A complete trading system goes beyond deciding what to buy or sell, combining a number of key trading elements together into a whole. Read on to find out what all of the different parts of a trading system are.
Knowing how much of what to buy is only part of the trading process. You also need to manage risk, assess your
That is where trading systems come in, and this is how to develop one that suits you and your investment aims.
Why do Traders use Trading Systems?
Traders use trading systems to instil more structure into their investment plans. To ensure immediate decision making falls in line with long-term objectives.
There are a wide variety of trading systems which can be adopted. Some lean towards being rules based and managing the temptation to let psychological biases influence your decision-making. Others allow greater tolerance for adapting your trading approach over time, but stipulate in advance which criteria need to be met before deviating from your Plan A.
As noted above, it’s clear that a complete trading system needs to consist of more than just an entry signal. What else is needed then?
To be complete, a trading system should encompass rules for all of the following:
- What range of markets to trade
- When to enter the market
- How much to trade
- When to cut losses
- When to take profit
Let’s discuss each of these in turn.
What Markets To Trade
If you are building a system, the first thing to consider is to which markets it will apply. This could very well be all available markets, but ideally it will be whatever you judge will work best with your strategy of choice.
You might choose to exclude some. For example, choosing not to trade certain markets because they don’t have enough liquidity. Whatever you decide, if you are using a mechanical trading system in order to remove trader discretion, it makes sense to apply the rule consistently.
When To Enter the Market
An entry signal tells you when to open a new position. There are a great many technical indicators that have been devised over the years that can generate signals to buy or sell.
Originally, they will have been designed for a specific purpose; ensure you understand this. For example, be aware of whether you are using a trend indicator designed for trend following, or a momentum oscillator designed to predict potential pullbacks.
Ideally a trader wants their signals to offer them a trading edge. A way of attempting to assess whether an entry strategy has an edge is via backtesting.
Using trade filters
We want our entry signals to work as effectively as we can achieve. One way you can attempt to optimise them is by applying what is known as a trade filter.
A problem with any technical tool that gives you a trading signal to buy or sell is that some of the signals will be false signals. It follows that it would be useful to try and screen out as many false signals as you can.
“What you can’t afford to do is throw away your capital on suboptimal trades”
Richard Dennis
Tip: A trade filter is a simple measure that attempts to tell you if conditions favourably match a given trading signal.
A generalised example might be ignoring any sell signals if your filter says conditions are bullish.
Any technical indicator that judges whether conditions are bullish or bearish could work as a filter in this way, but a common tool is a long-term moving average. A moving average (MA) is a tool that economists use to smooth out data and they have long been used by technical analysts as a
See the following simple example for the purposes of illustration:
A 20-period MA and a 50-period MA could be used in combination as a filter. If the shorter MA is above the longer one, it indicates a bullish state and only allows buy trades. If the shorter MA is below the longer one, it indicates bearishness and only allows sells.
Risk management
Even after optimising with a filter as above, every trading strategy will give false signals. In other words, there will inevitably be losing trades as well as winning ones.
Risk management is the skill of striking a balance in how much risk you take on at any one time. The
If you take too little risk, you guarantee there is no chance of a decent return. If you take too much risk, you are likely to lose everything or be squeezed out of trading. Risk management is all about finding the happy medium between these two extremes.
How Much To Trade
A crucial part of risk management is position sizing. This answers the question of how large each position should be.
For the markets you are trading, use historical data to look at the magnitude of extreme price moves. Consider if this was an adverse move and how, for a given position size, this would stack up against your total risk capital.
As discussed above, consistency also needs attention.
If you are inconsistent in your position sizing, you run the risk of losses from your bad trades outweighing the profits from your winning ones. You do not know which trades are going to win or lose, of course, and hence the need for consistency.
Note that consistency here does not necessarily mean simply trading the same dollar value on each instrument. If one instrument is more volatile than another, reducing the size of the more volatile position may offer a more equal exposure.
Exit strategy
Put simply, this is a rule that tells you when to get out of a position. If your position is going well, when do you take profit?
If the position is going badly and losing money, how large do you let that loss become before you close? Your exit strategy will answer these questions.
Some systems use time-based exits. This is simply closing after a certain amount of time has passed. Some trend-following systems close a winning trade only after giving back a certain percentage of the profits. Setting a stop-loss will serve to remove losing positions.
Consider what works best for you.
Well-chosen exit levels should aim to minimise the damage to your risk capital when trades don’t work out and maximise profits when they do.
Final thoughts
A complete system is more than just picking entry levels. A well-tested system does not guarantee future performance, but it does give a more solid foundation in which to be confident rather than using discretion or intuition.
Head to the eToro Academy to learn more about different trading techniques.
Quiz
FAQs
- I have a technical indicator that gives buy and sell signals. Is this a trading system?
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No. Technical indicators can form part of a trading system but a comprehensive trading system will encompass a more complete set of rules, including those for position sizing and exiting trades.
- I am considering a trading rule that only allows me to follow an entry signal during market hours? Is this a trade filter?
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Yes. Any rule that places a criterion on whether you act on a trading signal is a trade filter. If you are applying filters based around market hours then you will need to keep up to date with holidays and ad hoc changes to times when an exchange is open.
- What is backtesting?
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Backtesting is an attempt to appraise the effectiveness of a trading system by investigating its theoretical performance when applied to historical price data.
- What is the difference between a trading system and a trading strategy?
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A trading strategy is a set of defined rules designed to meet an investment objective, while the term trading system relates to the sometimes automated protocols used to implement the strategy.
- What are the main advantages of using a trading system?
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The main advantage of a trading system is that it introduces discipline. They reduce emotional bias, improve consistency, and help navigate the inevitable ups and downs of the market.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments.
This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Not all of the financial instruments and services referred to are offered by eToro and any references to past performance of a financial instrument, index, or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.