What most people think of as a trading system, I would call a trading strategy that consists of seven parts:
Set up conditions. An entry signal. A worst case stop loss. Re-entry when appropriate. Profit-taking exits. A position sizing(TM) algorithm. Multiple systems for different market conditions (if needed). The set up conditions amount to your screening criteria; For example, if you trade stocks, there are 7,000 plus stocks that you might decide to invest in at any time. As a result, most people employ a series of screening criteria to reduce that number down to 50 stocks or less. For example, you might want to find stocks that are great “value” or stocks that are making new all time highs or stocks that pay high dividends.
The entry signal would be a unique signal that you’d use that meets your initial screen to determine when you might enter a position—either long or short. There are all sorts of signals one might use for entry, but it typically involves some sort of move in your direction that occurs after a particular set-up occurs.
The protective stop is the worst-case loss you would want to experience. Your stop might be some value that will keep you in the trade for a long time (i.e., a 25% drop in the price of the stock) or something that will get you out quickly if the market turns against you. Protective stops are absolutely essential. Markets don’t go up forever and they don’t go down forever. You need stops to protect yourself.
A re-entry strategy. Quite often when you get stopped out of a position, the stock will turn around in the direction that favors your old position. When this happens, you might have a perfect chance for profits that was not covered by your original set-up and entry conditions. As a result, you also need to think about re-entry criteria. When might you want to get back into a closed out position.
The exit strategy could be very simple. It is one factor in your trading of which you have total control. It is your exits that control whether or not you make money in the market or have small losses. You should spend a great deal of time and thought on your exit strategies. This is an important shift in thinking that you will benefit from right now. You don’t make money when you enter the market you make your money upon your exit of the market. Far too many people focus only on market entry, or what to buy, rather than when to sell.
Position sizing is that part of your system that controls how much you trade. It determines how many shares of stock you should buy or “how much” you should invest in any given trade. It is through position sizing that you will meet your objectives.
Finally, depending upon how robust your trading system is, you might need multiple trading systems for each type of market. At minimum, I believe that you might need one system for trending markets and another system for flat markets. Many professional traders have multiple systems that operate in multiple time frames over many markets to help offset the enormous portfolio dependence of a single trend following system.
Your system should reflect your beliefs (i.e., who you are as a trader and as a person). Many people are just looking for “any system that works,” but if your trading system doesn’t match your beliefs about the markets, you will eventually find a way to sabotage your trading.
Improving your trading performance will not come from some indicator that better predicts the market. It comes from learning the art of trading and understanding how to create a trading system that fits your wants, needs, desires and lifestyle.
