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What are Trading Systems?

Trading Systems are an incredibly powerful way to profit from all financial markets including the stock market, cryptocurrencies, futures, and forex markets. Some very robust trading systems can even by applied to several financial exchanges with little to no modification, providing global diversification and profit potential with minimal effort. If you are new to trading or struggling to get consistent results, systems trading is the fastest and most reliable way to learn stock trading.

Built correctly, your system should be rock solid and make you money well into the future. BUT, if built the wrong way, you’re more likely to encounter drawdown and losses.

Let’s first define what a trading system actually is…

Before we go into detail, I want to clear up one super common question. All of the following terms basically mean the same thing and can be used interchangeably. They are all different terms for basically the same thing – 100% objective rules based trading. At Enlightened Stock Trading we refer to them mostly as ‘Trading Systems’, but all of these other terms are essentially referring to the same thing:

  • Trading Systems
  • Quantified Trading Strategies
  • Active Trading Strategies
  • Algos
  • Algorithmic Trading
  • Algorithmic Trading Systems
  • Mechanical Trading
  • Mechanical Trading Systems
  • Trading bots

A trading system is a comprehensive set of rules (similar to those used by many hedge funds) based on technical indicators like bollinger bands or moving averages or objectively defined chart patterns dictating how you enter, exit, and manage risk in the financial markets. The goal is to ensure that you earn more than you lose over many trades, even after accounting for commissions and slippage.

The primary advantage of system trading is its ability to eliminate human emotion, which is often a significant source of trading mistakes. By following a predefined set of rules, you can make consistent, informed trading decisions without being swayed by psychological factors.

Mechanical trading systems, or algos, leave no room for discretion. Every decision is dictated by fully codified rules designed to handle all potential market scenarios. This approach ensures your actions are in line with the system’s guidelines, not personal emotions or biases.

Why Does Systems Trading Work?

Many traders battle with psychological biases that can negatively impact their trading decisions. Discretionary traders must delve deep into trading psychology and eliminate these biases if they are to become profitable – this can take years of psychological work. Systems trading provides a faster, more disciplined alternative, allowing traders to bypass the pitfalls of emotion and become consistent sooner.

Systems trading also allows traders to answer the critical question – Do I have a real and measurable edge in the markets.

As you will see in this article, by adopting a systematic approach to trading you eliminate discretionary and subjective decisions from your trading. This results in an objective, testable approach which you can validate on past market history to ensure it is profitable (this is called backtesting).

Trading systems work because they bypass the psychological issues that plague most traders and can ensure you make informed trading decisions and have a positive edge in the market.

Trading System Diving Deep: Components and Types

Trading System Components

Many traders will be acquainted with the four core components of a trading system:

  • Trade Setup: Defines the conditions under which trades are sought.
  • Entry Signal: Pinpoints the exact entry into a trade, encompassing aspects like pyramiding and re-entry.
  • Initial Stop Loss: Determines the point of exit should the trade result in a loss.
  • Exit Signal: Establishes when a trade should be closed or when the position should be reduced.

However, a comprehensive system actually comprises 12 distinct components. These components can be observed in the subsequent diagram:

Trading system components

Figure 1. There are 12 trading system components in a complete system.

6 Types of Trading Systems

There are many different types of trading systems retail traders can use. Each of these types of trading system has advantages and disadvantages – none are perfect, but a diversified portfolio of systems is pretty much the holy grail of systematic trading.

The first trading system you choose should resonate with your Personality, Objectives, and Lifestyle because this will make it much easier to follow in the early stages of your trading career. Once you have mastered a trading system that suits you, then you can start to experiment with other types of trading systems from the list below.

Whether you’re hunting for systems tailored to stocks, futures, forex, or cryptocurrencies, trading systems predominantly fall into these categories:

Predominantly, mechanical trading systems lean towards rules based in traditional technical analysis, deploying price, volume, and technical indicators or custom indicators for decision-making. It is also possible to introduce fundamental analysis rules into your mechanical system, though this data can be more difficult and expensive to get in a timely way.

A good example of how trading systems can combine both technical analysis rules and fundamental rules is my article on the impact of a stock’s dividend growth on trend-following systems and my deep dive into trading stock dividend aristocrats.

The crux of any mechanical trading system, whether founded on technical, fundamental, or a fusion of data sources, is the incorporation of non-subjective, mechanical rules. Such objectivity eliminates emotional biases by giving clear-cut signals: buy, sell, hold, or stand aside.

For long-term traders, mechanical investing systems can help you objectively profit from broader market trends or sectors of strength and keep you safe during capital devouring bear markets.

Regardless of the type of trading system you are using, the most important thing you can do is build absolute confidence in your rules by learning to backtesting correctly. Such historical validation instils the confidence required to follow its signals, even amidst inevitable losses and drawdowns.

The Power of Mechanical Trading Systems

Mechanical trading systems offer a resilient and efficient approach for those seeking consistency in their trading decisions. They act as a shield against the overwhelming emotional biases that often infiltrate trading decisions, while also reducing the you’re your daily trading decisions take and ensuring consistency over time. Whether you’re just dipping your toes into the trading world or you’re a seasoned trader, trading systems are the cornerstone you need for better decision-making.

Mechanical Trading Systems: An Emotion-Free Approach

Mechanical trading revolves around a predetermined set of rules or algorithms, removing subjective judgment from trading decisions. Before adopting mechanical systems, many traders, including myself, would second-guess decisions, act impulsively, and spend hours stressing over each trade. Implementing a mechanical system reduces trading time and can increase profitability.

Whether you’re trading stocks, cryptocurrencies, futures, or forex, the principles of a mechanical system remain consistent. These systems can range from simple strategies, like moving average crossovers, to more intricate algorithms which analyse the price data to make trading decisions.

In essence, mechanical trading streamlines decision-making, neutralizing emotional trading decisions and offering a systematic, objective approach to the financial markets.

Advantages of Mechanical Rules and Edges

Mechanical trading systems offer huge advantages, some of which include:

  • Efficiency in execution, allowing traders more leisure and less screen time.
  • Extracting the trader from the decision-making process, reducing confusion, mistakes and overwhelm.
  • Offering a consistent decision-making approach irrespective of the trader’s emotional state.
  • Reducing emotions and biases that often plague traders.
  • Holding the system accountable rather than self-blame, providing room for research and improvement.

Critically, mechanical rules are the backbone of consistent trading decisions, helping eradicate emotional biases and ensuring objective judgments. They introduce efficiency, allowing you to swiftly scan international stock exchanges and vast crypto marketplaces daily, with technology doing most of the heavy lifting.

By basing these rules on market indicators, price patterns, and risk management techniques, the influence of cognitive biases and trading psychology is curtailed, leading to consistent profits, fewer trading errors and greater, more consistent profitability.

Gaining an Edge with Mechanical Trading

My journey in stock and crypto trading has always been driven by the desire to find an edge. Mechanical trading systems granted me that edge, turning my trading career around after years of grappling with discretionary strategies.

But the real game-changer is the capability to backtest trading ideas. Backtesting empowers traders to verify the profitability of their trading rules. Coupled with trading software, it’s possible to automate the trading process, freeing up time for research, analysis, and system refinement.

Mechanical trading offers a rules-based, data-driven decision-making process that gives consistent, more profitable outcomes. This gives systematic traders a substantial advantage over traditional discretionary counterparts.

And a crucial takeaway: mechanical trading isn’t reserved for the elite. Many novice traders could fast-track their proficiency and achieve profitability sooner by prioritizing mechanical over discretionary strategies.

Why Discretionary Trading Systems Fall Short

Discretionary trading systems, while flexible, fall prey to human biases and emotions. With discretion comes subjectivity, allowing cognitive biases such as loss aversion, confirmation bias, and overconfidence to infiltrate decision-making processes. These systems blend trading choices with a trader’s psychological vulnerabilities, leading to decisions based on impulse, fear, or greed rather than objective criteria.

If your trading process is even 1% discretionary, then effectively it is 100% discretionary!

In contrast, mechanical trading systems are driven by a fixed rule set, ensuring consistent and repeatable trading processes. They fend off human errors rooted in emotions and biases. Performance analysis is straightforward due to the unchanging rules over time. In essence, while the flexibility of discretionary systems may give the illusion of some benefit, in reality, mechanical rules are far more likely to result in long term profitability.

Who Can Benefit From Mechanical Trading Systems

Mechanical trading systems cater to a broad spectrum of traders, from trend traders, swing traders, and position traders to technical and price action traders, day traders, and long-term investors. All of these groups, benefit from the objective nature of mechanical trading systems. Even day traders, who are often exposed to the volatility and market fluctuations, can significantly benefit by implementing mechanical rules to insulate their decisions from emotions.

Every trader, irrespective of their chosen timeframe or strategy, grapples with trading emotions that can compromise the consistency and quality of their decisions. If you often find yourself swayed by market sentiments, failing to maintain a consistent, calm, and profitable stance, mechanical trading strategies can help you improve your results.

Good Trading Systems – How to tell the difference

The difference between a robust and an inferior trading system is nuanced yet critical in systematic trading. While many trading systems impress you with astronomically high returns from their trading strategy backtest, the real test lies in real-time performance against unforeseen market data.

A sound strategy, simplicity, and adaptability underpin dependable systems. Your system should have a minimal number of rules, avoid over-optimization, perform consistently across varied markets, and maintain profitability after accounting for trading costs.

For newcomers, the path to crafting a solid system is laden with potential missteps. This section aims to clarify the distinct traits of good trading systems, helping you sidestep common pitfalls and choose and / or build stronger strategies.

Sound Trading Strategy: The Heartbeat of a Good System

At the core of every successful trading system lies a well-structured and proven trading strategy. Such strategies are underpinned by a clear philosophy or principle that gives you an edge in the market. For instance, recognizing that markets trend and positioning oneself in an existing trend can offer positive returns. The rules of these systems are typically based on hypotheses and should encapsulate the essence of the strategy they’re built upon.

To truly harness the potential of your trading strategy, it’s imperative to:

  • Choose a proven trading strategy that aligns with your beliefs.
  • Refrain from diving into system development until you’ve zeroed in on a strategy.
  • Ensure that your system’s design is in complete harmony with the chosen strategy.

Complexity: Navigating the Fine Line

When it comes to trading systems, complexity can be both a friend and a foe. Flawed trading systems tend to lean heavily on complex mathematical derivations from price and volume data. They often use overly specific market conditions as rules and require a myriad of conditions for trade execution.

On the contrary, the best trading systems embrace simplicity. They employ clear rules based on straightforward price and volume data, with few conditions dictating trade entry and exit. To harness the power of simplicity, traders should:

  • Strive to express their algorithmic trading strategies as simply as possible.
  • Avoid over-optimizing rules, which can result in misleading historical results.

Adaptive Behaviour: The Art of Flexibility

The financial markets are dynamic, and trading systems must evolve in tandem. Poor systems often remain anchored to static references such as absolute price levels or specific percentage changes. Such rigidity can prove detrimental in the long run because it doesn’t allow the system to adapt to behavioural changes in the underlying market.

In contrast, robust systems possess the agility to adjust based on market volatility. They utilize metrics like Average True Range (ATR) or Standard Deviation to keep pace with the ever-changing market temperament. To ensure adaptability, it’s wise to:

  • Focus on metrics that adjust with market volatility.
  • Reference price movements that consider recent market behaviour.

Rule Restriction: Finding the Sweet Spot

While rules are essential, they can be counterproductive if overly restrictive. Inferior systems drown in a sea of rules, often layered with complex criteria. This not only complicates the trading process but can also stifle profitability and excessively reduce the number of trades.

Superior systems, however, operate on the principle of minimalism. They function optimally with a limited set of consistent rules— for a stock trading system this would typically mean 4-6 rules. To streamline your trading system:

  • Determine a rule cap and adhere to it.
  • Aim for simplicity and consistency.
  • Eliminate unnecessary, low value and marginal rules.

Optimization: Walking the Tightrope

Optimization can be a double-edged sword. In most cases optimization can improve your system’s performance, but excessive optimization degrades results. Be wary of falling into the trap of excessive optimization, chasing the perfect hypothetical outcomes. Good trading systems focus on optimizing a select number of parameters to ensure stability rather than focusing on finding the best possible parameter set.

For traders aiming to perfect the art of optimization:

  • A deep understanding and the right application of optimization techniques are paramount.
  • Optimizing for stability rather than maximum performance.

Exit Strategy: Preparing for All Contingencies

Every seasoned trader knows the importance of a well-defined exit strategy. Weak systems falter with ambiguous exit rules, leaving traders vulnerable. Strong systems, in contrast, have rules that ensure there’s always a clear exit point, irrespective of market dynamics.

To fortify your exit strategy:

  • Anticipate all potential market movements post-trade and design your exit strategy accordingly.
  • Ensure there are no market conditions in which you would not get an exit signal.
  • Design your exit rules to match your system’s underlying trading strategy.

Market Transferability: Broadening the Horizon

A hallmark of a robust trading system is its versatility. While inferior systems are pigeonholed into specific markets, superior ones can work across a diverse range of markets. For example, the trend following system you learn in The Trader Success System is profitable when applied to most of the different stock markets globally. Similarly a well designed stock trading system for the Australian Stock Exchange should also be profitable when applied to similar markets like the Toronto Stock Exchange. A well-designed trend-following system can even be effective between stocks, futures, and forex.

If versatility is your goal:

  • Diversify your system’s applicability.
  • Focus on broad-based historical testing to ensure adaptability.

Profit Margins and Trading Opportunities: Striking the Balance

Profitability is the ultimate litmus test for any trading system. While poor systems with very small average profit per trade may look good in historical backtests, in real time trading they often struggle once slippage and commissions are taken into account. Good trading systems typically have a higher average profit per trade (I aim for greater than 1% per trade on average) to allow for any slippage and commissions during live trading.

To optimize profitability:

  • Ensure your system generates consistent and high average profit per trade.
  • Regularly assess your strategies to ensure their edge is stable.

By understanding and implementing these insights, traders can enhance their trading systems without curve fitting so their systems work in real time trading.

3 Steps to Harnessing the Power of Trading Systems

In the dynamic sphere of trading, the ideal system is not merely a purchased product; it’s a tailored fit aligning with one’s beliefs, objectives, and lifestyle. This section outlines essential steps to successfully leverage trading systems tailored to individual needs, leading to consistent trading results. The steps are:

  1. Set System Goals
  2. Choose the Right Strategy
  3. Choose / Build and Document your System

Set System Goals

Trading goals are paramount, just as they are in personal and professional realms. To embark on the trading journey with direction and purpose, specific goals should be established. Rather than adopting generalized aspirations, traders should:

  • Define specific outcomes such as “achieve 15% annual return on average over a 30 year backtest” instead of ambiguous goals like “be more disciplined”.
  • Envision the lifestyle aspired to through trading gains.
  • Dedicate a predetermined amount of time for trading daily.
  • Determine risk per trade limits.
  • Establish maximum allowable drawdown percentages.

Choose the Right Strategy

Trading strategies form the backbone of any system. They must be rooted in discernible market behaviors to be effective. Some of the most successful strategies for retail traders include:

  • Trend Following: A highly profitable, low-maintenance strategy that profits from long-term trends. It targets rising stocks, holding them until trends reverse. Its strength lies in the potential for extremely large winning trades and small losing trades, yielding substantial annual profits even with few wins.
  • Swing Trading: More active than trend following, this strategy leverages the oscillations around the primary trend. While it generates trades frequently, the average profit per trade tends to be lower.
  • Mean Reversion: This strategy capitalizes on market overreactions. By positioning against short-term extremes, such as sudden stock drops due to unforeseen news, traders profit from the subsequent market bounce-back.

Selecting a strategy that aligns with one’s trading beliefs and then moulding a system around it is the foundation of a successful long term trading career.

Why a Trading System Should Suit Your Personality

Delving into the trading world often starts with a self-reflective question – traders should not ask “How do you make money trading?” but instead ask “How can I make money trading?”. This distinction is paramount.

Every individual is unique, which means blindly following tips, subscribing to newsletters, applying any strategy you find online is not be the key. Instead, the essence lies in crafting or choosing a strategy that resonates with your personality, objectives and lifestyle while also achieving your trading goals.

For instance:

  • Action seekers might struggle with a long-term weekly approach.
  • Those who value patience might find day trading overwhelming.
  • A perfectionist might find it hard to reconcile with a strategy that’s often wrong, even if profitable in the long run.
  • If you’re juggling trading with a full-time job, an end-of-day system might be more suitable to prevent any clash with work commitments.

Debunking popular myths, trading doesn’t necessarily entail constant market monitoring, day trading, high-frequency trades, or insider knowledge. In fact, strategies like day trading or scalping can be more taxing as a regular 9-5 job, negating the allure of flexibility. For those seeking time and location freedom, medium to long-term trading styles, such as trend trading, are more effective!

Ultimately, the most effective system isn’t necessarily the most complex or popular one. Whether you’re navigating the stock market, futures, forex, options, or any other domain, the best system is the one tailored to your understanding and needs.

Choose / Build and Document Your System

As we have seen, consistency in profitability demands a systematic approach. You have two alternatives for finding that system – either choose an existing trading system like those provided for you in The Trader Success System, or develop your own system. Developing a mechanical trading strategy, regardless of the market, involves the following steps:

  1. Hypothesis Formulation: Propose hypotheses for individual system components.
  2. Signal Identification: Pinpoint trading signals that correspond with the proposed hypotheses.
  3. Backtesting: Evaluate the system’s historical performance to refine its efficiency.
  4. Risk and Position Management: Lay out specific rules for risk management and position sizing.

Once you have your trading system in place, a thorough and documented trading plan is crucial. This plan not only dictates market approach but also prepares traders for unforeseen events, ensuring that investments remain protected regardless of market turbulences or personal adversities.

Mastering Trading System Application

Mastering the application of trading systems goes beyond just following the rules. It requires meticulous attention to detail, astute risk management, and embracing technology and software to your advantage. Here’s how you can elevate your trading system mastery…

Backtest for Confidence and Profitability

Backtesting is pivotal to developing and refining trading systems as well as building confidence in those systems. By simulating strategies on historical market data, traders can gauge a system’s theoretical performance before venturing into live markets. This not only gives insights into a system’s potential profitability under different market conditions but also arms the trader with confidence.

However, it’s vital to tread cautiously. Issues like overfitting or not factoring in trading costs can distort results. Always remember, past performance doesn’t guarantee future results. For a comprehensive understanding of backtesting, view our detailed article.

Risk and Portfolio Management Rules

All trading systems give you exposure to market risk which must be managed if you are to be a successful trader long term. Risk management is a cornerstone of successful trading. Proper planning, establishing stop-loss points, trade sizes and prudent market exposure limits are critical to prevent wiping out your account. Many traders unfortunately sabotage their gains due with bad trades, magnified by highly leveraged positions or missing stop losses. A strategic approach to risk and portfolio management is non-negotiable if you are to survive long term as a systematic trader.

Selecting Suitable Software

The right software is vital for testing trading ideas, keeping tabs on market opportunities, and ensuring accurate trade execution. Amibroker is a stellar recommendation for its speed, backtesting capabilities, flexibility, and value for money. It stands out as one of the best trading software for stock traders – several other backtesting software packages are also available to perform this task including Real-Test and Wealth Lab.

Automated Trading Systems: The Intersection of Software & Trading

Automated trading systems represent the fusion of technology and trading strategy, promising an efficient trading experience, reduced errors and mistakes along with lower time commitment than manual trading. With automated systems, traders can allocate their time better, diversify effectively across markets and strategies, minimize trading errors, and execute trades flawlessly. For users of Amibroker and Interactive Brokers, the Smart Stock Automation Engine ensures effortless trading automation.

Sadly though, if you are looking for automatic trading systems that will make you rich with no effort then you are going to be disappointed. Even with good automated trading systems you still need to closely monitor the automated trade execution and ensure all of your technology performs correctly each day.

Recommended Reading on Mechanical Trading Systems

For those keen on delving deeper, several influential trading books illuminate the intricacies of mechanical trading systems. ‘Mechanical Trading Systems’ by Richard Weissman stands out and has left an indelible mark on my own trading. Other essential reads include:

  1. Mechanical Trading Systems by Richard Weissman
  2. Trade Your Way to Financial Freedom by Van K. Tharp
  3. Market Wizards, Updated: Interviews With Top Traders by Jack D. Schwager
  4. Trading Systems and Money Management by Thomas Stridsman
  5. Evaluation and Optimization of Trading Strategies by Robert Pardo

Eliminating Trading Mistakes

Trading mistakes are part of a trader’s journey, but minimizing them is crucial if you are to become profitable and make money long term. Emotions often spur errors, be it from boredom or the dreaded FOMO.

Before any trade, always ask yourself – am I following my trading rules exactly?

By recognizing and learning from previous mistakes, traders can develop strategies to counteract emotional decisions and see the larger market picture. Dive into the intricacies of trading psychology to further your understanding.

Next Steps to Master Systematic Trading!

If this article has inspired you to master systematic trading and transform your results, then I want you to know that mastery is more accessible than you think. The Trader Success System isn’t just another course; it’s a transformational membership experience designed to accelerate your trading success, give you unshakeable confidence and launch your diversified portfolio of trading systems. When you join The Trader Success System you will shorten your learning journey from the typical 3-5 years to just a few months!

Dive deep into proven strategies, master backtesting and trading system analysis, get implementation support, learn to build your own trading systems, and be part of a community that’s as invested in your success as you are. Don’t let another moment slip by! This is your chance to redefine and dramatically accelerate your trading journey.

💡 Ready to conquer the markets? Take the leap into the Trader Success System and redefine what’s possible in your trading journey. Join us now and let’s chart the path to your trading goals together! 💡

Frequently Asked Questions about trading systems

I want to start using trading systems – What do I do next?

Mechanical Trading Systems are what I have been focusing on for over 20 years now and I have built a portfolio of systems along with a comprehensive training and mentoring program into The Trader Success System.

If you want to shorten your learning journey from the typical 3-5 years to just a few months and get access to a ready-made and diversified portfolio of mechanical trading systems covering a range of trading strategies, markets and timeframes, then joining The Trader Success System is your best next step.

What is a good trading system?

A good trading system is one that consistently produces profitable outcomes over a significant sample size and adapts to varying market conditions. No trading system makes money on every trade, but over many trades good trading systems will generate positive returns. A good trading system should be based on a sound strategy, be well-optimized without being overfitted, and consider trading costs such as slippage and commissions.

What is a system in trading?

In trading, a system refers to a set of predefined rules and criteria that guide entry, exit, and risk management decisions. It provides a structured approach to trading, ensuring decisions are based on objective criteria rather than emotions.

What are the components of a trading system?

The main components of a trading system include the trade setup (filters or conditions that determine the market environment’s suitability for trading), entry rules (when to enter a trade), exit rules (when to close a trade), Initial stop loss & risk management guidelines (how much capital to risk on each trade).

How do I create my own trading system?

Creating your own trading system involves identifying a strategy or edge in the market, formulating rules around this strategy, backtesting the system on historical data to evaluate its performance, and then refining it to improve the system’s performance.

Is automated trading profitable?

Automated trading can be profitable, but its success depends on the underlying trading system’s robustness. Automation eliminates emotional decision-making and allows for more precise execution, but the system must be periodically reviewed and adjusted to changing market conditions. There are good systems and poor systems – you should only look to automate your trading once you are confident you have a good, consistent and profitable system.

How do I start a trading system?

Starting a trading system involves identifying a trading idea or hypothesis, formulating a set of rules to trade this idea, backtesting the system on historical data, and then implementing the system in real-time trading—either manually or through automation—while continually monitoring and adjusting as necessary.

More Articles about Trading Systems

Read these articles for more insights about the benefits of trading systems and how to implement them into your own portfolio.

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