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What is a Market Trading System?Using Methodology and Discipline to Trade Stocks
Aug 21, 2009 © Harry P. Schlanger
A trading system is a tried and tested method to enter and exit a market for a profit
or loss. In the long run the wins should outweigh the losses.
There are many definitions in the literature of what a market trading system is. Simplistically, it is a
trading method known to work so that either a profit is achieved or loss incurred.
However, the aim of a
good trading system is that if the trading process is repeated over
and over in the same manner, eventually the wins outnumber the losses and a net profit is recorded.
In order for any market trading system to work successfully, the operator needs to exercise
trading discipline in running the system exactly the same way each time, as was intended.
A "System" in General
Van Tharp provides a vivid illustration of what a system is by thinking of an office task, which is
repeatable and simple enough to be run routinely by a 16 year old who might not be that bright, but works
well enough to keep many people returning as customers.
The reasoning behind such a system is not so
important since it has been previously tested to work and does not need to be scrutinised by the person
operating it. What is important though, is the outcome, which should be a positive one.
Different examples of routine, simple systems are computer programs.
Parts of a Trading System
Many people think of a trading system simply as a group of specific rules, or parameters, that determine
price entry and exit points for trading a given security. These points, known as "signals", are often
obtained by charts in real time and used as warning to place orders to execute trades.
However, a trading system may have additional components, consisting of a total eight parts:
- Market type: What type of market to include? For example, quiet, trending, volatile, flat, bullish,
and bearish.
- Set up conditions: What screening criteria to use? For example, screen stocks to find one of interest,
or choose a security based on technical reasons.
- Entry signal: A unique signal for entering the market either long (buy) or short (sell).
- Worst-case stop loss: A protective stop in case the market moves against the trade.
- Re-entry when appropriate: If the security favors the original position, what are the criteria
to get back into a closed out position?
- Profit-taking exits: When the stop is hit, the trade is terminated. Stops are always adjusted closer
to the market to lock in profit. For example, adjust the stop to 75% of the closing price whenever a stock
makes a new high. Exits are one of the more critical parts of a system, therefore exit strategies should
be well thought out.
- Position sizing: This controls how much money to trade. For example, do not risk more than 1% of the
portfolio per trade.
- Systems for different market conditions: A system used for trending markets may not be suitable for
say, flat markets, so that another system may need to be devised.
Trading Plan as Part of Business Plan
A trading system should be part of an overall
business plan
of a trading business. Without the business
plan, people will still lose money. For a good business plan, Van Tharp recommends a number of important
sections to be written down:
- The Executive Summary
- A Business Description
- An Industry Overview and Competition
- Self-Knowledge Section
- Your Trading Plan (contains trading system)
- Your Trading Edges
- Financial Budgeting
- Contingency Planning if things go wrong
In summary, a trading system is part of a trading plan, which in turn, is part of the overall business
plan. The trading system itself involves a set of rules that enable a trader to organize his/her actions in
market trading and control his/her emotional states. If the rules are abided by, then the expectation in
the long run is to achieve a profit.
References:
- "Trade Your Way to Financial Freedom", Van K Tharp, McGraw-Hill, NY, 1999
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