If you are considering automating your trading strategy, each of these area of the system needs to be well thought out and clearly defined.
But first, I thought I’d do something fun…
You may or may not have seen this video before. It is a Bluegrass song about the essentials of trading. Since this was done by Ed Seykota, one of the pioneers of computerized trading systems, I thought it would be relevant to creating Expert Advisors.
I’m sure you’ve seen other lists of the top trading system characteristics. In this post I want to go over what I think every trading system must have in order to be successful. (Over the next 6 posts, I’ll go into a more in-depth discussion of each of the characteristics).
Top 6 Characteristics Of A Successful Trading System
Time Frame: You can look at your charts from various points of view. You can zero in on recent price action by looking at the lower time frames. Or, you can take a more bird’s eye view of the market from the higher time frames. In a way, which time frame you decide to trade defines both your system and you as a trader.
For example, if you are looking at the lower time frames, you most likely are looking to get in and out of the market very quickly. On the other hand, if you need time to make a decisions and look to take profits off bigger market moves, you’ll most likely be trading off the higher time frames. Think about these questions…
- Are you looking for small pip gains or large pip gains?
- Do you consider your trading strategy to be scalping, intraday or swing trading?
Trend Direction – Direction Bias: I think it is very important to determine the overall trend direction. Your trading strategy can be a trend following strategy, a counter-trend strategy or something in between (like a breakout strategy). But in any case, I believe it is important to know if the market is trending or ranging.
Obviously, trend following strategies trade in the same direction as the trend. Countertrend strategies trade against the overall trend direction. Here are some questions you should answer…
- Will your strategy ignore the trend bias?
- Will it only trade when you have a signal in the trend direction?
- Will it only trade when you have a signal in the opposite direction?
Trade Entry Criteria: This is the characteristic most traders dwell over… when to pull the trigger and get into the trade. I think a lot of traders think if they get this part right, the other characteristics don’t matter. The truth is, while determining when to get into the market is important, it is the combination of all the characteristics together which determines your system’s success or failure.
Without a doubt, most trading systems use the alignment of different indicators as the trade entry criteria. For example… when indicator 1, indicator 2 and indicator 3 are aligned in the same direction, enter the trade. Then the trick becomes to figure out which indicators and settings to use. Here are some questions that need answering…
- Are you going to use price action to trigger your trades?
- Are you going to use indicators to trigger your trades?
- How many elements must line up for you to enter a trade?
- Are you going to have filters in place to keep you out of the market?
Initial Trade Levels (Stop Loss – Take Profit): You should have 2 levels determined before you place the trade. The first level is where to put your stop loss in case the market goes against you. (And yes, I recommend always trading with a stop loss). The second level is where to take profits if the market goes in your favor.
At some point, you need to determine a level where you admit to yourself that the trading decision was wrong, and that is where you need to place your stop. On the other hand, there needs to be a level where you admit you were right, and reward yourself by taking profits. Both these levels are important to your success in terms of profits and mental happiness. Here are some initial questions…
- What is the risk to reward ratio?
- Are you going after short term profits?
- Are you trying to let your profits run?
Money Management – Lot Sizing: Managing your risk is the most important part of trading. Since there is no trading system in existence that wins all the time, you need to manage your risk by having a money management strategy in place. You are going to have losses, and you need to determine beforehand what those losses are going to do to your account.
There are a lot of factors to consider when trying to determine your money management strategy. Think about these questions…
- How much do you want to risk per trade?
- How many trades are you going to take at one time?
- How do you determine the proper lot size to use in accordance with your money management strategy and stop loss used?
- Are you getting greedy? Does the trade size have you biting your nails with fear?
Trade Management 1 and 2: OK, so you’ve placed the trade with the proper lot size and your stops and targets in place. Now what are you going to do? In many respects, what you do after the trade is placed is as important as placing the trade. This about these questions…
- Are you going to let the trade run until it either hits your stop or take profit levels?
- At some point, are you going to move your stop to break-even if the trade goes in your favor?
- Will you be taking out partial profits along the way?
- Is there a point where you will cut the trade, either when in profits or in loss?
As you can see, there is a lot to take into consideration when planning a well thought out trading strategy. Each one of these characteristics must work together, in unison, in order to be successful. The good news is, by clearly defining each of these characteristics, you are well on your way to being able to automate your trading system by building an expert advisor. (I’m sure most of you here are interested in doing just that).
As I mentioned above, I’ll be going over each of these sections in more detail in the coming posts. I’ll even give some examples. Who knows, you might pick up some ideas you can use in your own trading strategy.
Did I leave out any critical ingredients? Let me know in the comments section below.
Read the next article: pick the right time frame for your trading strategy.
In my experience there are at least two other critical elements of a trading system success:
1. A predefined, mathematically sound way to assess the optimal amount to allocate to the system from an overall portfolio level (not only at the system level). This amount should be based on a number of factors including the correlation of the system the other systems as well as its recent performance. This also provide an objective way to know when to retire a system.
2. A predefined money management rule at the portfolio level (which obviously has an impact at the trading system level). This should allow to modulate what percentage of the total account is allocated between the trading systems. The percentage can be based on the overall current drawdown of the overall portfolio. When trading systems work well, a high percentage of the available capital is invested and on the contrary, when market conditions are not in our favor, you gradually take a more conservative approach.
I personally agree and incorporate all the points suggested in the article but believe these two are the ones making the biggest impact on my trading results.
I agree with the points in the article.
“Seb” can you elaborate your points a little bit more from practical perspective.
Regarding point 2 by Seb this is very important especially if you are a counter-trend trader in a now permanently supported QE environment which seems to be only going one way.
In normal conditions I like to find weekly divergences so I can hunt out turning points both shorting and buying. Just dipping my toe into these trades now as the environment does not suit shorting as the markets are much more trending upwards than normal.
I have found that at the moment it is mostly monthly divergences that provide meaningful points especially in shares and indices but these are rare so patience required, you can almost completely discount daily data.
I have always hated daytrading but find myself increasingly drawn to it on the indices using RSI in combination with Bollinger bands and SAR for moves intraday as my normal counter-trend trading on longer time periods has become frustrating to say the least and because I aggressively manage risk increasingly getting stopped out.
Shaun Overton says
The manipulated markets have been a blessing and a curse. The sloshing liquidity makes everyone desperate for yield, but at the same time, they also know they’re playing a dangerous game. It’s hard to play for the long term when you know that “he who sells first, sells best” – but only if the crisis is at hand. Otherwise, you miss the boat repeatedly.
Hi Shaun,this is a good post and I always take note of your comments,one stratergy I am running at the moment is quite simple.I picked Stocks that had declined or increased 10%+ ,I picked 20 stocks in mid Febuary ,I think timing the market was a major factor in my unexpected results of 104% profit so far.I used a 20k account with .50 risk on each trade,if it hit the stoploss I reinvested,no limit on profit.One other factor may play into my profit ,US year of election,something I have to look at.
Shaun Overton says
Thanks, Kieran. 100% profit on 20k sounds pretty darn nice. Well done!