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.