There are many definitions in the literature of what a market trading system is. It is a trading method known to work so that a profit is achieved or loss incurred. But 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.
However, in order for any market trading system to work successfully, one 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 needs not be scrutinised by the person operating it. What is important though, is the outcome. Another example 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:
- A 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.
- An 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 it is 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 a 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