6 Steps to Design a Trading System

Posted by Bigtrends on January 16, 2013 4:53 PM

Design Your Trading System in Six Steps


The main focus of this article is to guide you through the process of developing your system.  While it doesn't take long to come up with a system, it does take some time to extensively test it.  So be patient; in the long run, a good system can potentially make you a lot of money.

Step 1:  Time Frame

The first thing you need to decide when creating your system is what kind of trader you are.

Are you a day trader or a swing trader?  Do you like looking at charts every day, every week, every month, or even 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.  Even though you will still look at multiple time frames, this will be the main time frame you will use when looking for a trade signal.

Step 2:  Find indicators that help identify a new trend.

Since one of our goals is to identify trends as early as possible, we should use indicators that can accomplish this.  As an example, moving averages are one of the most popular indicators that traders use to help them identify a trend.

Specifically, they will use two moving averages (one slow and one fast) and wait until the fast one crosses over or under the slow one.  This is the basis for what's known as a "moving average crossover" system.

In its simplest form, moving average crossovers are the fastest ways to identify new trends.  It is also the easiest way to spot a new trend.

Of course there are many other ways traders' spot trends, but moving averages are one of the easiest to use.

Step 3:  Find indicators that help CONFIRM the trend.

Our second goal for our system is to have the ability to avoid whipsaws, meaning that we don't want to be caught in a "false" trend.  The way we do this is by making sure that when we see a signal for a new trend, we can confirm it by using other indicators.

There are many good indicators for confirming trends, but among the most used are MACD, Stochastic, and RSI.  As you become more familiar with various indicators, you will find ones that you prefer over others, and can incorporate those into your system.

Step 4: Define Your Risk

When developing your system, it is very important that you define how much you are willing to lose on each trade.  Not many people like to talk about losing, but in actuality, a good trader thinks about what he or she could potentially lose BEFORE thinking about how much he or she can win.

The amount you are willing to lose will be different than everyone else.  You have to decide how much room is enough to give your trade some breathing space, but at the same time, not risk too much on one trade.  There is much to think about and learn regarding money management rules.  Money management plays a big role in how much you should risk in a single trade.

Step 5:  Define Entries & Exits

Once you define how much you are willing to lose on a trade, your next step is to find out where you will enter and exit a trade in order to get the most profit.
Some people like to enter as soon as all of their indicators match up and give a good signal, even if the particular candle (or bar) hasn't closed.  Others like to wait until the close of the candle (or time interval).

Some traders believes that it is best to wait until a candle closes before entering.  This is due to the situations where you will be in the middle of a candle and all of the indicators match up, only to find that by the close of the candle, the trade has totally reversed!

It's all really just a matter of trading style.  Some people are more aggressive than others and you will eventually find out what kind of trader you are.
For exits, you have a few different options.  One way is to trail your stop, meaning that if the price moves in your favor by 'X' amount, you move your stop by 'X' amount.

Another way to exit is to have a set target, and exit when the price hits that target.  How you calculate your target is up to you.  Some people choose support and resistance levels as their targets.

Others just choose to go for the same amount of profit on every trade.  However you decide to calculate your target, just make sure you stick with it.  Avoid exiting early (against system rules).  Stick to your system!  After all, YOU developed it!

One more way you can exit is to have a set of criteria that, when met, would signal you to exit.  For example, you could make it a rule that if your indicators happen to reverse to a certain level, you would then exit out of the trade.

Step 6:  Write down your system rules and FOLLOW IT!

This is the most important step of creating your trading system.  You MUST write your trading system rules down and ALWAYS follow it.

Discipline is one of the most important characteristics a trader must have, so you must always remember to stick to your system!  No system will ever work for you if you don't stick to the rules, so remember to be disciplined.

Oh yeah, did we mention you should ALWAYS stick to your rules?

How to Test Your Trading System

The fastest way to test your system is to find a charting software package where you can go back in time and move the chart forward one bar or candle at a time.  When you move your chart forward one candle at a time, you can follow your trading system rules and take your trades accordingly.

Record your trading record, and BE HONEST with yourself!  Record your wins, losses, average win, and average loss.  If you are happy with your results then you can go on to the next stage of testing: trading live on a demo account.

Trade your new system live on a demo account for at least two months.  This will give you a feel for how you can trade your system when the market is moving.  Trust us, it is very different trading live than when you're backtesting.

After two months of trading live on a demo account, you will see if your system can truly stand its ground in the market.  If you are still getting good results, then you can choose to trade your system live on a REAL account.

At this point, you should feel very confident with your system and feel comfortable taking trades with no hesitation.


Courtesy of babypips.com