System development for dummies

I’m a newbie myself. So this document is basically a way to help myself(!) recognize all the factors that I should implement to build a successful system. (which I did 18 months ago and its not for sale!)

A trading system should have following clear details:

Money Management and Scaling details
What is money management? Is it just a compounding table using 2% of capital on each trade? Certainly not. In fact in college there are whole semesters and courses dedicated to this subject of “Portfolio Management”
Stop loss, pyramiding, target projection… risk to reward ratio all kind of big words. A retail trader however don’t have the advantages of a hedge fund. It’s a one man show business.

A trading system thus include only:

1. Maximum Risk on portfolio
2. Scaling out option to breakeven within minimum risk barriers
3. Pyramiding options (adding to winning position) to maximize profit potential.
4. Target projection and Risk to Reward projection on initial position
5. Compounding option based on actual trading system’s win ratio prospect.

Psychology and Drawdown Maneuvering
Trading is hard… only if too much of your money is on the line. Do you feel stress trading a demo account? If you do then you need to consult with a shrink or work your vertigo around. Trading with real money is stressful only because of the risk variables, when defined, are too large for the account. Trading psychology is nothing but management of that “too large risk” and the opposite of it “Too large profit prospect”

I’m not going to use two words that most people use to define these: 1) Fear and 2) Greed.

Make a sound money management plan. Define your risks and make sure you obey your risk potential and profit prospect. That means trading on hourly chart won’t give you 100 pips profit every hour nor having a 300 pips stop loss for a 100 pips target means all of your trades will hit target. Don’t think how much you are losing or making. Think in percentile. Because today’s 2% gain might be $2 USD ONLY but after 2 years 2% gain might be $2000 USD!

The Trading Strategy (itself!)

Commodity trading, regardless of what instrument you are using has few basic function.

1. Direction of the movement.
2. Speed of the movement (time variable as pace)
3. Duration of the movement (time variable as duration)
4. Actual size of the movement (percentile in terms of actual instrument or points)

And that’s all I can think of right now. If you know any other dimension of commodity trading please post a comment so that I can put my thoughts on that.

So when you work on your strategy you need indicators right? Well I personally use some, some of the times, some don’t use any at any time!
So if you need indicators:

1. Find an indicator that shows you the direction of the movement. (A)
2. Find an indicator that shows you speed of the movement. (B)
3. Find an indicator that gives you an idea how long the direction of the movement is going to be valid. Think like a block of time. 4 hours? 1 hour? 3 days? 2 weeks? (C)
4. Find an indicator that tells you at what point the movement has a chance of reverse. (Yes this is called picking top and bottom but use it to EXIT not to catch a falling knife and so on) (D)

Unless you are really a complete dummy, by now your brain started to pop the names of all kind of indicators in your head to match these four categories. You have used these indicators in past I’m just categorizing these to help you pick one cherry from each branch.

I’m not going to name the indicators, there are thousands of indicators that does basically same things. All are based on some statistical formula developed by great math geeks. All are lagging indicators based on derived information of the price. Pick the ones based on your personality. Nothing will give you that extra inch of edge or vice-versa.

Signal and Entry
The market always has a signal. As you should already know Bull, Bear and Lamb markets. These three kind of situation is always present in any given time. But does that mean you have to be in the market ALL THE TIME? Not really. That is why a signal is not an entry and an entry really doesn’t matter as long as the signal is valid.

Indicator A should tell you if it is a Bull or Bear market. But how you know if it is a Lamb market? Well without looking at the chart just by looking at Indicator B you can say if the movement is valid or not. If it has no volatility or pace, then it is just going to stay in a range. So now by using A and B you can detect the signal. A true idea about the market condition.
Now you know which direction to enter. If it’s a Bull market you are buying… vis-à-vis and if it’s a lamb market you are staying away right? But if you have Indicator D then you can trade the lamb market as well! Yes picking top and bottom works indeed when Indicator B says it is a lamb market!
Now that you know by using A, B and D you can find out the signals. That doesn’t mean you have an entry yet. A signal is not an entry. In fact an entry is the most delicate concept of the decision making process that actually going to make you wealthy in the long run.

You need Indicator C for the entry. Indicator C is the TF or Time Frame. This is where you create your own market. Think like this, there are 10 traders out there. Every one is using different time frame thus even though the price is X for everyone, 10 people are seeing that X from 10 different angle. Out of 10, 3 people are using five minute TF and seeing price is going up. But out of 10, 2 people are using daily TF and seeing the price is actually going up as a retracement and waiting to sell at a favorable rate. You see why Indicator C is the only thing that can define your entry? For those using five minute TF they got a signal for bull market and making money but the dudes at daily TF are have used indicator D to sell it whenever the price hits their area of TOP.

So before even going to find any of the other indicators… Find your Indicator C. Find your TF. You can use both five minute or daily chart. From the above example you can buy the five minute chart to reverse your position on daily chart’s TOP! But you had to be a superman or MIT material to keep doing that for 30 odd pairs or have to use something automated.

And still you don’t have an entry.

Because, trading is not all about jumping with Bull, Bear and Lambs. If you think so then open a farm or better, poultry. Stop trading today! You have to attach your signal with your money management and calculate the probability.

Probability of WHAT?

1.Indicator A is valid for how long by using Indicator C
2.Does Indicator C have enough Indicator B to reach Indicator D?
Confused? Read again. If you can’t understand what I’m talking about, please read it again.

Now, if you actually could speculate that you have a positive expectation from the signal then find out your risk.

And still you don’t have an entry.

Risk to Reward Ratio… does it matter? Yes it does but it has to be related to that “Positive expectation” of your strategy.

Win ratio… out of 100 trades you took how many reached +10? How many reached +50 and how many reached your target? And how many didn’t reach +10, how many didn’t reach +50 and how many didn’t reach your target? And how many didn’t even reach +10 but you had to get out of it with a loss? Use a tally sheet. Just like marketing research.

Put 100 trades result using tally on a table of +10 pips +50 pips and Target HIT! And yes, pure loss as well. Then you have a way to know how many trades were actual winners.

And yes, still you don’t have an entry.

Now, unless you are a sober Taoist and think you can wait for a signal, then wait for an entry and see +20 pips on the board and can stop yourself from closing the position early after growing up in a middle class family (provided that +20 pips can buy your entire week’s rice or +150 pips is what your dad earned from his 2nd job!) then go ahead you have your entry!

But, for those alike me, please pay yourself first. It takes a rich mentality to let your profit run. Unless you are not rich yet who don’t feel to protect his profits or bother chasing breakeven then you have to scale out your positions. This is why I’d recommend the strategy mentioned by Mark Douglas in his book.

Take 1/3rd of the profit at +5 pips or +10 pips. Take 1/3rd of the profit at your reasonable TOP or BOTTOM picked by Indicator D and let the leftover (1/3rd) to run as long as you don’t have a clear opposite signal. This way you will feel that you earned your wage and stop feeling losing out.

Now, as you know your win percentile and profit projection, now you know how many percent of capital you can risk on per position. If you have a very high rate of win prospective then you may put 3% at each trade and take out 1% on +10 pips at your TOP or BOTTOM and leave 1% after moving your stop loss to breakeven. All depends on your strategy’s positive expectation level. Don’t stick to 2% on every trade method. If I have a 100% profit prospective I can use 98% of capital and still be profitable. If I’ve a 30% profit prospective (less than 50% is really… you know better have a coin toss) I can still make money in any market by using proper money management (not taking any trade and by keeping it in my savings account with 3.4% annual interest... anyway).

This is why, you probably heard the saying that: a bad trader losses money with a good system but a good trader can win money from a bad system.

I wish you luck building your own system someday.

- A. I~