April 23, 2020

Trading System: Basic building blocks to make one

By equrve

A Trading System is not only what helps you to trade but it is your entire process of trading. A proper system should be so well defined, that nothing is left in the grey area of doubt. A good mechanical trading system should be such that if you hand it over to someone and they can execute it same as yourself.

A trading system is checklist.
A trading system should be like a to do or a checklist

Building Blocks of a trading system

Basic minimum requirement for a Trading System are the following:

  1. Setup
  2. Entry
  3. Risk Management
  4. Position Sizing
  5. Exit

Most people pay a lot of attention to entries but completely ignore the rest of the factors. The rest are as important if not more to be a successful trader.

  1. Setup – This is a trigger that tells you stock or commodity has aligned in a particular manner for your entry to be in place. Lot of people mistake setups for entries or sometimes do not have setups. Without setups we will me making entries and exits in the market all the time and have a lot of whipsaws.
  2. Entry – Entry is a condition on which we actually enter the stock or future, buy for long and sell for short.
  3. Risk Management – One of the most important aspects of trading which defines how big loss you are willing to take. This ends up defining a lot of other factors like how much profit you can expect? How can can you stay in market without getting wiped out? Anyone who goes bankrupt in trading will go because risk is what they did not respect
  4. Position Sizing: Related to risk, position sizing defines the quantity or volume that we are going trade. There are many methods to calculate this depending on risk.
  5. Exit: One of the least talked about but one of the most important factors in trading when and how do we exit. Remember its the exit that makes us win or lose money not the entries.

Before you start trading, you need a well documented set of rules. If trading is a hobby it really does not matter what is done. It is the time that is spent on building the system that ultimately bears fruits when actual trading begins.

Who needs a trading system

Very few traders actually spend time to sit down and properly define their trading system. One must write down the exact rules of a system and consult it before taking every decision of trading. Mechanical Trading is impossible without a proper set of well defined written down rules.

Even if someone is a discretionary trader, they need a system which can bring them to the point of their decision. Entry and exits can be based on discretion, but there has to be certain rules that bring a trader to the point of taking these decisions.

Personality and the system

Traders personality should be aligned with his/her trading system. For example: If someone believes that expensive things are better they might be more suited to buying on breakout, while someone who prefers buying things on discount may be more suited to buying on dips. Aligning your personality to the trading system is very important otherwise it becomes very difficult to trade. It will be like fighting your own personality. Like someone who likes buying discounts if buys on breakout, will be in constant fear that he has purchased at a very high price, and inversely someone who likes buying expensive, if buys a dip might live with a fear that he has bought when the down move has started.

Next Steps

So to start the journey, understand yourself, checkout a few online systems or make your own. Trade small with them to find what you are more confident with and refine, backtest and you have a winning system in your hand. Read out other articles to understand and make your own system.