Building a system

How to build a profitable trading system

Overview

The purpose of this page is to help you create a trading system that is reliable, consistent and hopefully profitable. It can also be designed to meet your appetite for risk.

We have already covered position sizing, entries and exits and money management so this page tells us how to bring them all together alongside our robust trading signals. I like to think of trading signals as triggers to start the process. They do not give you permission to buy or sell but instead to look more closely as the opportunity to buy or sell may be imminent. When your trigger fires then a lot of your criteria have been met but not yet enough to trade.

Many of the areas required to create a complete trading system have been touched on by other pages but now they are all being brought together. Any decisions you make here should always be reflected in your trading journal.

System design

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What are you going to trade?

As part of your trading journal you should have already documented what you intend to trade and the timeframe you will trade in. So we can refer to real examples throughout this page we will be using the currency pair EUR/USD as our example.

What timeframe are you trading?

We will generate our signals on daily data but time our entries and exits on hourly data.

The first decision you need to make is to determine whether you are trading an asset that is trending or range bound. This decision will determine which indicators and oscillators you choose to create your signals.

Our example of EUR/USD is a trending asset, as most currency pairs are. We will therefore adopt trend following indicators. We shall use simple moving averages for our signals.

Choosing indicators and oscillators

A common way of deploying these signals is to implement moving average crossovers. We would open a position when a fast moving crosses over a slow moving average and then reverse the position when it crosses in the opposite direction. This strategy is very limiting as it gives you very little scope to improve the system as you would always be in a trade.

We therefore break the system down into two sets of signals, one for a long only system and one for a short only system. Each system then has its own entry and exit signals. Instead of a simple moving average crossover we have now improved the system by having 4 discrete signals that work independently of each other.

Now we need to decide on the initial inputs that make up these 4 discrete signals.

Long only trading system

For our long only trading system we decide to use Fibonacci numbers (5, 8 and 21) as inputs to our moving averages.

We will therefore look to enter a new long position in EUR/USD when the 8 day moving average crosses above the 21 day moving average.

We will look to exit the long position in EUR/USD when the 5 day moving average crosses below the 21 day moving average.

Short only trading system

For our short only trading system we decide to use Fibonacci numbers (5, 8, 21 and 13) as inputs to our moving averages.

We will therefore look to enter a new short position in EUR/USD when the 5 day moving average crosses below the 21 day moving average.

We will look to exit the short position in EUR/USD when the 8 day moving average crosses above the 13 day moving average.

Test

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Test using different inputs

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Develop input parameters

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Trading system evaluation

  • Total trades
  • Winning %
  • Profit
  • Outliers
  • Drawdown and runup
  • Duration
  • Winning and losing sequences

Apply money management techniques

  • Maximum adverse excursion
  • Maximum favourable excursion
  • Drawdown support
  • Winning series

Summary

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