A trading system is more than just having a rule or set of rules for when to enter and when to exit a trade. It is a comprehensive strategy that takes into account six very important factors, not the least of which is your own personality. In this article, we will cover the general approach to creating a rule-based trading system. (To learn more, check out our Trading Systems Tutorial.)
Step 1: Examine Your Mindset
(A) Know who you are: When trading the markets, your first priority is to take a look at yourself and note your own personality traits. Examine your strengths and your weaknesses, then ask yourself how you might react if you perceive an opportunity or how you might react if your position is threatened. This is also known as a personal SWOT analysis. But do not lie to yourself. If you are not sure how you would act, ask the opinion of someone who knows you well. (To learn more, see Does Your Personality Match Your Trading Methods?)
(B) Match your personality to your trading: Be sure that you are comfortable with the type of trading conditions you will experience in different time frames. For example, if you have determined that you are not the kind of person who likes to go to sleep with open positions in a market that is trading while you sleep, perhaps you should consider day trading so that you can close out your positions before you go home. However, you must then be the kind of person who likes the adrenalin rush of constantly watching the computer throughout the day. Do you enjoy being computer-bound? Are you an addictive or compulsive person? Will you drive yourself crazy watching your positions and become afraid to go to the bathroom in case you miss a tick? If you are not sure, go back and re-audit your personality to be certain. Unless your trading style matches your personality, you will not enjoy what you are doing and you will quickly lose your passion for trading. (For more, see Day Trading: An Introduction.)
(C) Be prepared: Plan your trade so you can trade your plan. Preparation is the mental dry run of your potential trades - a kind of dress rehearsal. By planning your trade in advance, you are setting the ground rules, as well as your limits. If you know what you are looking for and how you plan to act if the market does what you anticipate, you will be able to be objective and stand aside from the fear/greed cycle.
(D) Be objective: Do not become emotionally involved in your trade. It does not matter whether you are wrong or right. What matters, as George Soros says, is that "you make more money when you are right than what you lose when you are wrong." Trading is not about ego, although for most of us it can be disconcerting when we plan a trade, apply our entire logical prowess and then find out that the market does not agree. It is a matter of training yourself to accept that not every trade can be a winning trade, and that you must accept small losses gracefully and move on to the next trade.
(E) Be disciplined: This means that you have to know when to buy and sell. Base your decisions on your pre-planned strategy and stick to it. Sometimes you will cut out of a position only to find that it turns around and would have been profitable had you held on to it. But this is the basis of a very bad habit. Don't ignore your stop losses - you can always get back into a position. You will find it more reassuring to cut out and accept a small loss than to start wishing that your large loss will be recouped when the market rebounds. This would more resemble trading your ego than trading the market.
(F) Be patient: When it comes to trading, patience truly is a virtue. Learn to sit on your hands until the market gets to the point where you have drawn your line in the sand. If it does not get to your entry point, what have you lost? There is always going to be an opportunity to make gains another day. (For tips on patient investing, read Patience Is A Trader's Virtue.)
(G) Have realistic expectations: This means that you won't lose your focus on reality and miraculously expect to turn $1,000 into $1 million 10 trades. What is a realistic expectation? Consider what some of the best fund managers in the world are capable of achieving - perhaps anywhere from 20-50% per annum. Most of them achieve much less than that and are well-paid to do so. Go into trading expecting a realistic rate of return on a consistent basis; if you manage to achieve a growth rate of 20% or better every year, you will be able to outperform many of the professional fund managers. (For more, see Gauge Portfolio Performance By Measuring Returns.)
Step 2: Identify Your Mission and Set Your Goals
(A) With anything in life, if you don't know where you are going, any road will take you there. In terms of investing, this means you must sit down with your calculator and determine what kind of returns you need to reach your financial goals.
(B) Next, you must start to understand how much you need to earn in a trade and how often you will have to trade to achieve your goals. Don't forget to factor in losing trades. This can bring you to the realization that your trading methodology may be in conflict with your goals. Therefore, it is critical to align your methodology with your goals. If you are trading in standard 100,000 lots, your average value of a pip is around $10. So how many pips can you expect to earn per trade? Take your last 20 trades and add up the winners and losers and then determine your profits. Use this to forecast the returns on your current methodology. Once you know this information, you can figure out if you can achieve your goals and whether or not you are being realistic. (To learn more, see How Does Leverage Affect Pip Value?)
Step 3: Ensure You Have Enough Money
(A) Cash is the fuel needed to start trading and without enough cash, your trading will be hampered by a lack of liquidity. But more important, cash is a cushion against losing trades. Without a cushion, you will not be able to withstand a temporary drawdown or be able to give your position enough breathing space while the market moves back and forth with new trends.
(B) Cash cannot come from sources that you need for other important events in your life, such as your savings plan for your children's college education. Cash in trading accounts is "risk" money. Also known as risk capital, this money is an amount that you can afford to lose without affecting your lifestyle. Consider trading money as you would vacation savings. You know that when the vacation is over the money will be spent and you are OK with that. Trading carries a high degree of risk. Treating your trading capital as vacation money does not mean that you are not serious about protecting your capital, rather it means freeing yourself psychologically from the fear of losing so that you can actually make the trades that will be necessary to grow your capital. Again, perform a personal SWOT analysis to be sure the necessary trading positions aren't contrasting with your personality profile.
Step 4: Select a Market That Trades Harmoniously
(A) Pick a currency pair and test it over different time frames. Start with the weekly charts, then proceed to daily, four-hour, two-hour, one-hour, 30-minute, 10-minute and five-minute charts. Try to determine whether the market turns at strategic points most of the time, such as at Fibonacci levels, trendlines or moving averages. This will give you a feeling of how the currency trades in the different time frames.
(B) Set up support and resistance levels in different time frames to see if any of these levels cluster together. For example, the price at 127 Fibonacci extension on the weekly time frame may also be the price at a 1.618 extension off of a daily time frame. Such a cluster would add conviction to the support or resistance at that price point. (To learn more, see Advanced Fibonacci Applications.)
Repeat this exercise with different currencies until you find the currency pair that you feel is the most predictable for your methodology.
(C) Remember, passion is key to trading. The repeated testing of your set-ups requires that you love what you are doing. With enough passion you will learn to accurately gauge the market.
(D) Once you have a currency pair that you feel comfortable with, start reading the news and the comments regarding the particular pair you have selected. Try to determine if the fundamentals are supporting what you believe the chart is telling you. For example, if gold is going up, that would probably be good for the Australian dollar, since gold is a commodity that is generally positively correlated to the Australian dollar. If you think gold is going to go down, then wait for the appropriate time on the chart to short the Aussie. Look for a line of resistance to be the appropriate line in the sand to get timing confirmation before you make the trade.
Step 5: Test Your Methodology for Positive Results
(A) This step is probably what most traders really think of as the most important part of trading: A system that enters and exits trades that are only profitable. No losses - ever. Such a system, if there were one, would make a trader rich beyond his wildest dreams. But the truth is, there is no such system. There are good methodologies and better ones and even very average methods that can all be used to make money. The performance of a trading system is more about the trader than it is about the system. A good driver can get to his destination in virtually any vehicle, but an untrained driver will probably not make it, no matter how great fast the car is. (Sometimes the best system is a mixture of methods. To learn more, read Blending Technical And Fundamental Analysis.)
(B) Having said the above, it is necessary to pick a methodology and implement it many times in different time frames and markets to measure its success rate. Often a system is a successful predictor of the market direction only 55-60% of the time, but with proper risk management, the trader can still make a lot of money employing such a system.
(C) Personally, I like to use a system that has the highest reward to risk, which means that I tend to look for turning points at support and resistance levels because these are the points where it is easiest to identify and quantify the risk. Support is not always strong enough to stop a falling market, nor is resistance always strong enough to turn back an advance in prices. However, a system can be built around the concept of support and resistance to give a trader the edge required to be profitable.
(D) Once you have designed your system, it is important to measure its expectancy or reliability in various conditions and time frames. If it has a positive expectancy (it produces more profitable trades than losing trades) it can be used as a means to time entry and exit in the markets.
Step 6: Measure Your Risk-to-Reward Ratios and Set Your Limits
(A) The first line in the sand to draw is where you would exit your position if the market goes against you. This is where you will place your stop loss.
(B) Calculate the number of pips your stop is away from your entry point. If the stop is 20 pips away from the entry point and you are trading a standard lot, then each pip is worth approximately $10 (if the U.S. dollar is your quote currency). Use a pip calculator if you are trading in cross currencies to make it easy to get the value of a pip.
(C) Calculate the percentage your stop loss would be as a percentage of your trading capital. For example, if you have $1,000 in your trading account, 2% would be $20. Be sure your stop loss is not more than $20 away from your entry point. If 20 pips are equal to $200, then you are too leveraged for your available trading capital. To overcome this, you must reduce your trading size from a standard lot to a mini-lot. One pip in a mini-lot is equal to approximately $1. Therefore, to maintain your 2% risk-to-capital, the maximum loss should be $20, which requires that you trade only one mini-lot. (For more on minis, see Forex Minis Shrink Risk Exposure.)
(D) Now draw a line on your chart where you would want to take profit. Be sure this is at least 40 pips away from your entry point. This will give you a 2:1 profit-to-loss ratio. Since you cannot know for sure if the market will reach this point, be sure to slide your stop to breakeven as soon as the market moves beyond your entry point. At worst, you will scratch your trade and your full capital will be intact.
(E) If you get knocked out on your first attempt, don't despair. Often it is your second entry that will be correct. It is true that "the second mouse gets the cheese." Often the market will bounce off your support if you are buying, or retreat from your resistance if you are selling, and you will enter the trade to test that level to see if the market will trade back to your support or resistance. You can then catch profits the second time around.
By fusing psychology, fundamentals, a trading methodology and risk management, you'll have the tools to select an appropriate currency pair. All that is left to do is repeatedly practice trading until the strategy is ingrained in your psyche. With enough passion and determination, you will become a successful trader. (For more, check out our Forex Trading Guide.)