Topics covered in this chapter:
- Why and when you need a mechanical trading approach.
- Advantages and disadvantages of some of the most common types of signals generated by technical indicators.
- From the hypothesis to the verification: the complete process of building a trading system.
- Why articulating a trading strategy can be both challenging and enlightening.
- Ideas and key factors to choose the variables that define your edge.
- Fine-tuning a system with back- and forward-testing.
Having studied Units A and B you should be familiarized with the Forex market to the extend that you know who participate in it, the reasons why participants chose this market and how you can emulate them. Moreover, you should also be able to pick the best set-ups, the optimal time to trade those set-ups, and know a lot of guidelines about how to trade them.
However, and because there are exceptions to analytical guidelines without which market analysis would be a science of exactitude - not one of probability-, you need a structured approach, in other words: a trading system.
But what exactly is a system? The point of this chapter will be to give you that information as clearly as possible, and to bring you to the next level in your education showing you what this amazing subject has to offer. Be prepared for a challenge: this learning stage is different than the analytical approach you learned in Unit B. Besides mastering good analytical skills, success in Forex requires a systematic way of making trading decisions.
First we will go through several definitions of trading systems. You will learn that a system is basically a methodology that you adapt to a certain market characteristic.
The second section will help you understand that a structured trading approach is about creating and following rules, with a keen sense of observation and discipline. To consistently make money in the Forex market you want to have a set of trading rules that guide you through your decision making. This will separate you from the market gamblers and give you the structure to become a professional trader.
As always, we will make it simple for you by building a trading system from scratch that you can use for your first tests. This will be the focus of the third section.
New traders are regularly fooled by expensive “holy grail” systems and perhaps you're looking for it too. You have to be realistic when searching for a useful system and consider if you really need to buy one. Some systems are very hard or impossible to understand. Only by understanding the methodology of the system, you will be able to effectively use it at your advantage. How can you follow something you don't understand? In the last section you will learn two methods for evaluating and finetune any trading system.
1. Definition of a Trading System
A trading system is a set of rules that formulate buy and sell signals without any ambiguity or any subjective elements. These signals are mostly generated by technical indicators or combinations of technical indicators. The primary aim of a trading system is to manage risk and to increase profitability in any market environment. Optimal levels of risk and reward are accomplished by modifying the different parameters within each rule of the system.
A benefit of trading with a system is the removal of emotion from trading: systematical trader will, for instance, not place an excessively high risk trade due to frustration from a prior losing trade. But there are many other benefits to extract from a methodological approach as you will see later.
No system is better than another, but a good system is one that is adapted to your goals, your time window, your start capital and also to your personality.
Trading systems can be classified in different types:
Trend Following Systems
As the name suggests, trend following systems aim to enter a trend and profit from a continued price movement in the same direction. According to Newtonian physics, an object in motion tends to stay in motion - this is also one of the principles of the Dow Theory. Therefore, if a certain currency pair has developed a powerful trend, that trend is likely to continue until something fundamentally changes.We have seen in the previous Unit B that determining the trend is an objective process, but the decision to enter the market can be discretionary or mechanical. For example, some traders can pull up a chart and instantly determine if they want to buy or sell - this is a discretionary approach. What we are going to propose you is to use specific indications to guide you through that decision.
Perhaps the most famous proponent of trend following systems is the famous commodities trader Richard Dennis. Dennis firmly believed that trading abilities could be broken down into a quantifiable system of rules that can be taught, while his friend and business partner Eckhardt felt the ability was something innate. In 1983 Dennis proposed to recruit and train some traders and give them actual accounts to trade in order to see who was right in this ongoing debate. Ten inexperienced students were selected, invited in Chicago and trained for two weeks. The trading methodology that was taught to them was a trend following system and the group was nicknamed “the Turtles”.
Over the next four years the Turtles earned an average annual compound rate of return of 80% and Dennis won the bet.
Counter-trend or Trend Fading Systems
This type of systems tend to be the riskier ones. They aim to identify reversal points in price making use of overbought/oversold conditions signaled by RSI or other oscillators, crossovers of the outer Bollinger Bands, regular bullish and bearish divergences using MACD, etc.
You need well-defined rules for trend reversals and it certainly requires a certain experience and also a great deal of confidence in your approach. How to gain confidence is something we will explore along the entire Unit C.
A counter-trend may also develop into a trend. Following such a system would imply to account for many small losses until a runner is hit and you pick a new trend from the beginning. That winner usually compensates the many small losses accumulated trying to pick reversals.Another difficulty of counter-trend systems is that the exchange rate may enter in a ranging condition before it reverses in the opposite direction. Your understanding of the Elliott Wave Principle explained in chapter B04 and PrB will give you a huge insight into that market characteristic.
What Is Fading? Simply put, fading means to buy bottoms and sell tops in price. Many aspiring traders dream of successfully picking swing lows or swing highs and watching the trades taking off in their favor for a sizable gain. This can seem easy when looking at past price action. However, when trading in real time, the peaks and bottoms become less apparent, and can lead you to believe that price will reverse, but in reality you the trend is resuming and stoping you out.
In a 24-hour market as the spot Forex, there is plenty of “choppy” price actions, that is, when the market has no clear direction. In fact, if you look at almost any long-term chart of almost any market you can clearly see this phenomenon, even without any statistics. In fact, ranges can be found in all time frames due to the fractal nature of the markets.
Derek Frey's ITC 2008 presentation about “Trading Ranges” helps us understand ranges:
What is a range?
- A definable region within a market that can be traded with a slightly greater degree of reliability than not.
- Ranges can be found in almost any market condition in any time frame.
- These can be horizontal, ascending, or descending.
- Range lines do NOT need to be parallel.
Why do ranges develop?
- Markets are fractal in their structure and therefore they are basically a series of ranges that scale over time.
- The word fractal was coined by the brilliant mathematician Benoit Mandelbrot.
- Most of the “tools” traders use today we built with the false assumption that markets are linear and distributed “normally” via the Gaussian or standard bell curve.
- These ideas have been proven false but for some reason most traders still cling to them.”
Here's a secret that the media don't want you to know because they wouldn't be in business if everyone believed this: prices don't trend because of news. Economic data frequently impact on the market but if you look closely, it only makes price action noisy.
For example, in 2008 the GBP/USD moved almost 60,000 pips up and down if we track the daily ranges for the entire year, while it dropped from the beginning to the end of the year by only 6,000 pips.
That means that on average, the total year's movement from the highest to the lowest level was only one tenth of all price ranging movement.
Only a handful of big moves contributed to the overall trend - the rest was the market engaging in a ranging behavior as it reacted to daily noise.
Breakout systems are based on the idea that if the exchange rate has been contained within a price range, sooner or later it will break out of it. The system will then search for scenarios of increased volatility expecting to capture a continuation of the breakout move based on momentum. This can be for example breakouts of support and resistance levels (horizontal levels, channels, trendlines), chart figures (triangles, flags, etc), volatility breakouts, breakouts of daily high and low prices, etc.
Reverse Breakout Systems
A reverse breakout system is designed to fade the moves described above. Concepts like “throw-over” from the Elliott Wave Principle, or false breakouts on chart figures, would be starting points for this methodology. It's based on the idea that a broken support sometimes fails to become a resistance and vice versa. Besides Elliot waves, tools used to spot reverse breakouts can be for instance Bollinger Bands, Parabolic SAR, or Envelopes.
Trade those patterns that are the most natural for you. Some people are very good detecting divergences, others are more focused on pullbacks, while others may use triangles as their favorite pattern. It takes a while to develop such a skill but it is something that happens naturally if you spend enough time looking at charts. A favorite pattern is something that you detect over and over again, and then you start to develop strategies to profit from that recurring event you’ve observed.
Derek Frey, in the above quoted presentation, goes on by saying:
“I have seen swing traders base trades on Lunar cycles, support resistance, pivot points, sun spots, regression lines, indicators, etc., etc. ad infinitum. I cannot tell you what will work for you but I can tell you that the key is comfort. This too may sound simple but it is very important. You must be comfortable with whatever system or set ups that lead you to trade in the first place. Trading a method that does not fit your personality or style is one of the biggest reason traders “override” the system and that is almost always a great way to lose.”