<meta http-equiv="CONTENT-TYPE" content="text/html; charset=utf-8"><title></title><meta name="GENERATOR" content="OpenOffice.org 2.0 (Linux)"><meta name="CREATED" content="20060823;19521800"><meta name="CHANGED" content="20060823;20072800"> <style> <!-- @page { size: 21cm 29.7cm; margin: 2cm } P { margin-bottom: 0.21cm } --> </style> This article is taken from Louise Bedford's new book - Charting Secrets. It is now available via the Trading Game shop. Click here for more information.
Chapter 10 – System Development Secrets
People are attracted to the markets to make money. They have high expectations about making this money using skills and techniques mostly learned from the experiences gained from other endeavours. Part of the attraction of investing in the stock market is also the apparent liberty to do whatever they like while the market is open. This feeling of freedom coupled with their high expectations will last for as long as their account is not in drawdown. This may take a single trade or many trades, however, drawdown is inevitable. Drawdown occurs when your trading account value is less than the highest value that it reached (which is usually the opening balance when first starting out). Things generally get worse from this point on as the novice trader starts to wrestle with their emotions, the market, their broker, and their tools. This generally leads to one outcome which can potentially account for all the trading mistakes and losses that follow – inconsistency. If there is a single goal that a trader should have, novice and experienced alike, it should be consistency. Of course you must have a trading plan that sets out your financial goals and why you are taking on this role of being an active investor. You should also have some personal development goals. With respect to trading, your personal development trading goal must be to become consistent. This is true of many other pursuits including all competitive sports. Consistency is required in deciding the conditions under which you enter trades, exit trades, how much capital you commit to each trade, what markets you trade and how many open trades you monitor. Other considerations include how much time you allocate to analysis, trade management and your trading paperwork, when you do these tasks and how they fit into your other daily tasks etc. The list goes on. Achieving consistency is no mean feat. As trader John Hayden states: “Indecisive traders will always produce inconsistent behaviour, and consequently inconsistent profits.” The best weapon available to you to beat indecision and achieve consistency is the development of a trading plan. Your trading plan will include answers to many questions, one of which is, “What trading system will you use?” There are many more aspects that need to be considered when writing your trading plan. These are covered more completely in other texts, including my book Trading Secrets.
In this chapter, we will investigate trading system development.
Developing a Trading System
A trading system is typically comprised of three components: the entry/exit methodology, risk management and money management.
The entry/exit methodology deals with the techniques you will employ to enter/exit your trades.
Risk management deals with your risk profile. That is, how much you are prepared to lose on a trade before you can no longer hold on or how much of your portfolio you are prepared to lose before you stop trading altogether, ie. maximum portfolio drawdown. How much financial pain can you bear before you throw in the towel? The idea is to establish your trading approach so that you have very little chance of reaching that point.
Money management deals with how much capital you will invest in each trade as your portfolio value fluctuates. You must calculate how much of your capital to invest in each position. This is called position size.
When developing a trading system, or indeed, your overall trading plan, your aim is to be consistent. Consistent methods can be measured and repeated; inconsistency cannot.
Many traders aspire to be discretionary traders. Discretionary traders use consistent discretion – this is their personal trademark for success. Whilst there are exceptions, discretionary traders come through the ranks of the mechanical traders. The great majority of “wannabe” traders never reach the successful ranks of the mechanical trader. They remain in the trading wilderness for many years until eventually they give up because of lack of trading funds or too many emotionally painful market experiences.
Entry/Exit Methodology
Entry Signals
This book is mainly focused on entry signals that you could use when trading shares, as well as leveraged instruments. You do not have enough information to start trading if this is all that you understand about putting money into the sharemarket. Even though it is essential to articulate your own personal set-ups and triggers, you must also consider the other major aspects of a trading plan, or your success will be short lived. Entry signals will only help you to engage trades with a high probability of success. They will not tell you how to exit or how much money to place into a trade.
If you would like some more assistance with these concepts, you need to read my book Trading Secrets, which goes into each of these topics in-depth. My Candlestick Charting Home Study Course available through my website will provide more trading insights and supplies you with specific exercises to complete.
Exit Signals
As stated by William J. O'Neill in ‘24 Essential Lessons for Investment Success’; “Investors spend most of their time deciding what stock to buy. They spend little if any time thinking about when and under what circumstances their stock should be sold. This is a serious mistake.”
Before you place your order, you must decide on where you will exit. I advocate that you use a stop loss to capture your profits and avoid large losses. There are four main ways to set a stop loss:
Pattern based stop loss traders will exit trades if the share breaks downwards through a trend-line, for example, or a significant line of support. Throughout this workbook I have given you many examples regarding appropriate places to position a pattern based stop loss. Technical indicators can be used as a stop. For example, a dead cross of two moving averages may trigger an exit. Percent drawdown or retracement methods suggest that if the instrument drops in value by a set percentage eg. 7%, then an exit should be made. Volatility based stops rely on significant changes in volatility past a pre-defined level in order to trigger an exit.
To exit a position in the sharemarket, you can choose to implement one of these types of stops or even a hybrid of any of these methods. Derivatives can use all of these types of stops and more. If you are unfamiliar with any of these techniques, it is essential that you research them to find out the most appropriate stop for your own requirements.
Successful technical traders have a defined set of rules to enter a position, to exit from the market promptly at the first sign of a downtrend, or to preserve their capital after the share or derivative has retraced in value. Some traders even set auto-stop losses so that when the share price reaches a certain level, the computer software exits their positions automatically. If you are struggling with the discipline required to take an exit when your stop has been hit, this is probably a good alternative.
It actually doesn’t really matter what techniques you use for entering and exiting positions in the market, provided that over a large sample of using the selected techniques, you end up with more cash in your trading account than your starting capital! The more cash added and the longer the cash accumulates in your account, the better the method.
While trading through the large sample of trades, it also does not matter how many winning trades you had compared with the number of losing trades. What matters is that the total winnings add up to more than the total losses net of trading costs. It also matters that the techniques for entry and exit, which you deployed in the market, are repeatable in the future so you can continue to use those techniques to generate more profits.
Deciding when you will take profits will mean that you have gone a long way towards ensuring your success as a trader. You could apply a trailing stop loss, or apply profit targets. The decision is up to you.
The question is: how can you determine whether an entry and exit combination over a large sample of trades will result in a net profit before you start trading it? For some ideas regarding how to effectively back-test your trading system, have a look at Appendix C.
It’s also important not to let your trading results dictate how you feel about a particular transaction. A good trade is made when you follow your trading plan to the letter regardless of a profit or loss result. It is a sign of a disciplined trader. If you are having trouble developing your own system, I suggest that you plagiarise the ideas of other relatable traders/authors. After you have tried out their concepts, you can make alterations to suit your situation. Duplicate before you innovate.
Risk Management
Whilst risk management is about limiting the size of loss for loss trades, more importantly, it has to do with limiting the amount of drawdown that may result from a portfolio of open positions in the market and from recently closed trades.
The risk management rules and processes are closely aligned with the entry/exit methodology you have designed. Obviously risk is lower with taking medium to long term non-leveraged positions than short term leveraged positions. Your risk management rules need to be customized accordingly.
Not only should the risk management rules match the entry/exit methodology, but they should also match your risk profile. Are you a risk taker or are you more risk averse? A good methodology should allow risk to be customised to match a trader’s risk appetite which will change over time.
The sorts of indicators that can be used to assess risk include overall market direction, sector direction, liquidity, traded volume, market volatility, stock volatility, stock direction and market capitalisation. Using these tools you can construct unambiguous rules that assess risk as high, medium or low or even according to a scale of 1 -10.
The risk management rules should also determine how much risk a trader can take with their overall portfolio funds. This involves determining how much drawdown a portfolio might expect in certain market conditions in the future. Whilst it is impossible to foresee future market action, it is possible, using a database of the researched trades, to compile portfolios of historical trades that will give you an excellent idea of what drawdowns you might expect in the future.
Money Management
Once risk is assessed, the risk can be managed by adjusting the amount of capital you commit to each trade and/or to the market for your portfolio.
Your trade size is therefore determined by how much risk you are prepared to take. Your portfolio value and other factors will also come into the position sizing algorithm such as the amount of leverage that you are trading with and the risk assessment for each individual trade.
As a rule, when your portfolio value increases, so do your position sizes. If your portfolio value decreases into drawdown, your position sizes should also decrease. Also, the higher the risk assessment, the smaller your position size will be.
The objective of money management is to define how much capital you commit to each trade to potentially generate portfolio profits over a large sample that provides geometric growth.
Summary
Whilst system design can be personally rewarding, do not kid yourself that it is a simple task. By reading this book, you have proved that you are amongst the small minority that even attempt trading systems design at all. The great majority of traders start trading the markets based on nothing more than a newsletter or a broker’s advice. I wonder what the expectancy of the newsletter might be? And what are the money management rules that should be integrated with the newsletter’s stock tips?
If the concept of controlling your risk makes sense to you, hopefully you will realise how futile it is engaging the market based on newsletter, magazine, broker, chat forum or other tips. In order to achieve the consistency required to make money in the market over the long term, you must have a robust entry/exit methodology integrated with risk management and money management.
If you are feeling overwhelmed with the task of doing all this yourself then at least take comfort that you now know what to look for in a methodology that is available for purchase. I would like to thank Gary Stone for his assistance with writing this chapter, as well his ongoing support for my trading concepts over the past several years.
Alternatively, Chris Tate runs a Mentor program via Trading Game from time to time to help people create their own trading system. Keep an eye on this website to book in.
Chapter 10 – System Development Secrets
People are attracted to the markets to make money. They have high expectations about making this money using skills and techniques mostly learned from the experiences gained from other endeavours. Part of the attraction of investing in the stock market is also the apparent liberty to do whatever they like while the market is open. This feeling of freedom coupled with their high expectations will last for as long as their account is not in drawdown. This may take a single trade or many trades, however, drawdown is inevitable. Drawdown occurs when your trading account value is less than the highest value that it reached (which is usually the opening balance when first starting out). Things generally get worse from this point on as the novice trader starts to wrestle with their emotions, the market, their broker, and their tools. This generally leads to one outcome which can potentially account for all the trading mistakes and losses that follow – inconsistency. If there is a single goal that a trader should have, novice and experienced alike, it should be consistency. Of course you must have a trading plan that sets out your financial goals and why you are taking on this role of being an active investor. You should also have some personal development goals. With respect to trading, your personal development trading goal must be to become consistent. This is true of many other pursuits including all competitive sports. Consistency is required in deciding the conditions under which you enter trades, exit trades, how much capital you commit to each trade, what markets you trade and how many open trades you monitor. Other considerations include how much time you allocate to analysis, trade management and your trading paperwork, when you do these tasks and how they fit into your other daily tasks etc. The list goes on. Achieving consistency is no mean feat. As trader John Hayden states: “Indecisive traders will always produce inconsistent behaviour, and consequently inconsistent profits.” The best weapon available to you to beat indecision and achieve consistency is the development of a trading plan. Your trading plan will include answers to many questions, one of which is, “What trading system will you use?” There are many more aspects that need to be considered when writing your trading plan. These are covered more completely in other texts, including my book Trading Secrets.
In this chapter, we will investigate trading system development.
Developing a Trading System
A trading system is typically comprised of three components: the entry/exit methodology, risk management and money management.
The entry/exit methodology deals with the techniques you will employ to enter/exit your trades.
Risk management deals with your risk profile. That is, how much you are prepared to lose on a trade before you can no longer hold on or how much of your portfolio you are prepared to lose before you stop trading altogether, ie. maximum portfolio drawdown. How much financial pain can you bear before you throw in the towel? The idea is to establish your trading approach so that you have very little chance of reaching that point.
Money management deals with how much capital you will invest in each trade as your portfolio value fluctuates. You must calculate how much of your capital to invest in each position. This is called position size.
When developing a trading system, or indeed, your overall trading plan, your aim is to be consistent. Consistent methods can be measured and repeated; inconsistency cannot.
Many traders aspire to be discretionary traders. Discretionary traders use consistent discretion – this is their personal trademark for success. Whilst there are exceptions, discretionary traders come through the ranks of the mechanical traders. The great majority of “wannabe” traders never reach the successful ranks of the mechanical trader. They remain in the trading wilderness for many years until eventually they give up because of lack of trading funds or too many emotionally painful market experiences.
Entry/Exit Methodology
Entry Signals
This book is mainly focused on entry signals that you could use when trading shares, as well as leveraged instruments. You do not have enough information to start trading if this is all that you understand about putting money into the sharemarket. Even though it is essential to articulate your own personal set-ups and triggers, you must also consider the other major aspects of a trading plan, or your success will be short lived. Entry signals will only help you to engage trades with a high probability of success. They will not tell you how to exit or how much money to place into a trade.
If you would like some more assistance with these concepts, you need to read my book Trading Secrets, which goes into each of these topics in-depth. My Candlestick Charting Home Study Course available through my website will provide more trading insights and supplies you with specific exercises to complete.
Exit Signals
As stated by William J. O'Neill in ‘24 Essential Lessons for Investment Success’; “Investors spend most of their time deciding what stock to buy. They spend little if any time thinking about when and under what circumstances their stock should be sold. This is a serious mistake.”
Before you place your order, you must decide on where you will exit. I advocate that you use a stop loss to capture your profits and avoid large losses. There are four main ways to set a stop loss:
Pattern based stop loss traders will exit trades if the share breaks downwards through a trend-line, for example, or a significant line of support. Throughout this workbook I have given you many examples regarding appropriate places to position a pattern based stop loss. Technical indicators can be used as a stop. For example, a dead cross of two moving averages may trigger an exit. Percent drawdown or retracement methods suggest that if the instrument drops in value by a set percentage eg. 7%, then an exit should be made. Volatility based stops rely on significant changes in volatility past a pre-defined level in order to trigger an exit.
To exit a position in the sharemarket, you can choose to implement one of these types of stops or even a hybrid of any of these methods. Derivatives can use all of these types of stops and more. If you are unfamiliar with any of these techniques, it is essential that you research them to find out the most appropriate stop for your own requirements.
Successful technical traders have a defined set of rules to enter a position, to exit from the market promptly at the first sign of a downtrend, or to preserve their capital after the share or derivative has retraced in value. Some traders even set auto-stop losses so that when the share price reaches a certain level, the computer software exits their positions automatically. If you are struggling with the discipline required to take an exit when your stop has been hit, this is probably a good alternative.
It actually doesn’t really matter what techniques you use for entering and exiting positions in the market, provided that over a large sample of using the selected techniques, you end up with more cash in your trading account than your starting capital! The more cash added and the longer the cash accumulates in your account, the better the method.
While trading through the large sample of trades, it also does not matter how many winning trades you had compared with the number of losing trades. What matters is that the total winnings add up to more than the total losses net of trading costs. It also matters that the techniques for entry and exit, which you deployed in the market, are repeatable in the future so you can continue to use those techniques to generate more profits.
Deciding when you will take profits will mean that you have gone a long way towards ensuring your success as a trader. You could apply a trailing stop loss, or apply profit targets. The decision is up to you.
The question is: how can you determine whether an entry and exit combination over a large sample of trades will result in a net profit before you start trading it? For some ideas regarding how to effectively back-test your trading system, have a look at Appendix C.
It’s also important not to let your trading results dictate how you feel about a particular transaction. A good trade is made when you follow your trading plan to the letter regardless of a profit or loss result. It is a sign of a disciplined trader. If you are having trouble developing your own system, I suggest that you plagiarise the ideas of other relatable traders/authors. After you have tried out their concepts, you can make alterations to suit your situation. Duplicate before you innovate.
Risk Management
Whilst risk management is about limiting the size of loss for loss trades, more importantly, it has to do with limiting the amount of drawdown that may result from a portfolio of open positions in the market and from recently closed trades.
The risk management rules and processes are closely aligned with the entry/exit methodology you have designed. Obviously risk is lower with taking medium to long term non-leveraged positions than short term leveraged positions. Your risk management rules need to be customized accordingly.
Not only should the risk management rules match the entry/exit methodology, but they should also match your risk profile. Are you a risk taker or are you more risk averse? A good methodology should allow risk to be customised to match a trader’s risk appetite which will change over time.
The sorts of indicators that can be used to assess risk include overall market direction, sector direction, liquidity, traded volume, market volatility, stock volatility, stock direction and market capitalisation. Using these tools you can construct unambiguous rules that assess risk as high, medium or low or even according to a scale of 1 -10.
The risk management rules should also determine how much risk a trader can take with their overall portfolio funds. This involves determining how much drawdown a portfolio might expect in certain market conditions in the future. Whilst it is impossible to foresee future market action, it is possible, using a database of the researched trades, to compile portfolios of historical trades that will give you an excellent idea of what drawdowns you might expect in the future.
Money Management
Once risk is assessed, the risk can be managed by adjusting the amount of capital you commit to each trade and/or to the market for your portfolio.
Your trade size is therefore determined by how much risk you are prepared to take. Your portfolio value and other factors will also come into the position sizing algorithm such as the amount of leverage that you are trading with and the risk assessment for each individual trade.
As a rule, when your portfolio value increases, so do your position sizes. If your portfolio value decreases into drawdown, your position sizes should also decrease. Also, the higher the risk assessment, the smaller your position size will be.
The objective of money management is to define how much capital you commit to each trade to potentially generate portfolio profits over a large sample that provides geometric growth.
Summary
Whilst system design can be personally rewarding, do not kid yourself that it is a simple task. By reading this book, you have proved that you are amongst the small minority that even attempt trading systems design at all. The great majority of traders start trading the markets based on nothing more than a newsletter or a broker’s advice. I wonder what the expectancy of the newsletter might be? And what are the money management rules that should be integrated with the newsletter’s stock tips?
If the concept of controlling your risk makes sense to you, hopefully you will realise how futile it is engaging the market based on newsletter, magazine, broker, chat forum or other tips. In order to achieve the consistency required to make money in the market over the long term, you must have a robust entry/exit methodology integrated with risk management and money management.
If you are feeling overwhelmed with the task of doing all this yourself then at least take comfort that you now know what to look for in a methodology that is available for purchase. I would like to thank Gary Stone for his assistance with writing this chapter, as well his ongoing support for my trading concepts over the past several years.
Alternatively, Chris Tate runs a Mentor program via Trading Game from time to time to help people create their own trading system. Keep an eye on this website to book in.
