What is a Trading System?
A trading system is basically a trading plan with a set of rules that define the entry and exit conditions to go in and out of the market. Having a trading system with clear trading rules is like having a roadmap with directions that you must follow. If you plan your journey (trading system) right and follow the instructions correctly you will safely reach your (financial) destination.
There is no limitation to the approach you can take in order to obtain the set of rules that construct your trading system. Some trading systems are based on fundamental analysis, some on technical. What is important in any case is that the conditions of the system must be clear and unambiguous.
Quite often beginner analysts find trading systems that seem extremely profitable and easy to follow. They look so simply, that the junior analysts wonder how they could possibly be overlooked by the professionals. Most often there is a particular reason why a method is not used. As beginners learn more about trading, they find that there are not so obvious factors that make a system look good on paper but is doomed to fail in real trading. For example, the execution might be difficult, the risk is much higher than initially expected, or that the system has too many losses in a row.
It does not mean automatically that simple systems do not work. But rather that each system must be put through a series of tests and prove itself robust before it is selected to go live. As you saw there are different trading methods and approaches. Each of them has its own specifics and risk to reward profile. It is up to the trader to gain enough knowledge and understand the true cost of trading.
With the rise of computing power mathematical modeling, regression or statistical analysis, have become quote popular inspiration for creating systems to for predicting the price direction. Most of these modeling methods are applications of econometrics and basic probability and statistical theory. This approach is precise because it is based entirely on numerical data. However, these predictions still need trading rules to make them operational trading systems.
How does a trading system look like?
A trading system does not have to be complex. There are simple trading systems that follow just a couple of rules that prove to be quite successful. Experienced traders say that if your trading system is too complex to be explained, then most probably you don not follow a system at all. Every good trading system must have three clearly defined components – a trading signal, an entry, and an exit rule.
Trading signal
The trading signal is the “When?” of your trading system. This is the initial condition that must be met in order to initiate a further action. For example:
When a 50-period Moving Average crosses above a 200-period Moving Average, you have a bullish trading signal and you should prepare to open a long position.
Entry rule
The second component in a trading system is the entry rule. If the trading signal is the “When?”, then the entry rule is the “How?” of your trading system. The entry rule describes the way your system enters a trade. This can be a direct entry condition – a market order, or an entry conditional entry – a pending order. For example:
If you have bullish trading signal, you place a market order
or
When you have a bullish trading signal, you place a pending buy limit order at the lowest low level for the last 3 weeks.
Exit rule
The last component in your trading system an exit rule. These is the condition or the conditions which trigger an exit signal and tell you that you must close your trade. Like the entry rule the exit can be with a market or a pending order. For example:
When you get an exit signal, you close your position at the current market price
Or
You exit your trade if your take profit or stop loss levels are reached.
Developing a trading system
There are two basic factors you should focus on when creating a trading system:
• Learn to recognize recurring patterns in historical data and quantify the results of the most likely outcomes of such patterns. If you want to be successful in trading, you should build a trading system that detects when these repetitive patterns occur and take advantage of them.
• Understand the different types of price movement regimes and be able to determine the current state of the market. The proper assessment of the current market regime is critical to most trading systems. The prices can be moving in trends, ranges or consolidations. The first thing a systematic trader should learn is to clearly distinguish what is the current market regime. Regardless if you are using a trend following or a mean reversion counter-trending system it is equally important to know if there is a trend at this time or not.
Which is the best trading approach for beginners?
The best approach for people who are new to trading is is to focus on trading systems based on technical analysis.
Technical analysis is a methodology for forecasting the direction of prices by studying historical market data. As you saw in our previous article – Introduction to Quantitative Finance Part 02: Technical analysis, algorithmic, automated and quant trading – there are many approaches in technical analysis. Some trading systems are based on technical indicators, others on mathematical and statistical methods and there are ones that combine elements from both.
Why technical analysis is the best approach for beginners?
Technical analysis is the best approach for beginners, because the the necessary tools to start are easily available. Most retail trading platforms have a module showing historical price data that can be used for plotting charts. The most popular trading platforms like MetaTrader 4, MetaTrader 5, Trade Station, Ninja Trader also have scripting languages that are easy to learn even by non-technical users. This way the implementation of the trading system does not solely depend on the programming skills of the analyst. On the side, for the technical user, popular programming languages like Python have a huge variety of specialized libraries with technical indicators and functions that are ready to use.
This article is a part of a series on quantitative finance developed by “Quantitative Strategies Academy” Foundation according to its mission for the benefit of people who want to know more about quantitative analysis and automated systems.
Sources:
1) Trading systems and methods, book by Perry J. Kaufman
2) Wikipedia
3) Investopedia
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