So far in this series of articles on building a trading system, we have defined what a trading system is, why it is so important to have one, and some of the basic elements required in constructing one.
In this week’s article, we want to present some important considerations in the build up to actually selecting elements for, and testing a trading system. We will stick with the theory a little longer, but promise the practical aspects of constructing a trading system, and more importantly testing your system are not far way.
There’s an old saying that ‘you need to know where you’re going so you can figure out how to get there’. Well, this is true for trading systems as well. There is no such thing as a one size fits all approach. A trading system should have a clear set of goals which it is to accomplish, and as the saying goes, this will define the elements of the system.
Obviously, the overall goal of any trading system is to make you money. Sure, but how much risk do you want to take to make that money, in what time frame would you like all of these profits to occur, and what mix would you like – income or capital gains?
Ok, a few of you smarty pants out there just answered ‘None’, ‘as fast as possible’, and ‘both’. But in reality, these are important questions to ask when developing a system. As an analogy, if your objective is to build a birdhouse, then you’ll need a certain set of materials, the right tools, and a well planned methodology. If you try to build your birdhouse with a set of plans for a doghouse, you could end up in one.
A trading system works in the same way. The objectives of a system will define the type data which you will need to gather, what specific fundamental and technical tools will be required to get the job done, and your plan or methodology. Let us focus on these elements a little closer.
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Timing is everything
Before you think about the timeframe over which your system may work, you must first determine how much of your own time you can devote to trading. Are you able to watch the market constantly (in real time), or are you only able to view data a few times a day when decisions can be made? Perhaps your non-trading commitments mean you can only analyse data once a day? Once a week? Your ability to access data and make time to perform the analysis required to make decisions will influence the type of data you need to source, and therefore the timeframe your trading system should be designed to suit.
There’s no point designing a trading system which requires constant attention to real time price data if you can’t possibly be in front of your screen to analyse that data, make a decision, and implement a trade. If you can only spare enough time to do the above once a day, then your trading system should be based around end-of-day data, and trades which therefore last for days or weeks. If you can realistically only do your analysis once a week, then weekly data is the way to go. Don’t be in too much of a hurry, and don’t try and trade in a timeframe which you can’t possibly devote enough time and effort to.
Once you’ve determined a timeframe you can reasonably be expected to commit to, you will find that this requires a specific arsenal of tools to get the job done. For example, analysing end of day data will generally involve you setting trades as ‘limit orders’ or ‘on-stop’ orders, to be executed in the market by remote the following day. Should you be able to watch the market constantly, you may find yourself using ‘market orders’ to enter a trade setup which has just fired based upon intraday data.
Also, some fundamental and technical analysis tools are better suited to different timeframes of trading than others. For example, using a 20-day – 50-day moving average crossover to generate buy and sell signals would more than likely yield you better results on a medium term, end-of-day system than a short term, intraday system. In this case, one would be better off using a 20-minute – 50-minute moving average cross-over.
This realisation that some tools are better for longer term trading, and some are better for shorter term trading, is important for system design. Good system design is all about using the appropriate tools for the job. But, having said this, many of the principles on which indicators and price patterns are based upon can be applied over different timeframes. So that killer candlestick pattern you’ve seen work time and again on a daily chart will more than likely work on an hourly chart, and perhaps even a 15-minute chart. You just have to match the timeframes of the tools you’re using with your ability to perform the analysis.
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I’ve been setup!
Once you’ve determined your timeframe, you can now begin to define your setups. A setup is a series of events which are required to occur before a trade is entered, the prevalence of these events being predictive of the price action which is likely to occur next. A setup defines your edge in the markets: this is what gives your system its positive expectancy (for more on expectancy see MarketPulse article How to Build a Trading System Part 1).
The conditions which we use in our setups can be drawn from any field of analysis, including fundamental analysis and technical analysis. Some traders use even astronomy, but whatever your approach is, the events which occur to define our setups need to be discretely identifiable with no room for discretion. It’s either a setup and all rules are met, or it’s not.
Rather than get into the old Fundamentals versus Technicals argument now (we’ll leave that to another MarketPulse article) we’ll try and keep this discussion as practical and concise as possible and simply focus our attention on technically based setups, that is, setups derived from charts.
Alas, we’ve run out of time in this week’s article and will pick up the discussion with some actual examples of tradeable setups in next week’s MarketPulse.