How to Create Your Own Trading System
The two main problem most of traders experience are greed and fear. Greed leads to overtrading and losing profit because of late exits. And fear leads to keeping losing trades too long and profitable trades too short. Even people with nerves of steel often cannot coop with these feelings. The thing that helps a trader is a trading system.
Any currently successful trader before they became successful had come to necessity of trading system to survive in the market. A trader without a trading system is one on one with his greed and fear, while a trader with it knows that he is backed up. This article is intended to describe a step by step process of trading system creation.
First of all there are many types of trading systems: breakout, channel, martingail, grid, forecasting, following, etc. There are even astrological systems basing on moon phases and planet cycles. Describing each type is not the task of this article. We will model the process of building a trading system.
Step 1. Select a trading system type.
So, what our system will be about? For this time we select a simple but effective system: oscillator based entries with a trend filter. The ultimate goal of such systems is to buy dips in an up trend and sell rallies in down trend.
Step 2. Select a timeframe.
Here we need to decide who we are. Whether we are scalpers, short term, mid term or long term traders. The decision will determine the main timeframe. Scalpers work on 1-15 minutes timeframes. Short term traders work on 1-6 hours timeframes. Mid term – on daily – weekly and long term – on monthly and above timeframes. We will build our system as a short term and therefore select 4 hour timeframe. For a trend filter we will use mid and long term trends.
Step 3. Select a trend detection mechanism.
There are a lot of ways to determine trend. The easiest and most useful one is by moving averages. The author of this article will use Tom DeMark Moving Average, because it unlike most of the MA based trend indicators has 3 states up, down and flat. It is also useful for exits. You can use any other trend indicators like: MACD, Parabolic SAR, Hull MA, Linear Regression, Trend Envelopes and many others. With good settings the results will be similar. We will place the indicator on 3 higher time frames: Daily, Weekly and Monthly and define the main trend if we have 2 timeframes pointed in the same direction. If we have a defined trend we will trade only in its direction.
Step 4. Entry
We will have oscillator based entries. You can find hundreds oscillators around, but as usual most useful are a few: MACD, Stochastic, RSI and their variations. We will use MACD with standard settings 12, 26, 9. Now, to entries. With oscillator we have several possible ways to entry a trade: Crossover with a signal line, turn of oscillator momentum, exit from overbought/oversold areas and divergence/convergence. We will use the latter. While divergence is a good way of trading by its own, unfortunately it fails against a strong trend, you can have 4-5 and even more divergences until the trend stops and the price retraces. To avoid this we have our trend filter.
Step 4. Exit
Exit is a very important part of a system, which is often overlooked by traders. We will exit on either opposite divergence or trend change. We will also trail our position with help of DeMark Moving Average. The stop loss will be placed under last important high/low, determined by the MACD peak or valley where the divergence or convergence happened.
Step 5. Risk and Money Management
Whatever strategy you have, there will be losses. When you see a trade setup, you should always assume that the trade will be a loser. And select the trade size no bigger than you can afford to lose if stop loss is hit. It is not wise to trade 1 full lot on $5000 account with 100 pip stop loss. Because of stop loss is hit you will lose $1000 or 20% of your account. This is usually beyond the normal risk tolerance.
This is it, now you have a system. Write its rules visually backtest it, study, trade and make money. And remember that discipline is a virtue.
When you have a trading system you may want to code it. Instead of having many windows with many indicators, it's better to have one with all information in. Go to http://www.EAForexProgramming.blogspot.com and we will code you system. We will help you to write synopsis, improve the results, add important features and much more.
