A trading system is a set of rules that define all of your trading actions given any circumstance that might arise. Once you have a trading system, you no longer have to make subjective or discretionary decisions about when to buy or when to sell as your system will determine this for you. A properly constructed trading system will leave no room for human error, as it will define your actions for you given any circumstance that may arise.

A trading system is composed of the following elements:

• Style - Definition of a trading objective
• Entry - Conditions required to enter a trade
• Risk - Rules to limit losses
• Exit - Rules to define exit points
• Testing - Proving the strategy

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Trading Style

No two people have exactly the same amount of money, tolerance for risk, personality, financial needs, time to trade or investment experience. For this reason, to become a successful trader you must consider these factors and develop a trading style that will suit your lifestyle. If you don't, you will greatly reduce your chances of success.

You cannot design a trading system without an idea of your objectives – these are the driving force creating your need to design it. What do you want from trading and when?

Are you designing a trading system for cash flow or capital growth? Decisions like these will have the largest impact on the composition of your trading system.

Trading style defines the type of trading you are going to do. Here you make broad decisions such as deciding what market you are going to trade and how intensively you want to trade including the following:

• Timeframe - will govern how intensive the trading is and how many positions may be open at the same time. Timeframe refers to the average length or 'duration' of trades including: short term (e.g. up to 3 weeks); medium term (e.g. up to 6 months); and long term (e.g. up to 1 year).
• Direction - refers to the whether the trade is attempting to take advantage of rising prices (i.e. going 'long') or falling prices (i.e. going 'short'). The words 'long' and 'short' in trading can describe both the direction and the timeframe. Generally a system will be designed to take advantage of either a 'bull' market (i.e. where prices are rising) or a 'bear' market (i.e. where prices are falling).
• Market and Product - refers to the financial instruments that the system will trade, e.g. AUS or US market and shares or derivative products. This can be further broken down, e.g. all ASX shares or only the top 200.
• System Type - is defined by the particular market condition (or price activity) the system is attempting to take advantage of. Broadly it can be described as where on the price chart the trade is trying to enter and exit. HomeTrader teaches different system types including trend following and mean reversion.

Entry Conditions

Entry conditions are a precise set of criteria that a share must pass for it to be signalled by the system. The conditions leave no room for discretionary judgment and trades will only be signalled if all the criteria is passed.

The objective is to only take trades when conditions are ideal to the system rather than taking trades just for the sake of it. Depending on the type of system a trader may also go some time without taking a trade.

A system will generally contain the following as part of its entry conditions:

• Triggers – alert you to potential trade opportunities
• Gates – filter opportunities down to those with the highest probability of success

Risk and Money Management

Perhaps the most important and least addressed aspect of trading is the ability to manage risk. Risk and money management is there to handle the inevitable trades that have not gone in the desired direction, and used properly should allow you to continue trading even after several losses.

As part of your money management a number of things need to be considered including:

• trading float
• drawdown
• risk per trade
• trade position size
• stop loss size
• maximum number of open position

A trading system should define exactly how much money you are willing to lose on any given trade.

A profit or loss on a trade is the result of the direction and extent of a price move, multiplied by the number of shares that you own. You cannot control the direction of a market, or the extent of a price move but you can control your position size (i.e. the number of shares that you own). Your ability to do this is going to directly affect your profitability as a trader.

A profitable trader is one who has the ability to manage their losing trades. Losses are inevitable so you have to make sure you are aware of them, and keep them to an absolute minimum.

The most important variable in the risk management component of a trading system is the volatility of the share that is being traded.

The volatility of a share is a measure of how 'jumpy' the price movement is. This can be quantified easily through most charting packages. The volatility of a share will affect the way your system treats the amount allocated for the trade.

In summary, the lowest amount of capital should be allocated to high volatility shares and the highest to low volatility shares.

Stop Loss

A stop loss is a tool that is crucial to all trades. It is the price below your entry price that you will exit a trade. A critical part of a trading system is to have a predefined method of calculating and implementing a stop loss.

As an example, a trader may purchase shares in a company at $2.00 and set a stop loss at $1.95. Consequently if the price of the shares falls to $1.95, the trader would exit the position accepting a small loss.

Remember: all big losses start as small losses.

There are many different methods of calculating the placement of a stop loss including:

1. Percentage Stops
2. Volatility Stops
3. Technical Stops

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Exit Conditions

Having a strategy that defines your exit is as important as one that defines your entry. As with entry conditions, exits should be devised using a statistical approach.

Exits conditions are usually defined into two broad categories:

1. Profit Target - a pre-determined price objective.
2. Trailing Stop - an exit that allows for the potential of a trade to be maximised

Exits can be executed manually (i.e. end-of-day) or automatically (i.e. intra-day). The method you use to implement exits will vary depending on the facilities provided by your broker and your particular system type.

Most medium term traders use end-of-day exits where they compare the day's close price to the stop loss and exit the following day on open if necessary.

Most short term traders use intra-day exits and will place contingent orders to be automatically executed during the trading day if necessary. Using automatic exits helps remove some of the emotion from trading.

Testing and Evaluation

In order to trade a system with consistency and discipline you need to have confidence in its potential performance.

By thoroughly testing the system over historical price data you can see its historical performance. This process is referred to as “backtesting”.

It is reasoned that price movements in financial markets are the result of actions taken by people. Because people continue to be the main factors in the market, similar performance can be expected in the future. For this reason you can gain an idea as to the future performance of your system based on how it would have performed in the past. However, as with anything, past performance is not a guarantee of future returns.

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