How to Create a Trading System

It’s simple, but not easy to create an effective trading system that has a positive expectancy of success.

And if you’re like me, you don’t mind skipping a few steps along the way to get to the exciting aspects of your system, that being its execution with real money. Ah, but it will cost you to skip steps. It’s like putting flour in the oven to bake a cake, even before you mixed in the sugar, eggs and milk.

Here is a recipe for creating a trading system. It has six steps. After that, you get to trade it with real money. You get to eat the cake you’ve baked.

1. Observe Patterns

Markets have recurring patterns that are reflections of the psychology of its participants, namely other traders. You can observe these patterns by simply looking at candlestick formations or by seeing how a technical indicator such as RSI responds when a price action develops. You need to notice something is happening. You need to listen. You need to be aware of your surroundings and what is happening in the moment. Remember that you have no money on the table at this point so the chances of your vested expectations clouding your observations is minimal.

2. Quantify Your Observations

Every time the 10-day simple moving average crosses the 30-day simple moving average, the price action follows in the direction of the cross. Well, maybe not always but mostly always. How can I quantify that observation? Simple. IF the 10-day crosses the 30-day to the upside, THEN price action will likely be bullish. IF the 10-day crosses the 30-day to the downside, THEN price action will likely be bearish. You will notice the use of the word ‘likely’. How likely is ‘likely’. That’s what we’re here to find out.

3. Define a Trading Criteria or Method

Based on our moving average crossover observations, we would like to exploit the price action to the upside and downside, depending on what the market is telling us at the time. A system is a specific procedure for entry, stop and exit. I don’t like the “R” word (‘rules) because of personality issues I have, but you can certainly use the “R” word if you are not prone to a blatant, rebellious penchant for breaking rules. The important thing is to feel comfortable in your own skin here. Your system must be specific or the data you’re about to glean will be rendered meaningless. If you are not consistent in execution, you will get statistically invalid testing results. This is the science part of trading. So it can run like this: IF the 10-day crosses the 30-day to the upside, THEN I enter on the open of the next 5-min bar, stop 0.30 Average True Range (ATR) below, and exit when the 10-day crosses the 30-day to the downside. There, that was simple, no?

4. Do a Backtest of 30

Thirty is generally considered the minimum sample size to get even remotely valid probabilities. With this size you can calculate average wins, average losses and compare the two for an expectancy ratio. Now, backtesting is kind of a chore. Actually, it is a chore and probably nobody really takes pleasure in this step. There will always be the few that do enjoy this part of the process, just like there is always someone that takes great delight in measuring a cup of flour. Regardless, we are going to do this thing.

Apply whatever studies you used in your previous observation and go back in time on your charts. Wherever you system says to go long, jot that number down, jot down the stop number and then observe where the system exited, whether at the stop or at the exit. Now do that 29 more times. Add up your winners versus your losers. Calculate your average winner versus your average loser. Now do simple math. Expectancy = (% winners x average winner) – (% losers x average loser). If this number is not greater than zero, throw that strategy into the trash can. If it passes the smell test, move to the next step.

5. Do a Backtest of 100

Repeat the top exercise but this time you’re investing more time to get a more statistically valid sample size. If the results still yield better than zero, go to the next step.

6. Paper Trade the System for 100 trades

This one is pretty hard for a lot of us. Paper trading is bogus and a waste of time, we tell ourselves. You don’t get the same emotional conflicts with paper money as you do with real money. That’s all true, but that is also the point. We will use results from paper trading to measure the performance of real money trading later on. Airline crews don’t jump into a new jet before executing procedures in a simulator. That’s done for some very good reasons. Once we’ve completed our 100 live paper trades, we compare it to our backtest of 100 samples. Were the results as expected? Good, it’s time to eat your cake.

7. Trade Real Money

Everyone loves this step. We now execute 100 trades with real money. Don’t stop after 7 trades just because the first 6 were losers. You’re violating the statistical requirements of your analysis. There is a random distribution of each trade, but patterns develop after a significant sample size. Now compare your real money trades to your paper money trades. Similar? You probably did worse with real money and the reason is you are prone to execution errors when real money is on the line, just like our free-throwing NCAA basketall star is with 1 second left on the clock and down by 1. The difference between your paper results and your real results represents what you need to learn.

We’ll take on trader psychology at another time. In the mean time, enjoy the bounty of your trading system as you become wealthy beyond your wildest dreams.

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