Trading system and methods applied to its elements

A trader should consider particular elements of a trading system (program). Each of them demands a careful elaboration and assessment of possible versions of implementation. In this article we will consider major elements of a trading system and describe methods on how to form these elements.

Element: currency pairs. First of all, you should ask yourself “What do I sell?” and “What kind of currency pair this trading program is purposed for?” Many authors of trading systems think that their trading systems is the best one and its methods can be applied to every currency pair. Unfortunately, test proves there is no such trading system which gives equal results for different currency pairs. That’s why every single currency pair should be provided with a certain trading program and an individual approach. Any trading program must be modified so that it can be used for another currency instrument. In particular, it means selection of other technical indicators, which provide the most reliable signal for a specific currency pair.

Method: As we mentioned above, Forex market deals with four main currency pairs (Euro, British Pound, Swiss franc and Japanese Yen against U.S. dollar). Cross-rate trade is less popular and requires more experience than work with major pairs does, so beginners are better not to start with cross-rates and are recommended to concentrate on majors.

Element: fundmantal releases. Many traders consider that they can do without fundamental analysis, because market accounts for everything. This statement still matters nowadays. Some traders manage to start working on market and getting profit almost without fundamental analysis. But let’s look from another side. Imagine that a trader works within a day and thinks that position will be closed in few hours. It will happen for sure, but on condition if there are no important events. You should always remember: information about economic situation in leading countries comes on a regular basis and market's respond is immediate. As a rule, the most abrupt movements in the market (50-100 points for one hour) occur as a result of certain types of news.

When important economic data is expected, following methods are applied:

• do not open any new position, especially if you don’t know what happens with market after the news;
• put buy stop pending order, if you wish to open a trade a lot. If price moves to the right direction, then position will be opened. Otherwise the position won't be open;
• close current open position or reduce rate of its stop-order. Anyway, deeper knowledge of fundamental analysis can help you to understand the market better. That’s why it is reasonable for a trader to study the market;

Element: time frame. When we talk about time frames, we mean choice of candlestick or bars (primarily, hour bars and day bars), on which we focus on.

One of the main principles of choosing time frame is the amount of funds on trader's deposit. Working with hour bars level of stop order varies from 30 to 70 points and with day bars, this rate is more than 100 points and often it reaches the level of 250 points. Most of trading systems allow several unprofitable trades one by one (maximum drawdown). So it’s dangerous to keep minor funds when you work with day bars. With a good yield, these losses are insignificant.

The second criteria is how often you can access the information. Connection can be rapid and easy, but at the same time Internet access can be quite expensive. If you have an opportunity to get the information about market and connect your broker at any time, you can work with hour bars. But if you can spend only one hour per day on market, you should work with day bars.

The third significant criteria is trader’s temper. Several days can pass till there conditions for opening a trade occur and it doesn’t even depend on type of trading system. Therefore, if a trader wants to open positions quite often, then he/she should use hour bars, because working with day bars will be boring and uninteresting.

So, the methods as applied to timeframe are: account for the amount of your capital and decide how often you need to check charts.

Please note that we are talking only about hour and day time frames. The reason is that week and month's intervals are usually in interest of large corporations, whereas frames less than 1 hour don’t give the opportunity to use the full potential of technical analysis. Surely, you can work with these kinds of time frames, such tactics are called “jobbing” and “surfing”. But we recommend you to gain some experience to do it. For beginner, it is preferable to work with hour bars.

Element: indicator. A correct choice of indicators are the guarantee of reliable signals produced by trading system. First of all, you should choose the main indicator which will give basic signals. After that, you will need the second indicator to remove or diminish drawbacks of system, e.g., to exclude false signals of the core indicator. Stochastic oscillator can be used as the main indicator to predict the market. Whereas combination of moving averages can be added to it which will confirm direction of trend. Also, combination of candlesticks or divergence can be an indicator. Please keep in mind that system built on the basis of the sole indicator won’t give positive results. Usually system is modernized several times through adding different filters. Filter is an extra condition for opening or closing a position. Then trading system is tested by different currencies and then it can be approved or rejected. Sometimes even a small change of selected indicators can make it possible to form a good trading system.

Trading system can be built on the basis of almost any technical indicator (but it’s better to use the most popular). Generally, a good trading system does not contain more than 5-6 parameters. At the same time, it can’t be built with only 1-2 of them. Only combination of these parameters can provide you with reliable signals for opening or closing a position.

Method: test and combine technical indicators to get the best possible result.

Element: volume.

Let’s remind the definition of the term “lot”. It is the amount of money a traders uses in a specific trade.

We have already mentioned the best possible volume of lot depending on the amount of money of deposit (in the chapter named “Capital management”). Main recommendation is illustrated by the following principle: volume shouldn’t be more than 33,3% of current deposit. In many cases this principle can help you to avoid loss of deposit. But all the above said has no relation to the trading system chosen by a trader. Now let’s try to define what volume of lot is based on properties of trading system and funds of deposit.

Testing any trading system, you can get several false signals in succession. Imagine that the result of one of the long-term tests is 5 unprofitable transactions, 50 points each. To continue work after these losses, it’s necessary to open positions with the same lot. So if you deal with EUR/USD currency pair and lot in the volume of 3000 points (therefore one point is 0,3$), then minimal startup capital should be: (0,3$*50)*5+3000/100*quotation.

This calculation is based on assumption that there won’t be large loss further (test of trading system in historical aspect should confirm it). But experience shows: in one time period there can be more unprofitable transactions.

The next question is whether to change volume of open position or not. There are different ways. If position is profitable, lot can be can be reduced to minimize losses. But profit also will be smaller if the price moves in right direction. And you can increase the lot volume if you think that price would continue to go this way. But if price turns as well, your initial profit will be lost. That’s why we don’t recommend you to change lot of open position and increase it in the hope that price will turn and go in a right way. If your desire to increase lot volume is too big, a trader should ask a question: if there is no open position, would you open it now? And make a decision corresponding to the answer.

Some traders change the volume of further opened lots after notable success either failures. On the whole, variation of lots includes 4 strategies:

• keep lot without changes;
• doubling of lot volume after a successful transaction (desire to be rich in a fast way);
• reducing lot volume after an unprofitable transaction (fear of new loss);
• doubling lot volume in spite of loss.

From psychological point of view, such behavior is easy to see. But what kind of results it brings? Test of trading systems can give a fair ground for thinking over this question. The table below includes the results of using the strategies on the example of one of trading systems. They are almost independent from the trading system (except the average yield).

This table shows that doubling of positions in both cases (2 and 4) increases risk of losing the deposit (increasing of losses). Reducing of the lot volume minimizes risks. The 4th strategy shows us that in spite of a highly increased MIDD level (almost in twice), the profit of the system increases only by 4,8%. So it means that depending on current results and emotional state, it’s better not to vary lots in process of trading.

Method: never change volume of open positions.

Element: Open trades.

A good entrance to the market is the opening of a position, which starts a trade in the point with a low potential risk and a high potential profit. The point with low risk is the point, where market is less likely to move against a trader. Such entries are good for work, because they allow to establish very close protective stops, thereby reducing risk. Soon after opening, a good entry also should be supported by favorable market movement. Transactions without favorable market movement just keep the money which could be used for other more effective positions. An ideal entry includes buying at the minimum price and selling at the maximum price. Of course, it hardly ever happens and such entry is not obligatory for successful trade. To make a successful trade, it is simply enough that entries in combination with good exits would ensure an effective trading system.

Let’s discuss the most popular ways of opening a position. As you may know, there are many numerous ways such as to follow trend or go against it, based on price either external characteristics, traditional or exotic, elementary or extremely complicated. For example, there are models, where opening is determined by solar and lunar activity. And the interesting fact is that the systems based on them are quite effective. Here we describe only a small part of all possibilities. We will look through popular methods, which are used very often and for a long time (some of them are used for decades).

Breakthroughs and moving averages – these are traditional models following the trend. Entries are very simple and attractive: purchase is made when price breaks through the top of a certain price range. Selling or opening a short-term position takes place when price breaks through the bottom limit. Thus, such entries provide a trader with participation in every large market or trend movement and also they are the basis of many popular systems.

Like breakthroughs, moving averages are also attractive in their simplicity and very popular among traders. Entries can be generated by moving averages in several ways. You can enter the market when price crosses the moving average upwards, when fast average crosses the slow one, when inclination of the moving average changes its direction or when prices interacts with moving average. Moreover, there is a great variety of averages: simple, exponential, balanced and many others.

The models of entry based on oscillators are also very popular among traders and included in many trading systems. The main feature of oscillators is that they can predict the price change by identification of turning points and try to enter the market before its movement, not after. The oscillators’ signals for entering the market were discussed in the second chapter. Traditionally this distortion (divergence) is between the movement of the oscillator chart and the price movement as well as signs of signal line. In trading systems such oscillators like Stochastic, RSI and MACD are used most often.

Market cycles are also used to determine a moment to enter the market. The idea is very simple. This is extrapolation (the method of scientific research, which consist of transferring the deductions received from research from one part of phenomenon to another part of it) of observed cycles into the future and the attempt to buy at the lows of cycles and sell at the highs. If cycles are quite stable and well-defined, such system will give a great profit. If not, then results of entries won’t be good. The nature of market cycles is rather different. Seasonal rhythms, effects of holidays and cycles related to periodic events (for example, presidential elections or economic releases) are referred to as exogenous (or external) factors. Other cycles are endogenous – their external moving causes are unknown and only market data are needed to make the analysis.

Element: Close trades.

In many cases a good exit is more important than a good entry. The main difference is that when you expect a good time to enter the market, there are no risks. If you miss one chance to enter the market, there always will be another one. However, a trader, who missed the best possible exit is potentially at risk (to close at the worst price and to suffer great damages).

The market exit strategy has two goals. The first and most important is the strict control over losses. The point is that any trade is impossible without loss. That’s why market exit strategy should dictate, when and how to close an unprofitable position, preventing great losses. This goal is often called capital management and is realized by stop orders. The second goal means to stay in a profitable position till its maturity. So it’s not preferable to stop a trade early, taking only small profit. If trade goes in favourable way, it’s necessary to stay there as long as possible getting maximum profit from it. Taking profit is often made by tracing stops and target profit levels – limit orders. The market exit strategy coordinates application of various types of exit by limiting risk and taking profit.

• Fixed exits of capital management (protective stops). Each exit strategy should contain a capital management exit. A capital management exit is realized by stop orders (stop loss). That’s why it is often called protection stop.
  This kind of stop closes a position after unfavourable market movement (movement against a trade) or according specified price below (if position is long-term) or higher (if position is short-term) than price level of entry. Protection stop usually stays at the same place as long as positions is kept. Its goal is to limit risk by a certain acceptable level. Trading without protection stops reminds the flight in an old plane without parachutes.
  There are many methods to make protection stops. The simplest one is connected to maximum amount of money, which trader is ready to risk with in a certain trade (money protection stop). Also there is a more sensible way, which is based on price barrier such as trend line or support/resistance level.
• Tracing exits. Tracing exit is usually implemented by so-called tracing stop. The goal of this exit is to take some profit or protect a trade (which is more effective than initial one) when the market moves in an unfavourable direction.
  When the market moves in a favourable direction, tracing stop can be shifted following to the price (up – for a long-term position and down – for a short-term position) to protect the most of current profit which grows. Many principles of placing protection stops are applicable for tracing stops too. Tracing stop can be placed at a fixed distance from current price or it can be linked to the current market volatility (price range). Levels and lines of consolidation also can be used as targets for the tracing stop.
  Taking into account the above-said, it's clear now that protection stop is a compromise. It is good to have a very close protection stop, as in that case loss will be minor. But the closer protection stop to a opening position is, the stronger probability of closing is (even if market goes in a preferable direction).
• Exits made when target profit si reached. Usually it is made by limit order (take profit), which closes a position, if market moves in the way favourable for a trade.
  Limit order with the exit upon reaching a target profit can be in the form of a protection stop or can follow the price as a tracing stop. Target profit can be based on volatility or a certain amount in US dollars. There are advantages and disadvantages of this method. One of the advantages is that you can make many profitable transactions.
  The main disadvantage is that you can exit the market early with a small profit especially when entering methods don’t provide multiple entries on long-term trends. As in the case with exits on stop orders, there is a compromise: target profit should be close enough to be able to take profit, but at the same time it shouldn’t be too close to be able to keep an average profit high.
  It’s not mandatory to include exit on target profit. We recommend to use one kind of target profits, which can be called “squeezing target”. It was created to close faded trades which won’t be able to initialize other types of exit. Firstly, target profit is established far away from the market. Then a limit order (take profit) gradually shifts to the market prices. And finally, it reaches the point, where the natural market volatility causes its reaction and gives some profit.
• Exits based on time of trade. They mean to close after some time passes from its opening. If during this period market is not changed so that the exit on target profit would worl (or another type of exit), then this trade has no sense and probably consumes your resources. Obviously, the forecast for this position has failed. That’s why transaction should be closed till the next opportunity occurs.
• Signals exits occur, when system gives a signal which is contrary to the current position and causes closing of this position. System producing a signal exit may not coincide with the system producing a signal for entry. Signals exits are the exits based on cross of moving averages, divergence and other signals from all possible indicators.

Conclusion: every trader should use certain types of protection stops. Also it’s desirable to use tracing stops to protect target profit, when the market moves in a favourable direction. Exit based on time of position allows trader to save the capital, which is used in a bad transaction. Elements considered above are the fundamentals of trading strategy. At the same time, this list is not exhaustive and many other elements can be added to system, while trader gains an experience.