What's required to get a computer to do the trading for you
Firstly, let me say that I am interested only in mechanical systems. "Mechanical" as in "no interpretation possible".
Secondly, you shouldn't just take some advice you read on the internet and apply it to your particular situation. You should experiment first. Does what I say make sense? Does what I say make sense for you? Does what I say bring you increased profits? Decreased losses? Lower risk? The opposite?
This information is free. Do you get what you pay for? Or are the best things in life free? That's your decision. In short, I can't be held responsible for what you do with the information I give. I'm just some guy with a website. *You* decided to take action based on what *you* thought was the best way forward.
Finally, I won't be giving "rules" per se. I'll be giving ideas. Ideas for you to play with. To experiment with. To add to your portfolio if you think they're better than what you've got now.
I've bought other people's rules on two occassions. I couldn't get either of them to work for me. I don't consider myself to be unintelligent - quite the opposite. But what I now realise is that trading rules are completely individualised and thus purchasing them is a fallacy. At least it is for me. Other people have probably made quite a bit of money trading those same rules that I couldn't get to work.
So what I think should happen when you go to a seminar, etc, is that you are given a bunch of ideas. Then you mix and match to suit your personality. Of course, it helps if the system you decide upon is profitable :-)
A quick recap of terminology:
A trading "rule" is something like "RSI in overbought".
Many rules combine to form a trading "system".
However, a system is not just about the rules for when to buy and when to sell. There's also rules for how much money to use, times of day you shouldn't buy, and so forth. These extra bits are so very incredibly important, and these are the things which prevent the loss of all your capital.
Briefly, a complete system should have:
Entry Rules specify exactly when an entry signal is generated.
"Buy when the high of the most recently finished price bar is higher than the previous bar" is an example. On a daily chart, this rule would translate to "buy when today's high is higher than yesterday's".
Note that the entry price has not been specified - that's for the next post. At the moment we are dealing with "Yes we can enter a trade" and "No we cannot" only (and maybe a direction for the trade, but sometimes the Entry Price we use does this for us. I'll explain about this more next post).
You might have a whole bunch of Entry Rules: "Buy when the today's close is above the 20-day moving average" "Buy when 20-day moving average is above the 30-day moving average"
Etcetera, getting more and more complicated.
ALL of the Entry Rules must be satisfied for a trade to be allowed. If you have the word "OR" in your system, essentially you have more than one system.
For example:
"Buy when the today's close is above the 20-day moving average"
OR "Buy when 20-day moving average is above the 30-day moving average"
That is actually two systems - one where you can buy when today's close is above the 20-day MA, and another where you can buy when the 20-day MA is above the 30-day MA.
There's no problem with this, but I'd split them out to 2 systems so you can better judge each rule's effectiveness. If you kept it as 1 system and things go wrong, how can you tell if it's the first Entry Rule that's stopped working, or the second?
The result of adding all the Entry Rules together is a simple Yes/No answer (again, and maybe a direction for the trade). Yes - we are allowed to enter the trade. No - we are not allowed.
Sounds simple, but if it is so simple, why are we sometimes in the state of "I'm not sure"?
Your system might even specify a further rule to cover this case: "when you're in doubt - don't trade". But if the Entry Rules are specified clearly, how can there be doubt? It could only be if the system was not mechanical - if there was some subjective aspect at play. Mechanical systems have rules that you, me, your neighbour's kid, would all come up with the same answer. Systems with some kind of subjectiveness often have this "if in doubt get out" clause.
Support and Resistance (SR) lines are often the culprit.
SR lines look objective at first, but they can be placed at different prices by different people. They can be placed at different prices by the same person on different days. Unless there are mechanical rules on how to determine the location of SR lines (unlikely), they are subjective.
"Divergence" of the price from a specified indicator is also rather subjective. Divergent over what time period? Divergent by how much? If the stock price goes up a lot, but the indicator goes up only a little, is that divergence?
"Only trade in the direction of the trend" is another good one. In one of the systems I bought, a rule was "the trend is defined by the 3-month chart looking at daily candles". Easy to judge if the chart starts at the bottom left and ends at the top right. But what if it goes down for 6 weeks, and then up for 6 weeks, kind of finishing flat over the 3 month period? What's that trend - flat or up? What decision would you make if all of your other rules were screaming out for a trade entry?
The next system I bought clarified this - "If the close is above the 20-bar MA, it's an up-trend. If below, it's a down-trend". And there you have why I gravitate to mechanical systems - two systems involving "the trend", one was subjective, the other objective. One leaves you in doubt when things aren't clear cut, the other makes things rather simple.
You (well, I) need a trading system that is written down somewhere. Kind of like a checklist. Exactly like a checklist. Before entering a trade, all the Entry Rules *must* be satisfied. All of them. You can't ignore Entry Rules. If you've got 10 of them, and just 1 fails, there is no trade. There is no point to have the 10th rule if you're going to ignore it. If you want to drop it then backtest your system with and without that rule. If you get better results without it, then you can remove it. But you can't remove it just because it's in the way of a trade you want to take.
Because the rules are mechanical, there will not be much thought required. You've already backtested the system and the results were good. Now just tick off each rule. One rule not satisfied is enough to prevent the trade. All ticks means you can enter.
But at what price? That's next time.
You'll need to experiment. You can come across possible rules on websites, at seminars, in books, in lots of places. The short of it is though, that you have to experiment yourself so you can be satisfied.
Here's the thing - each and every indicator is included in someone's profitable system, somewhere. Guaranteed. It doesn't actually matter too much whether you stick with simple moving average crossovers, or you want to use Bollinger Bands, or Stochastics, or whatever. There'll be a way to squeeze whatever indicator you want into a profitable system. The key, I think, is experimentation and backtesting.
Here's another thing - some people swear by trend-based systems, and others believe break-out systems work, and others think everyone else is wrong and only scalping works in today's market.
It's similar to how some people swear by stocks, and others by real estate. Actually both work, but some people are more suited to one than the other. If someone tells you why real estate is so much better than stocks, it simply means they couldn't get stocks to work for them. Maybe you can. A lot of money is made everyday in both.
And so I can guarantee that there are profits to be made using all three methods - trend-following, break-outs, and scalping. If someone says one is better it means they couldn't get the other two to work. Maybe you can.
The test for Entry Rules is done by placing arrows on the chart. How close to peaks and troughs do they signal entries?
Unfortunately, your Entry Rules will probably give you a chart filled with arrows. You'll really need to combine your Entry Rules with your proposed Entry Price in order to really get a picture on what your system would do. More on Entry Prices next time.
This page displays all currently available trading rules in our Automated Trading Machine. We're always adding more. Mix 'n' match.
Okay, so you've got Entry Rules, and they say "yes, you may enter a trade", or "no". Yes or no. If there's a "not sure" in there, "maybe", "it could be", it's not an objective trading system. I'm only interested in objective trading systems (due to my inability to trade subjective ones).
Now we need an exact price at which we will be entering the trade. These are pretty easy. Normally.
For example, "the high of the most recently completed bar". Your Entry Rules say "enter the trade", and your Entry Value says "...when the price hits the high of the most recently closed bar".
Some people like to add a bit, so they know the price has a bit of momentum. For example, "the high of the most recently completed bar, plus 1 tick". Or plus 2 ticks, or 5 ticks, or whatever.
Notice though, that we don't have a direction for the trade yet. Sometimes your Entry Rules will specify the direction, like "enter a long trade if the bar closes above the 20-bar moving average". And then the Entry Values specify exactly where to open that long trade.
Or, sometimes the Entry Rules simply allow you enter a trade, and the Entry Values specify the direction. For example, the Entry Rule is "enter a trade when the RSI with period 14 goes above 70". And if the price hits the high of the most recently completed bar, you enter long at that price. If the price hits the low of the bar, you enter short at that price. In this case your Entry Rules have told you that the price is about to move, but it doesn't know in which direction. Your Entry Values answer the direction question.
Sometimes though, the price is already above (or below) the price that your Entry Values say to enter. What to do then? Do you pass on any trade where you can't get your intended price? Do you get in at any cost? Do you get in, but only if the price hasn't gone "too far"? In that case you need to specify what "too far" means. 20 pips? 50? 100? Backtest.
This page displays all currently available trading rules in our Automated Trading Machine. We're always adding more.
Alrighty, Entry Rules say "yes or no", Entry Values set the price to enter, now we need an Initial Stop Loss Value. That is, at what price do we admit that the trade did not do as we thought? At what price do we cut our losses?
I've heard some people don't trade with stops. They reason that the stops are too restrictive, and are actually more likely to make people lose money. But I couldn't do that. First, too scary, and second, they'd be relying on some kind of intuition as to when to get out. I don't do intuition.
Stops also allow us to define in exact terms, how much are we risking on this trade. Sometimes there is slippage though, and so you might lose a bit more than you thought.
Anyway, the beauty of forex is that the stops are automatic. The worst trade I ever did was with Options. The price was already below my Initial Stop Loss Value. But I just couldn't call the broker to get out. "It'll come back" I kept saying, as the price kept falling. Automatic stops take away that problem. When the price hits your stop, you're taken out of the trade. Perfect.
So, where are we going to put that puppy? We need to give the price enough wiggle room. On the other hand, we don't want to risk too much. It's backtesting time.
Possible values are essentially the same as for Entry Values. High, Low, Close of current bar, the value of a moving average, the lower bollinger line, low of the last X bars, etc. You can also use a specific number of pips below (or above) the entry price.
This is optional. You don't always need an Initial Take Profit Value.
There are two ways to exit the trade - either your stop is taken out, or the take profit is hit.
Your Initial Stop Loss Value will always be, for long trades, below the Entry Value. Obviously.
Sometimes you rely on your Trade Management Rules (next article) to gradually move your stop loss from that loss position, to a break-even position, and eventually to a spot where even if your stop is taken out, you will make a profit.
Or, you can have a Take Profit set. Your trade will be closed at a profit if that level is hit. Or you could do both. Anyway, Take Profits are optional, but only if you have Trade Management Rules which will eventually move your stop to a profitable position.
Initial Take Profit Values are exactly the same as Initial Stop Loss Values, which are essentially the same as Entry Values. High, Low, Close of current bar, the value of a moving average, the lower bollinger line, low of the last X bars, a specific number of pips above (or below) the entry price, etc.
As I said in a previous article, to obtain profit from a trade, you either have a take profit set, or you gradually move your stop loss to a position of break-even (if you want), and then to positions above your initial entry.
When you are relying on the stop loss being moved above the initial entry point, that's where Trade Management Rules come in. As with everything else, I believe they need to be explicit and objective.
In the example trading systems I gave, you'll notice the Trade Mgmt Rules I gave were something like:
Long - S/L Mgmt Rules: Every Bar
And the Trade Management Value was (for example):
Long - S/L Mgmt Values: Low Of Previous 50 Bars
If we are trading a system manually (i.e. no computer involvement), then the rule for setting and moving the stop loss would probably be written something like "The stop loss is, and remains at, the low of the previous 50 bars".
But when you're making a computer do this for you, it must be specified exactly what that means. And what it means is "every bar calculate the low of the previous 50 bars. Use that as the new value of the stop loss". So I made a "Every Bar" rule, which of course evaluates to "True" at every bar. Without it, the stop loss would be set initially, but wouldn't move after that.
Some systems have more complicated Trade Management Rules than that. For example, and assuming of course the period and standard deviations for the bollinger setup are specified, "When the price closes above the upper bollinger line, move the stop loss to the value of the upper bollinger line". In this case, the Trade Management Rule is "close is above upper bollinger line", and the Trade Management Value is "the value of the upper bollinger line".
A close above the upper bollinger line isn't going to happen all that often. But when it does, this system is going to move it's stop to the value of the upper bollinger line. Given that there aren't too many bars that have their low above the upper bollinger line, that trade would probably get closed out the following day, but this is just an example.
Now, while I haven't exactly been thorough on Trade Management Rules and Values in this article, because the possible rules to pick from would be a lot like the Entry Rules and the possible values a lot like Entry Values, they are very, very important.
This is, after all, how we decide when to exit the trade. And exiting is when the profit is made, regardless of how we got in the trade in the first place.
There are some people who believe spending a lot of time on the Entry Rules is futile, that even random entries would work, because it's all in the exit. The thing about systems that you buy is that they focus mostly on the entry. Personally I think it all adds to your probability of success, but certainly the exit is where it either fills your wallet, or empties it.
You enter long and the price goes higher. Do you sell now? Is the price going even further, or is it about to turn around?
You enter long and the price goes lower. Do you sell now? Is the price going even further, or is it about to turn around?
Guess-work. It's why you need a solid trading system, proven over a long-ish period (which varies depending on the timeframe you trade), with clear, objective rules.
When you enter a trade and the price goes against you, that's where your stop loss comes in. You've already set it, hopefully, at a spot where you decided that if it went there, you are prepared to admit you got it wrong this time and take the loss.
When you enter a trade and the prices goes in your favour, your Trade Management Rules now specify when to move that stop loss to lock in some profit. When we set the stop loss initially, we gave the price some wiggle room. Because the price wiggles. We have to keep doing the same thing when we move the stop loss. Set it relatively close and yet relatively far.
And therein lies the problem. Exactly when and where to move the stop loss? Here's where experimentation and backtesting comes in. Buy some of those $49 systems to get some ideas. Try them out. Add rules of your own.
By this time you should have everything needed to specify entries. Look on the chart to see what normally happens after your system entered a trade. If the price continues on in your favour, then retraces 20 pips, then goes on, then retraces 20 pips, then you can't move your stop loss closer than 20 pips away from the price.
If the price seems to always retrace through the 0.382 fibonacci retracement level before heading further north, but it hardly ever breaks the 0.618 except when it's a reversal, then it stands to reason that your stop loss should be just below the 0.618 fibonacci level and not the 0.382 one.
And this is why your Entry Rules can't be random. Because probably your Trade Management Rules are going to change based on what normally happens to the price after you've entered. Random entries aren't going to allow you to work this out.
So, backtest. Experiment. Work out when the price is *most likely* just retracing before continuing on, and when it's *most likely* reversing. Difficult to do, but a worthy task. And then tell me :-)
I've completely neglected this kind of trading systems, sorry. That's where your system is always in the market - if it's not going long then it's going short. In this case you wouldn't need either a take profit or (strictly speaking) rules which move your stop loss.
But, I include to "Exit At Market", which is what you do with your long trade in the stop-and-reverse system when you want to go short, as a Trade Management Rule.
Sure, in forex, if you have 100,000 going long, you could purchase 200,000 going short, which would effectively close your 100,000 long and leave you with 100,000 short. But I prefer to keep my trades distinct.
And so if I create a stop-and-reverse system in my software, I set the entry rules for going short to match exactly the Trade Management Rules of the long, and vice versa, with the Trade Management Value set to "Exit At Market". That way the long trade is closed, and the new short trade is opened.
So now your system has:
You can also have Take Profit Rules and Values, if you use a take profit and you want to move it from its original position.
Anyway, that's what you need for a trading system. Pretty much. Not really rocket science. On the other hand, far better than buying because the newspaper said so and having no defined point of exit.
But there's a couple of bits left. One is Money Management - how much money to risk on a particular trade.
There is also When Not To Trade Rules, which I refer to as holidays. Even if your Entry Rules are signalling a trade, there might be specific times of the day, week, month, or year that you shouldn't get in.
And then there's equity curve analysis - is this just a normal drawdown the system is having, as all systems do, or has the system stopped working altogether? If it's still there, have a look at this chart on the Collective2 website. Gained 500% in a couple of months. But now? It's fallen back to a 100% gain. Is that a drawdown or failure? Stop using the system and bank the 100%-odd profit, or stick with it? Get this right and it won't really matter what rules you use for everything else.
[Edit: That system had a 100% profit at time of writing, then a few weeks later it had gone to a roughly 50% loss.]
I sometimes get suckered into paying the $69 for an e-book detailing a "fantastic" trading system. Each guarantees to tell me why 90% of traders (or 95%, depending on the website) fail, and promises to show me how I can become part of the 10% (or 5%) that succeed.
And there's always a $20 discount if I act within the next 10 minutes, or before midnight, or whatever.
And there's always free extras "worth hundreds of dollars", but only for the next 17 people, or 47 people, or whatever relatively smallish-largish prime number they've decided upon.
Anyway, when I do purchase these books, I do it with the hope that they'll introduce something new to me - a new idea I can play around with. I don't hope beyond hope that the system they describe will do me any good without change. As I said before, I think trading systems have to be individualised for them to work. In my case at least.
Here are the rules for the most recent one. I won't go in to explaining everything. Buy the book. Anyway, this system uses points to determine if a trade is allowed or not. You don't need each item to be true - if you can get 36 points it means you can enter the trade. My theory is, that actually the below describes a whole bunch of different systems - one for each way the rules can add together to equal 36 or more.
Entering on the long side (buying)
This could be made to be objective. You can obviously give a True/False answer as to whether today's volume is more or less than yesterday's. But, you would need to specify for how many days the volume should be increasing. Also, what if the volume is increasing, but is still less than the "average" volume? Is that a buy? To answer yes or no, it needs backtesting.
Ah my old friend, the Support and Resistance lines. I also like the words "bouncing off" and "moving through". What, exactly, do these mean? Oh sure, these are very easy to work out looking at a chart of historical data. But in real-time? Tell me how to program this into a computer and it becomes objective, otherwise, this rule is very very subjective.
Trendlines are just as bad as Support and Resistance lines. If you look at a chart, any chart, you'll see that sometimes there does seem to be very clearly defined places that you can put these lines. You'll also see that the price completely ignores these lines whenever it feels like.
Again we have the words "bouncing off" and "moving through". Look at your chart again. The candles aren't always exactly above or below your lines, right? So how do you decide when a candle has "broken through"? Hindsight allowed you to put that line where you put it, and to ignore the times when the candle moved below the line. The rules change when you're doing it real-time. You don't know if it's breaking through, or if it's another of those candles that doesn't fit neatly with the line.
Wait... does it say *about* to cross?? Oh my god. This rule relies on future knowledge.
Hooray! An objective rule.
Dude. Seriously. "Easily recognizable"??
Price *approaching* the upper Bollinger Band. What the hell does "approaching" mean?
You could make this rule objective though, by using the %b indicator. It gives a value of 0 if the price is at the lower bollinger line, less than 0 if below it, 1 if the price is at the upper bollinger line, more than 1 if above. 0.5 should therefore be right in the middle of the two bollinger lines. So you could say if the %b value is 0.8, then give your 6 points. Or is it 0.9? Who knows? Backtest.
Hooray! Another objective rule.
Most of the candlestick patterns can be programmed into a computer, and are therefore objective.
So there you have it. I guess there are people that can use this system effectively, but I guess my $49 investment is the cost of the preparation to write this article.
A lot of stuff to read, perhaps some examples will make what I'm trying to say clearer.
| Rule Type | Description |
| Long - Entry Rules | Close Below High Of Previous 100 Bars |
| Long - Entry Values | High Of Previous 100 Bars |
| Long - Init. S/L Values | Low Of Previous 50 Bars |
| Long - S/L Mgmt Rules | Every Bar |
| Long - S/L Mgmt Values | Low Of Previous 50 Bars |
Reverse for shorts.
Explanation: Whenever the close is below the high of the previous 100 bars, an order will be placed at that high of the previous 100 bars. If the order is taken up, i.e. the price goes above the intended entry point, the initial stop loss will be set at the low of the previous 50 bars.
On the completion of each new bar, the stop loss is re-set at the low of the previous 50 bars. Often this means the stop loss will not be moved, but when it does, it will only move to a position of decreased risk. Eventually, hopefully, the stop loss will be moved to a spot above the original entry price, and that's how this system would make it's money.
| Rule Type | Description |
| Long - Entry Rules | Close Below High Of Previous 100 Bars |
| Long - Entry Values | High Of Previous 100 Bars |
| Long - Init. S/L Values | Low Of Previous 50 Bars |
| Long - Init. T/P Values | 50 Pips Above Entry |
Reverse for shorts.
Explanation: Whenever the close is below the high of the previous 100 bars, an order will be placed at that high of the previous 100 bars. If the order is taken up, i.e. the price goes above the intended entry point, the stop loss will be set at the low of the previous 50 bars. The stop loss will not be moved from that point. The take profit will be set at 50 pips above the entry.
This system puts barriers on either side of the entry, and doesn't move them. Either we get our 50 pips profit, or we take the loss.
| Rule Type | Description |
| Long - Entry Rules | Close Above Simple Moving Average (Period=50) |
| Long - Entry Rules | %b (Period=20) Value Must Be Below 1 |
| Long - Entry Values | Price Where %b (Period=20) Would Equal 1 |
| Long - Init. S/L Values | Simple Moving Average (Period=50) |
| Long - S/L Mgmt Rules | Every Bar |
| Long - S/L Mgmt Values | Simple Moving Average (Period=50) |
Reverse for shorts.
Explanation: The %b value specifies where the price is in relation to the bollinger bands. A value of 0 means the price is at exactly the lower bollinger line. A value of 1 means it is at exactly the upper bollinger line. 0.5 is in the middle, etc. I could have just used the "Upper Bollinger Line" value in this case, but %b allows greater flexibility when it comes to experimentation.
This system has two Entry Rules. Firstly, the price must close above a moving average with period 50. It must also be below the upper bollinger line with period 20. When both of those rules are true, an order will be set at the upper bollinger line.
Should the price rise above the upper bollinger line, our order will be taken up, and the initial stop loss will be set to the value of the moving average.
With the completion of each new bar, the stop loss is adjusted so it remains at the same price as the moving average. However, my software does not allow stops to be moved to positions of increased risk. Therefore, if the moving average went down, the stop loss would not follow it.
This system relies on the moving average to eventually rise above the entry value.
By the way, these are just example systems, and may or may not be actually useful in real trading. My point is to simply give examples of purely objective trading systems.
In my previous articles, I seem to be fixated on exactly how many different trading systems a set of rules specify.
I've talked about having the word "OR" in a system effectively creates more than one system. If you've got a system which a whole bunch of rules, but one that specifies an entry when the close is above the 20-bar moving average, OR when the 14-bar RSI is above 70, then actually you have two systems - one which enters when the close is above the 20-bar moving average, and one which enters when the 14-bar RSI is above 70.
Then, in that system with the points (where any combination of rules adding to more than 36 points signals an entry), I said that effectively those rules made X number of different systems - one for each combination of adding the rules together to get more than 36 points. In that particular case, where there were 9 rules, with respective points of 8, 8, 8, 8, 6, 8, 6, 6, and 4, I did start to work out exactly how many different combinations could add to more than 36, but I quickly realised there were going to be many. Maybe about 20 or so. 20 different trading systems.
Why is this important?
Because one day the markets going to change its "personality", and the system you've used for years isn't going to work anymore.
When that happens, you need to find out what's wrong and fix it.
Is it the close above the 20-bar moving average that doesn't work anymore, or is it the 14-bar RSI above 70? Or both? Keeping track of them as one system will not tell you.
Trying to find out the problem in that points-based system would just be a joke.
Dare I say it, but knowing when to use a trading system and when to stop using it, is probably more useful than entry rules.
We all want equity curves that start in the bottom left, and end in the top right. But what if it starts bottom left, goes to middle top, and is currently working its way to bottom right? Is this a temporary drawdown, or catastrophic failure?
Much like we need exact, written-down, objective rules for when to enter, where to set the stop loss, when and where to move the stop loss, when to exit, how much money to use, etc, we also need such rules for when to stop using a system.
Without objective rules set out for when to stop using a system that's in a drawdown, we have essentially moved our "oh, I'll stay in a bit longer - it'll come back" thoughts from the price chart to the equity curve chart.
The reason these rules would be more important than entry rules, is because these rules would stop us using a poor-performing system - it wouldn't matter what rules made up that system.
So, what might be an example of an objective "This is not just a drawdown, but rather a catastrophic failure of your trading system" rule? I'll talk more about this at the end of the series.
Money Management rules tell you exactly how much money to risk on each trade. They also tell you when to add more capital to your trading bank.
In short, these money management rules keep you trading even if your trading rules stop working (or didn't work in the first place).
For example, let's say your trading system used to make a profit 80% of the time. So, because of the great strike-rate, you start using more and more money in each trade. You decide to use a fixed amount of $10K on each trade, even though you only have a $50K trading bank.
Well, 5 losers in a row and you are dead in the water. Even systems with 80% strike-rates can have 5 losers in a row. Very quickly. That's not good money management.
So let's change it and use 20% of your trading bank on each trade. First losing trade you risk and lose 20% of $50K, which is $10K. Now you have $40K.
Second trade you risk and lose 20% of $40K, which is $8K. Now you have $32K.
Third trade you risk and lose 20% of $32K, which $6400. Now you have $25,600.
Fourth trade you risk and lose 20% of $25,600, which is $5120. Now you have $20,480.
Fifth trade you risk and lose 20% of $20,480, which is $4096. Now you have $16,384.
So, you can see that using a fixed amount of money lost us everything in 5 trades. Using a percentage of your trading bank adjusts itself each time, so that 5 losses in a row still leaves us with money.
And there aren't too many people that suggest you risk 20%. Most people seem to say between 1% and 3% of your trading bank is all you should have at risk on any one trade. Even if you had a string of losers, risking just 3% of your trading bank is going to keep you trading for a long, long time.
The downside, of course, is that by risking so little, your profits aren't going to be so big. Frustrating if you're just starting out. But let's not forget the oft-quoted 80% (or 90%, or 95%, whatever) of traders who quit or lose their money. Perhaps, expecting only to profit, they risked too much of their bank.
So that's Money Management. Do you use a fixed amount of money on each trade? Do you use a percentage? Easy.
There's some other stuff about when to add money to your trading capital. I remember "pyramids" and other things in a book I read by Daryl Guppy (his books started me off on the technical analysis journey). For me, I just use 2% of my trading bank, and the trading bank fluctuates as I make and lose money. Essentially it means I add the money to the bank straight away.
For currency trades, the calculation is:
A. Get total trading bank.
B. Get 2% of A. This is how much money we want to risk.
C. Get pips at risk in the trade to be opened.
D. Get $ per pip of the currency of the trade ($10/pip for currencies ending in "USD", variable for others).
E. Multiply C with D. This gives us how many dollars would be at risk if we traded 1 contract (1 contract = 100,000 units).
F. Divide B by E. By dividing the amount of money we have to risk, by the amount of money risked if we traded 1 contract, we can get the number of contracts that we are able to trade.
We now have a figure like 0.869 or 1.342. It's up to you and your broker what you do now. You should always round down so that you are actually risking less than the maximum amount you said you wanted to risk.
If you use Oanda, then you can actually trade 0.869 or 1.342 contracts, which equate to 86,900 and 134,200 units respectively.
If you use FXCM's mini account, you need to round it to the nearest lot of 10,000 - 80,000 and 130,000 units.
If you use a broker that allows only whole-numbers of contracts, then 0.869 means you can't trade until you get more money from somewhere, or you find a trade risking less pips. 1.342 means you can trade with 1 contract.
There are some times when you don't want to be in the market. At all. Even if all the signs say "GET IN!". And normally these times are around announcements. "Major" announcements.
When major announcements happen, the price quite often spikes. In fact, it quite often spikes in one direction, then the other, then reverts back to where it was before all that happened and continues on as if nothing ever happened.
Only something did happen - one of the spikes took out your stop. Very frustrating, especially in the times when the price does revert back its previous price and course.
And, because brokers quite often cannot guarantee your stops in extremely volatile times, such as when major announcements occur, perhaps you incurred a bit (or a lot) of slippage as well.
Some people trade the announcements by putting entry orders on either side of the current price action just before the announcement, and probably cancelling the order that doesn't get taken up. And probably they do well out of it. But for me, no broker guarantees your order or your stop loss around announcement time. Slippage is a big risk factor.
Anyway, I don't get into it, so I need rules to tell me what to do when this is about to occur and what to do about it.
First, define "major". Not all announcements move the markets. There are some economic calendars you can use for this. There's the Forex Factory one, which specifies whether an announcement is of the "Volatility Expected", "Volatility Possible" or "Volatility Unlikely" variety. Choose which ones you want to avoid and do it. There are other calendars about also.
Other times to avoid trading might be around public or national holidays, weekends, Christmas, Easter, Thanksgiving in the US. Because we always want to be able to get in and out of a trade when we want to get in and out, liquidity is important. And liquidity might be affected around these days. Might be. Up to you.
Once you've defined the times you don't want to be trading, now you have to answer a couple of other questions.
If you don't have any trades open, it's simple - just don't open any new trades in these times. But you should specify, exactly, when these "holidays" start and end. Is it 2 hours before an announcement where volatility is expected, or is it 1 hour? Or 5 minutes?
Does your trading systems Christmas holiday start when the clock ticks over to Christmas day, or does it start at 1pm on December 23rd? Does it end when the clock ticks over to December 26? Or does it end at 10am on January 4th when the New Years festivities have also died down? This stuffs not hard, just write it out and follow it.
Further, if you have an open trade, what do you do with it? Close it? Move the stop loss to lock in as much profit as possible? Leave it alone if you've already locked in a certain amount of profit? Write it down. Follow it. Easy.
Browse through the Collective2 website and have a look at the differing equity curve charts.
When your equity curve is looking fantastic - starts in bottom left and ends in top right - there is nothing to think about. Keep doing what you're doing.
But, during drawdown time, what to do? All systems have drawdown times. But is it just a drawdown, or has your system stopped working?
I gave the example of this chart on that Collective2 site a few posts ago. That system gained 500% over just a few months. Fantastic. And a few months after that it was in 100% loss territory.
The question is, if you were the person using that system, when do you stop using it? When it fell back to a 400% gain? When it fell back to a 300% gain? 200%? 100%? At zero?
So here again, we need some clearly defined, objective rules. It's not good enough to erase the "I'll just hold on for a bit longer - it'll come back" way of thinking from the trade exit, if you're going to be doing the same thing here.
In fact I think it's more crucial here than anywhere to be clear about when to stop using the system.
Now, there is this thing called Profit Factor. Here's what I've said about Profit Factor in a blog entry:
Profit Factor is (Av Win / Av Loss) * (Pct Winners / Pct Losers). If it equals 1, the system has neither lost nor made money. If it's less than one then the system is losing money, more than one and the system is making money. The bigger the number, the "better" it is. But this calculation falls down in that it doesn't take into account the total number of trades, or the total amount won/lost.
(5/4) * (55/45) equals (500000/400000) * (55/45).
It does.
Really.
Anyway, you could use the Profit Factor of the last 5 or 10, or however many, trades to determine if you will continue to use your system. Once the Profit Factor falls below your set level, you continue to track the trades, but do not actually trade them. When (if) the Profit Factor comes back above that level, you can then start making real trades again based on that system.
I dare say that poor "500% gain to 100% loss" chap could have benefited from something like this.
On the other hand, here's something I also said about this method in a previous post:
...just because the last 5 trades have a Profit Factor of 2, doesn't mean the next trade is going to be any good. In fact, a scenario of events could take place where this rule keeps you out of the good trades and let's you get in on all the bad trades.
In the scenario I'm talking about, you have some bad trades, so the Profit Factor falls below the set level. Then, while you are paper trading, you get some good trades, so the Profit Factor comes back up. You now start real trading again, but have some bad trades. The Profit Factor falls below the set level. Then, while you are paper trading, ... repeat.
This Profit Factor idea is not bad, but it's not perfect. More research is required.
So, we're all done.
I haven't given you a trading system - I've explained what a trading system needs to be complete.
Hopefully I also gave you some ideas for some rules to experiment with.
Hopefully if you purchase a trading system from somewhere you can now validate that it's a "complete" system.
Hopefully if you read something and profoundly disagree, you'll get in contact with me so that I can learn further.
Our automated trading machine of course implements the concepts talked about in this series. Download it and give it a shot :-)