Trading Systems: Designing Your System - Part 2
  1. Trading Systems: Introduction
  2. Trading Systems: What Is A Trading System?
  3. Trading Systems: Designing Your System - Part 1
  4. Trading Systems: Designing Your System - Part 2
  5. Trading Systems: Constructing A System
  6. Trading Systems: Troubleshooting And Optimization
  7. Trading Systems: Conclusion

Trading Systems: Designing Your System - Part 2


The preceding section on designing a trading system examines the different types of markets in which to trade, and takes a look at the two basic genres of trading systems: trend-following and countertrend systems. These two strategies form the foundation on which all trading systems are built, and the markets provide the medium. In this second section on designing a trading system, we break down the two genres into individual components, examine the empirical decision-making process and, finally, take a look at how software has revolutionized system trading.

Basic Trading System Components
As mentioned in the introduction, trading systems are constructed using parameters - the groups of specific rules that generate entry and exit points for any given equity. Both trend-following and countertrend trading systems adhere to four basic principles that govern the construction of any trading system. These principles are also the essential characteristics of an effective system:

  • The system must make money - This is easy to say, but hard to do. Maximizing the percent return should be your primary objective while designing a trading system.

  • The system must be able to limit risks - It's difficult to use a system that fluctuates between extreme highs and lows; not only does it inhibit your ability to liquidate, but it can also be psychologically taxing. Furthermore, by limiting risks, you are able to decrease the effect of a "bad entry" (for example, going long during a downward fluctuation).

  • The system's parameters must be stable and feasible - Trading systems cannot rely on coincidence or luck! The system designer can fulfill this principle of stability by broadening the parameters and not optimizing too much in an effort to increase his or her chances of success. The feasibility of parameters, including 'slippage', is discussed in the second section of this tutorial. Again, it is very important to take slippage into account when designing a system.

  • The system's timeframe must be stable and feasible - For a system's timeframe to be successful, coincidence and luck should not play a factor. Feasibility must also be considered in this instance. If timeframes are set too close together, the resulting amount of trading frequency may not be possible due to software limitations and/or market-side limitations.

Empirical Decision Making
A trading system requires the designer to make some empirical decisions that directly affect the system's performance - if there was no need for this decision making, everyone would be rich. Here are some basic factors that system designers must decide on and some guidelines:
  • What time period should I use? All equities can be analyzed from multiple perspectives of time periods, ranging from one minute to one decade (or more). Deciding which time period to test can drastically affect the performance of the system. More reliable results generally come from longer time periods, while short periods can be misleading when judging real market conditions. However, this does not mean that only extremely long price periods should be used. It is important to keep in mind that the longer the time period, the longer it may take for profit to be realized. Observe the following example of Microsoft's long term, a period of more than 20 years, compared to its short term, a period of a few weeks:





We can clearly see that the short term is not an accurate representation of the long term, and vice versa. As a general rule of thumb, five to 10 years is a good target for medium- to long-term system traders, and six months to five years is a reasonable range for short-term traders. Again, it depends on when you plan to liquidate.

  • What price series should I use? Most equities are charted on an unbroken price series - that is, the charts are continuous. When trading futures and some other equities, however, there is an option to use actual contract data instead of continuity. Futures contracts themselves only last a few months, and system backtesting often requires a year or more of data; therefore, system traders often utilize continuous futures, which are a series of contracts combined to create a continuous stream of data. As a general rule of thumb, long-term traders should stick to continuous futures, while short-term traders should use actual contract data.

  • What parameters and settings should I use? We explore this further in subsequent sections that address the construction of a trading system. Basically, parameters are selected by "guessing-and-checking," or producing "blind" simulations, or presetting a group of parameters, and then using the average to determine performance.

    Again, many of these factors can be influenced by desired liquidity, time until liquidation, risk and a multitude of other factors, so it is important to take the time to decide which works best for you.
Software and System Trading
The evolution of the computer is perhaps the greatest driving force behind system trading. Originally, computers were just used to crunch the numbers; eventually they acquired the capacity to conduct simulations, generate signals in real-time, and even place trades for the trader! Some software is designed simply as a platform from which a system developer can build a system; other software uses neural networks to "learn" from the markets and enhance itself. Some software is installed on the user's hard drive; other software is provided only online. Here are a few of the basic programs used by system developers:



Client-Side Software
Client-side software must be installed on the user's computer. It is often connected to the internet and is able to obtain real-time data (including prices, news, etc.). Note: some companies charge you not only for the software, but also for the data. These applications typically allow the user to specify the time period, types of parameters, and more. One of the most crucial features, however, gives the user the ability to program a system. This is done using a simple programming language (often specific to the application used) with which you can set up rules to generate buy and sell signals - these then appear directly on the chart. Here is an example of a client-side application called MetaTrader:



Server-Side Software
Server-side software is installed on a remote server. Often, these applications return signals that are displayed to the public by means of a webpage (or a subscriber base). This eliminates the need for any client-side software other than a web browser. Furthermore, the user pays a small subscription fee as opposed to buying a program and paying for a data subscription. Finally, the user does not have to develop the system, only receive generated signals. But you should remember that this kind of software is often susceptible to scams, while the client-side software is not. (For more on this, see Trading Systems Coding.)

Conclusion
Now you have a basic understanding of trading systems: you know what they are, the different types of systems that exist, the factors to keep in mind while designing them, and the software used to make system trading easier on you. Next, we will examine how to actually construct a trading system and put it into use!
Trading Systems: Constructing A System

  1. Trading Systems: Introduction
  2. Trading Systems: What Is A Trading System?
  3. Trading Systems: Designing Your System - Part 1
  4. Trading Systems: Designing Your System - Part 2
  5. Trading Systems: Constructing A System
  6. Trading Systems: Troubleshooting And Optimization
  7. Trading Systems: Conclusion
RELATED TERMS
  1. Financial System

    A financial system can be defined at the global, regional or ...
  2. Alternative Trading System - ATS

    A trading system that is not regulated as an exchange, but is ...
  3. Forex System Trading

    A method of trading forex that is based on a series of analyses ...
  4. Currency Day Trading System

    A set of analyses that the forex day trader uses to determine ...
  5. Mixed Economic System

    An economic system that features characteristics of both capitalism ...
  6. Forex Signal System

    A set of analyses that a forex trader uses to determine whether ...
RELATED FAQS
  1. What is the difference between a capitalist system and a free market system?

    Learn about capitalist and free market systems, how these economic systems function and the main difference between capitalism ... Read Answer >>
  2. How do I pick the best method for forex system trading?

    Discover how to identify the best type of forex system trading style for you based on your available time, your trading preferences ... Read Answer >>
  3. How do I implement a Forex Signal System into a forex trading strategy?

    Learn how traders use different types of forex signal systems such as trend-based or range-based to create or supplement ... Read Answer >>
  4. How does portfolio management software work?

    Discover the functions of various complexity levels of portfolio management software, and learn how traders utilize portfolio ... Read Answer >>
  5. What is the difference between systemic risk and systematic risk?

    Systemic risk is generally used in reference to an event that can trigger a collapse in a certain industry or economy, whereas ... Read Answer >>
  6. What are the most important aspects of a capitalist system?

    Understand the main aspects of a capitalist system and how they contrast with the tenets of other types of economic systems, ... Read Answer >>

You May Also Like

Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center