ANATOMY OF A
TRADING SYSTEM

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.

This is the final article in a five-part course aimed at providing education about trading that goes beyond basic skills.

Stock tips are not uncommon: Moneyweek, for example, runs a “share tips of the week” page; research firms publish their opinions on the best investment prospects; Morningstar has a “stock of the week” feature.

There is evidently an appetite for “stock picking” such as this and, when it comes to trading successfully, knowing what to buy or sell and when to do it is a key part of the process.

It is, however, not the whole story.

A stock pick, such as those mentioned above, is effectively an entry signal.

It gives you no information about how much you should buy. It does not tell you how to manage your money. It does not give you any information about how or when to exit your trade — either if it is going well or if it is going badly.

Furthermore, it is essentially a one-off entry signal — and unless you are privy to the thinking behind the tip, you are unable to assess whether it’s a valid signal or not.

This is why some traders opt for a mechanical trading system, which comprises objective rules for trading. A mechanical trading system can be tested, so that you can assess its historical effectiveness. And because it is rules based, it offers consistency and removes the emotional component from trading.

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.

Trade filter

What you can’t afford to do is throw away your capital on suboptimal trades.

Richard Dennis

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.

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 lagging trend indicator.

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 risk-return relationship says you cannot profit without taking on risk.

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.

Conclusion

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.

Quiz

FAQs

I have a technical indicator that gives buy and sell signals. Is this a trading system?

No. A 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?

Yes. Any rule that places a criterion on whether you act on a trading signal is a trade filter.

What is backtesting?

Backtesting is an attempt to appraise the effectiveness of a trading system by investigating its theoretical performance when applied to historical price data.