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  1. Trading Systems: Introduction
  2. Trading Systems: What Is A Trading System?
  3. Trading Systems: Different Markets and Types
  4. Trading Systems: Components of a Trading System
  5. Trading Systems: Building a Trading System
  6. Trading Systems: Other Considerations

You should now be familiar with some common elements that make up a trading system, as well as the advantages and disadvantages of using them. Let's build upon that knowledge in this section to examine what markets are well-suited to trading systems and then take a more-in-depth look at the different genres of trading systems.

What Markets Work Best?

Trading systems work best in markets that are statistically predictable with high levels of liquidity and low costs. While many traders are aware of the first requirement, relatively few appreciate that costs play an important role in success. Low costs - including commissions, spreads, and slippage - yield more opportunities and greater profits.

Equity Markets

The equity market is the most well-known among retail investors familiar with blue chip companies. While long-term prices are driven by institutional investors, short-term price action is dominated by automated trading and day traders.

There are several important factors to keep in mind:

  • Diversity. There are many different types of equities with very different characteristics, from stable blue-chip stocks to volatile over-the-counter stocks. This yields many opportunities for traders using strategies like statistical arbitrage.
  • Commissions. Commissions are relatively low for most large equities, but they can eat into profitability over time. Traders should be aware of the effects of commissions, slippage, spreads, and other factors when building trading systems.
  • Focus. Many equity trading systems are focused on value-based parameters, such as those that identify undervalued securities compared to its past performance, peers, or the general market, as well as statistical arbitrage.

Forex Markets

The foreign exchange, or forex, market is the largest and most liquid market in the world. Between governments, banks, and institutional investors, trillions of dollars are traded on the forex market each day, which is a major draw for traders using trading systems.

There are several important factors to keep in mind:

  • Liquidity. The forex market has greater liquidity than any other major market due to the large transaction volume. This makes the market very attractive to traders since they can easily scale their trading systems to larger dollar amounts.
  • Costs. Forex traders don't have to pay a commission, in most cases, but there are spreads to consider. Traders should consider the spreads in various currency pairs and consider trading those with the tightest spreads to minimize cost.
  • Limited Options. There are fewer currency pairs than equities, which means that there may be fewer opportunities for traders. Exotic currency pairs provide additional options, but they tend to be a lot riskier than established pairs.

Futures Markets

Futures markets are popular among traders due to their high levels of liquidity and number of options. In addition, futures markets permit higher levels of margin, or leverage, than many other markets, which opens the door to greater earning potential.

There are several important factors to keep in mind:

  • Costs. Commission costs and spreads tend to be lower for futures than equities, which translates to greater profitability for traders developing trading systems.
  • Options. There are more futures contracts than currency pairs, which means more opportunities for traders, but equities are still the most diverse pool.
  • Leverage. Leverage can be used to amplify gains, but traders should keep in mind that it's a double-edged sword that can also amplify losses.

What Market is Best?

The best market depends on your trading style and individual preferences. For example, traders focused on trend following systems may want to consider the forex market since it tends to trend a lot more than other markets; those interested in leveraging fundamental analysis in their trading systems may be limited to equities; and, those looking for the greatest leverage may want to consider the futures market.

Types of Trading Systems

There are many different types of trading systems and deciding on the right type of system depends largely on your own preferences.

Statistical Arbitrage

Statistical arbitrage trading systems are among the most popular among quantitative traders. These trading systems are often built using programming languages like MATLABĀ®, R, or Python and leverage platforms like Quantopian or QuantConnect to manage trading activity. But, they can be as simple as Microsoft Excel with historical data or as complex as a custom-coded application that interfaces with exchanges.

Technical Analysis

Technical analysis-driven trading systems are popular among retail investors that are looking to automate their existing strategies. Often times, these trading systems are built using software provided by brokers, such as MetaTrader or TradeStation. These platforms have their own proprietary programming languages that can be used to build strategies, but these strategies are often limited to technical indicators.

Technical strategies can be broken down into two categories:

  • Trend Following Systems. The most common technical trading systems utilize trend following methods. In its most fundamental form, this system simply waits for a significant price movement and then buys or sells in that direction. The downside of these trading systems is that empirical decision-making is required, lagging indicators are required, there may be whipsaw effects, and sideways markets may eliminate any opportunities for a prolonged period of time.
  • Countertrend Systems. Countertrend systems are designed to buy at the lowest low and sell at the highest high. The biggest difference between countertrend and trend following systems is that countertrend systems are not self-correcting. In other words, there is no set time to exit positions and there's unlimited downside potential.

Other Trading Systems

There are also many other types of trading systems focused on more advanced strategies, such as neural networks or machine learning. While these trading systems are beyond the scope of this tutorial, there are many new open source technologies being developed that have democratized these advanced concepts, such as Google's TensorFlow. But, neural networks and machine learnings are by no means a silver bullet to profitability.

Coming Up

In the next section, we will take a look at the major components of a trading system.

Trading Systems: Components of a Trading System
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