profit.
The large volume in a security is a synonym to a large interest and trading activity that make it possible for you to enter (buy or short) and exit (sell or cover) at the price you want.
When you enter and exit the market you pay a charge to your broker, the transaction cost. You want this to be as low as possible because it adds up in the long run.
The spread is the difference between the bid and offer; this should be small so if you make a trade, you do not have to wait for a large price move before you can sell at a profit.
This goes hand in hand with our belief that; you should not chase price but rather become better at market timing with the use of limit orders and a winning trading strategy.
What is shorting a security? It is taking a trade in the opposite direction of buying.
You make money if the price declines so it is a way of making money when others loose.
This is possible in most securities today and it gives you the opportunity to make money not only from rising markets (bull markets) but also declining markets (bear markets).
The importance of a trading system is about choosing what to do and not to do — it is about gaining clarity around rules and options and making informed decisions.
Additionally, it is important to have a convincing “why” to reinforce a sense of confidence when you favored other decisions.
Finally, as you go deeper into the actual execution aspects, you need to clearly state what decision you should make as well as what should not be done (anymore). Otherwise, the default option is often to continue with the old habits.
While there is no guarantee for profits, these words help to focus your thinking on building the best trading system for you: to make well-thought-out trades and to take focused actions.