Trading Systems

A trading system is just a set of rules which very basically tells you the following:

1. when to enter a trade
2. how many units to buy
3. the stop loss price
4. when to exit the trade

Here's an example:

1. if the close is above the simple moving average, enter at market
2. buy as many units as possible so that a maximum of 2% of my account balance is at risk
3. put the stop loss 5 pips below the low of the bar
4. exit at market if the price goes 50 pips in my favour

In this case, either the price will go up 50 pips and we'll exit at market for a profit, or the stop loss will be hit and we'll take a loss.

That is a trading system. A very simple one, but everything we need is laid out in black and white.

Moreover, the rules are not subjective at all. There's nothing in there that says "if it's in a down-trend", or "if the simple moving average looks like it's about to turn down". Each rule could be calculated by a computer, which is what you want.

(n.b. sometimes it's very easy to tell when a stock or currency is "in a down-trend", and sometimes you're just guessing. I don't like guessing).

How about we try to increase our chances of a profit? What we're going to do is modify our trading system so that we use a trailing stop loss.

A trailing stop loss means that instead of just setting the stop loss at the time we place the entry order, what we're going to do is move the stop loss up until eventually even if it was hit we would still make money.

The trading system becomes:

1. when to enter a trade
2. how many units to buy
3. the stop loss price
4. when to exit the trade
5. when to move the stop loss
6. where to move the stop loss

Which might be something like:

1. if the close is above the simple moving average, enter at market
2. buy as many units as possible so that a maximum of 2% of my account balance is at risk
3. put the stop loss 5 pips below the low of the bar
4. exit at market if the price goes 50 pips in my favour
5. if a new bar has a higher low and a higher high than the previous, move the stop loss
6. move the stop loss to 5 pips below the low of the new bar

And trading systems grow like this to be as simple or as convoluted as you think necessary.

The main points about trading systems are that:

• everything is written down
• everything is objective

No interpretation of what you've written should be required, nor indeed should it be possible for one person to interpret your rules differently to another person. If you can do computer programming, or you know a friend or next-door neighbour's kid who can do it, you or they should be able to program the rules into a computer.

This makes the rule "in a down-trend" an invalid rule. Instead you have to specify an objective way of calculating a "down-trend". And that might be as simple as saying:

• close is below a simple moving average; and/or
• the close of today was lower than yesterday, and of the day before that; and/or
• today's bar had a lower low and lower high than yesterday

Which of these rules works best, if any, takes us back to backtesting :-)