If I Were to Develop a Trading System Today .....

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Numerous books, websites, and “trading gurus” [correctly] prophesize the relationship between trading profits and trading plans. Although they all clearly and eloquently list the ingredients of a trading system: Risk Management, Exit, Entry, etc., there is no article that this author is aware of which talks about HOW (i.e., the process) to develop a system and the areas where one should focus when performing ORIGINAL research or where existing indicators might fit within the grand scheme of things.

 

This article is an attempt to fill that void. The author wishes he had access to such an article when he was a noob many many years ago. For a seasoned trader, everything in this article will be obvious, for she has internalized all these steps. However, for those struggling traders and noobs, this information might be beneficial.

 

Note: To this author, a trading “system” or a trading “plan” are synonymous. Hence the words “plan” and “system” will be used interchangeably.

 

Bias: We are all speculators. Unlike hedgers, our reason to engage with the market is based on our opinion of the market -- for outright traders it is our opinion on market direction; for options traders it could be market direction or lack there of, or volatility; for spreaders it is the direction of the spreads. Our opinion or bias can be derived from fundamental analysis, technical analysis or a hybrid of both.

 

Note: The definition of technical analysis is debatable with the “holier than thou” quants insisting that mathematical models based on price-action and/or volume are NOT technical analysis. However, according to this author, anything that is not fundamental analysis IS technical analysis and that is the definition used in this article. This author practices technical analysis as per the above definition even though he uses mathematical models based on hetrodox economic theory.

 

All trades should be motivated by a trader’s bias. Hence, the first order of business when developing a trading plan is to objectively measure a trader’s market bias. Numerous indicators exist that provide a basis for a trader to establish her bias. Should the trader not be happy with any existing indicator, then the trader should develop indicators to objectively measure her market bias.

 

The identification of Bias can be dynamic (i.e., identified as the market evolves) or static (i.e, based on previous price action). The complexity increases as one moves from static to dynamic identification.

 

Practical Note for noob: The old trading adage “Trend is your friend” is very true. However, should you decide to engage in original research, don’t limit yourself to identification of “trend”. This author trades outrights based on the author’s bias on price volatility and volume distribution.

 

Stop, and Exit: Once you have identified your market bias, you need to identify the following:

1. Stop area;
   
   
2. Exit Criteria;
   
   

 

The easiest of these areas to identify is the Stop area, yet many noobs and poorly capitalized traders choose a “bad” stop area only to see their other wise good trade prematurely stopped out. The key to selecting a “good” Stop area is to select a support/resistance that is properly formed and is visible to a higher time frame. A noob should reread the previous sentence and reflect on it: think why that is important. Such a selection of Stop area would allow for a smaller position size than a trader would want but it will prevent premature exits. As a trader gains experience in understanding market dynamics, she will seldom let price reach the Stop area.

 

The identification of Exit Criteria defines you as a trader. This is the reason why one finds numerous articles and books on entries and not much information on exits. Research exits based on your tolerance and personality. You will note that the author has mentioned Exits not as a “area” but as a “criteria” (unlike entry and stops which are “areas”), and the author has used plural (criteria) instead of singular (criterion). The noob would be wise to spend a lot of his time researching exit criteria.

 

Risk Management:

Numerous good books and articles are available on risk management. So the author will not rehash the same information here. However, this author suggests the following methodology for risk management:

 

1. Identify the amount of capital you want to risk per trade, x% (usually all good risk management books tell you a percentage between 1 and 3. It is up to the trader but understanding the reasoning, based on principles of probability, for suggesting such risk capital is vital);
   
   
2. Fix the position size you want to trade (as a noob,
   do not
   calculate position size based on entry price and stop area. Always fix your position size up front).
   
   
3. Based on the Stop Area calculate your Entry Area.
   
   

 

Entry Area:

Entry areas are NOT entry “setups”. This is the area where a trader should contemplate an entry should price reach this point/area. Too many noobs spend inordinate amount of time exploring entry “setups” without understanding when those “setups” might work.

 

If, based on the market dynamics, the trader expects to get an entry better than the entry at Entry Area, she might at her discretion do so. Doing so will not only requires experience in understanding market dynamics but also lower the risk per trade.

 

According to this author, there are three take aways about entry:

 

1. Only enter trades in concert with one’s market Bias;
   
   
2. Patiently wait for price to approach the Entry Area;
   
   
3. Do not spend time researching entry “setups”.
   
   

 

Note on Trade Management:

 

All the books a trader might have studied and the countless hours she might have spent in front of the screen to understand market dynamics should be used NOT to come up with an entry “set up” but to manage the trade once entered.

 

Most of the time, if the entry is aligned with one’s market bias, and if such market bias is the view held by majority, the trade will work. When that happens the trader might take some heat, but the trade will eventually be a winner. However, there will be times when one’s market bias is not the view held by majority or the market bias changes due to changes in market conditions. These are the times when one will have to manage one’s trade. A trader will not know before hand of such changes, but as a noob gains experience in gauging market dynamics she will be able to detect such changes.

 

Note on Trading Psychology:

 

Do not fall for the hyperbole that “fear” stifles traders and hence it requires consultations with Trading Coaches/Psychologists. Trading coaches who advertise based on such “fear” are not being forthright.

 

Fear of trading can arise due to a lack of confidence in the trading system. Such fear can only be mitigated if one makes the trading system her “own”. The only way to do it is to UNDERSTAND one’s trading system -- why it works, when it is expected to fail, etc. The easiest way to understand YOUR trading system is for YOU to build or re-build it!!!! No psychologist can help a trader here.

 

Fear of trading can also arise due to the human tendency of risk aversion. As humans we are very bad in making decisions under uncertainty (assessing probabilities) and make very predictable mistakes. A way to overcome this fear is understand the theory of probability and decision making under uncertainty. There are a lot of books on this topic which might be of help (look up the works of Tversky & Kahneman; the author found the books by Mark Douglas insightful. The author has no affiliations with any of the mentioned authors). If you needs help in this area, you should seek help but before you do so please ask yourself if you REALLY want to be a trader. Trading is NOT for everyone.

 

Final Note:

 

Once a trading system is found to have a positive expectation based on backtests, the trader using that system must become an execution machine: for the edge in that system is only as good as the trader’s discipline to execute that plan. Even better, a trader should strive to automate her system if possible.

 

 

Short Summary:

 

If the author were to start all over again with the knowledge he has gathered over time, he will conduct original research or use existing indicators to:

 

1. Measure Bias;
   
   
2. Devise Exit Criteria; and
   
   
3. Understand market dynamics so as to manage trades better.
   
   

 

He wouldn’t have spent ages trying to come up with the “best” entry setup or trying to understand market dynamics to get a “good” entry.

 

“Learn all you can from the mistakes of others.* You won't have time to make them all yourself.”

* ~Alfred Sheinwold

 

Good trading!

 

-MadSpeculator.

Edited August 1, 2012 by madspeculator