Lecture 14

Trading systems.

At the previous lectures we have got acquainted with the technique of deals’ execution, technical analysis methods, considered the major indexes which the fundamental analysis if based upon. All potential traders examine these fundamentals which are necessary for starting analyzing and understanding any financial market. However as experience has shown it is not enough. It can be often observed that that almost one and the same people work in dealing centers in front of one and the same computers, using one and the same systems and indicators, seeing and reading one and the same. However some of them leave in 1-2 months, some of them continue working. What is a recipe for success of some traders? What allows them to “win”? What do they see at the screen, that allows them stably, exactly stably, blossom? In reality, nothing special, each successful trader has his/her own trading system.

We are going to talk about exactly trading system in this lecture.

Trading system is a concentration of experience, efforts and knowledge of trader. Cost of such successful trading system is really high – days and nights spent in front of computers, careful and sometimes agonizing analysis of mistakes, nerves, nerves and nerves. However as a result of all this, trader himself, like it or not, create his/her own, individual trading system. It is his professional secret and not because he/she does not want to share it but because it cannot be passed on. It cannot be two similar systems; each trader has his own methods and skills which he/she can share. However he cannot explain all nuances and niceties of his/her market understanding, adjustment, tests, control, further development of his/her trading system with the bet will in the world. It should be created by yourself – from the very beginning, from the first step. And if someone decided to become a real trader – i.e. work stably and effectively (read, with profit) at the market for a long time – then he/she must create his/her own trading system. There is extended literature where famous traders share their secrets and give examples of their trading systems which helped them to achieve success. It is very useful to familiarize yourself with these systems; however their copying will not give you desirable result and professionals’ experience should be used only as an example. The example shows how to use technical instruments, how to combine the methods of analysis, what can be considered as a wake up call and what to retreat. It will help to find rational kernel which will help you to create your own unique trading systems.

Trading system is rather complicated mechanism which consists of several components each having its own key value.

It is similar to the details of one mechanism, if one little screw is not in appropriate place, the whole mechanism will not work or will work badly. The same is with trading system: if some component will not be adjusted, the whole work will come to nothing. Moreover, since one and the same factors in different conditions can lead to the opposite market reaction, the system should be rather flexible. Also system is never static, it should be constantly checked and updated. For all that it should provide minimal risks with maximal accuracy of forecasts made (exactly in such sequence). System is an accurate calculation, balance point between several unknown quantities and constantly changing factors. It is correct question and correct answer. Specifically it is gaining trader’s profit. That is why it is very important to highlight the key points, spread the risks, calculate the point of entering and exit the market and choose the analytical instruments. Trading system is a system of hard rules defining the points (prices), time and conditions for entering and exit the market. Experienced, or in other words, having trading system, trader is always ready to any turn of events on market. He/she can give a detailed account of his/her future actions with any currency. He/she should be able to explain it distinctly. If he/she cannot explain this, then he/she cannot understand it but this is inadmissible luxury which can turn to the great loss. The only criterion confirming effectiveness or inefficiency of any system is practical results of work.

As it was said above, trading system is a system of rules detecting the consequences of several major factors influence on financial markets. Saying specifically, it is combined results of fundamental analysis, technical analysis, risk management and allocation of capital. Concrete “embodiment” of trading system is trading plan.

The first step of trading system creation consists of trader’s decision on some principle questions. They are questions concerning allocation of capital, trading strategy and risk management. In other words, he/she should clearly know:

  • volume of initial funds (i.e. account size); providing by the company (or choosing by yourself) leverage;
  • margin call level (minimal margin for opened position keeping);
  • lot sizes, general level of maximal losses;
  • level of losses by one position, possibility of hedging (for instance, work not only on Forex but also at the currency futures market, if account size allows);
  • maximal number of opened positions;
  • average amount of profit built in the trading plan, approximate cost of one point in some currency, etc.

Then future trader should decide what exactly tools he/she will use. Traditionally one start trading with four major currencies, quoted against the US Dollar: Euro, Swiss Franc, Japanese Yen, British pound. Moreover, trader can work with other instruments: Canadian or Australian dollar, ruble, hryvna or cross-courses. However trader should know here relative value of currencies against each other and the cost of one point. After that technical analysis turn comes: trader should create some range of means of technical analysis which he/she will use. They include resistance and support levels and/or lines, trends, indicators, graphical patterns, Elliot waves, analysis of Candlestick charts, Fibonacci relations and others. Choice is rather wide, and to make a choice it is necessary to get acquainted with all of them. Process of indicators selection is more complicated. In spite of a huge number of them, we advise to limit them to the several simplest ones. Indicators from the trend group as well as from oscillators group should be presented in your set. Choosing of indicators mostly depends on traders’ work type – intraday trading or medium-term positions. Meanwhile the possibility of one and the same indicators’ variation is limited only by the technical capabilities of the system.

In the end, the last step is development of trading plan ready form which trader will fill in daily in several copies – one for every chosen currency or cross-course. Besides the necessary column with enumeration of technical analysis means and set of indicators, trading platform should include separate line for fundamental analysis with enumeration of further events, probable data and time of publication. You can also indicate there so-called “market expectations” – such information is being published at the website of our company – www.instaforex.com in the section devoted to the work on Forex market. One more obligatory “supplement” of trading plan is column “Results” and “Check”. Result of trader’s reflection: enter the market or not, if enter then what price and what conditions at (for example, after data publication), where to place stop-loss, where to close profit position, etc. In other words, concrete trading plan for current day. Thereafter, column “Check” is filled next day taking into consideration the results of previous day: if the trading plan was drawn accurately, if not – indicate reasons and/or mistakes (if possible). It is obligatory to indicate status of account by the results of executed operations – “executed conventionally” for the short haul. Developed the scheme of trading plan and methodology of market analysis, trader is quickly used to the chore, which will be becoming easier and habitual every day. The main thing in this chore is discipline. Making up of trading plan is the first step of trading system development. Created technology of daily work will become that basis which your own system of work at financial markets will be based upon.

Selection of means and instruments of technical analysis is very important; on basis of this criteria trader should forecast the market movements. The main question is defining what really important and what useful addition is. What is primary and what is secondary. And the most important why and what for some instruments are necessary. At this stage of selection and analysis, trader starts working directly on the thing which will become his/her trading system in future.

Technical analysis tools are used for:

  1. reveal of existing trend (ascending, descending or side);
  2. calculate the points (levels) of entering and exit from the position – major and local.

Usage of such instruments as trendlines, support and resistance levels, graphical patterns (reversal and continuation), Fibonacci lines in different application (retracements, fan, arc, etc), Elliot wave theory and analysis by the candlesticks will bring the invaluable benefit. Indicators are mostly uses for:

  1. receiving confirmation of entering points;
  2. determine the possibility of trendline reversal.

Before analyzing of indicators, traders should make analysis using so-called instruments of “classical” technical analysis. Every trader should understand that indicators are derivations from the prices. Even besides the fact that some of them make advance signals.

With the help of classical technical analysis instruments, trader should get answers to the following questions:

  1. What trend is leading at the market (ascending, descending, sideward), which trend is major one, which one is local (for example, small ascending correction while the long-term trend).
  2. Patterns and their meanings.
  3. Necessity of usage some Fibonacci numbers (after the abrupt price movement or for projection of future movement).
  4. What price levels are major points of support/resistance, which one are local.

Having an idea of market and what is going on there, trader can proceed to the computer analysis. As it was said, computer analysis is secondary against the price movement and, consequently, against the classic technical analysis.

Signals and reading of indicators should be considered as confirmatory – or contradictory – to the conclusion made on basis of usage of classic technical analysis instruments.

Universal indicator does not exist. Any indicator gives only approximate forecast. To answer the question what to start and what to finish with, we bring to your attention some pieces of advice about the making up of your own instruments:

  1. Trend indicators and oscillators must be in the set. Naturally, preference to one indicator or another will be shown according to the character of operations which will be executed by trader. In other words, if trader is going to work intraday, then oscillators should prevail in his/her instruments. If preference is given to the medium-term trading, then trend indicators and oscillators should be presented in the instruments half-and-half. If inclination to the long-term trading exists, then among using instruments trend indicators will prevail.
  2. Besides the belonging indicators to some group, trader should know what each indicator intend for, what signals it gives and what their meanings are. For example, it is supposed that ADX is the best indicator for trend beginning determination, and MACD (divergence at MACD) shows its finishing.
  3. It is better to have indicator which can work at trend and non-trend market. For instance, MACD – histogram.
  4. Indicators calculated by different principals must be in the set of instruments. It helps to avoid duplication (for example, slow stochastics, relative strength index (RSI), and the Rate of Change indicator, moving average and Bollinger bands, etc.). Doubling indicators will often make similar signals, meanwhile coincidence of indicators calculated by different principles gives rare signals of enter/exit with more accurate forecast. Set of indicators should not be too wide because you will have to analyze their data in different time period – from week to hour. Even from three-four indicators receiving of discrepant signals is probable.

 

OPTIMIZATION AND TESTING

 

After selection of one-two computer indicators it is necessary to test them. Testing is usually made in two steps – by history and on a real-time basis. Testing process helps trader notice some nuances which rarely mentioned in educational literature. During testing trader learns how to recognize signals: in past everything looks simple, but at real-time some skills are needed. Then trader makes his/her own list of enter/exit signals and ascertains that these signals are not always correspond to described ones in the literature during the real work.

At the first step of testing trader decides how chosen indicator suits for future work. In this case  the testing process consists of simple count of number of correct signals on basis of available data. If trader decides that indicator worth working with it, then second part of the first step (optimization) starts. In other words, trader will try to achieve an increase of number of correct signals. The most common way of optimization is change of entering variable, with the help of which this indicator is calculated. Methods of mathematic optimization with the help of different is also possible formulas – for example, computation of exponential formula and etc. But it suits those who know mathematics or market very well. It is not necessary to use one and the same variable for work during different time charts. It can be supposed that at daily charts moving mean with the period 10 will make more correct signals, and at intraday charts optimal number of periods for moving averages will be 5or 7. The main thing is to find optimal conditions for indicator to make more correct signals; it is the aim of optimization.

The second step of testing is based upon the work of already optimized indicator. It is the “highest instance” already – indicator must make correct signals on real time. Trader should learn how to recognize these signals – also on the real-time mode. It can appear to be another number of correct signals that is why trader will need to make optimization again.

The third step is coupling of signals from all chosen indicators and methods of classic technical analysis to a signal which will determine the moment of entering the market (buying and selling) and exit from the position.

For instance, signal of entering the short position can be appearance the following situation:

Uptrend is at the market, the last event allowed to determine reversal pattern “Engulfing” (candlestick analysis), at the moment of this pattern formation histograms MACD (computer analysis) did not show new maximum relative to the previous maximum, it means that opportunity of divergence appeared. Followed reduction confirmed that supposition, breakdown of uptrend line (trend analysis) became additional confirmation of previous signals about probable trend reverse, stochastics chart left overbought area and downward direction complete the list of necessary components of the signal which was accepted by trader for short position opening.

Optimized up to 90% of success trading systems are rare. So please do not attempt impossibilities: ratio 70% to 30% can be considered as sufficient for successful trading on market.

Let us now try to create our own trading system. I offer to pay attention to logic concept which must be used during the trading system building and based upon the theoretical knowledge and observation practice.

So let us firstly clarify that we are newbies and will follow the main rule – TRADE TO THE DIRECTION OF TREND, so our trading system should be developed as a system of trend following. From the beginning we should determine with instrument which the trading will be built upon. Then choose the time period off the chart. It depends on what type of trading we prefer. If it is intraday trading then time period should be short – 5 – 30 min charts, if trading will continue longer, then chart should be of longer level. I would advise you to start from the time interval which seems for you the most informative, afterwards, while the correction and optimization of the trading system optimum alternative will be found. Let us start selection of instruments which will be a basis of trading system (TS). From the theory and observations it is know that trend formation is accompanied by the consequent formation of maximums and minimums. These cardinal points are the completion of continuation patterns formation (flag, pennon, triangle, that is why the first object for our selection is these patterns, precisely the moment connected with completion of their formation. Besides, to be sure that trend is continuing it is better to choose trend indicator. I advise to include to the set of instruments the following: simple moving average (MA), better two MA with different periods, let it be 21 and 34 (Fibonacci numbers). And, of course, one oscillator because formation of mentioned above patterns occurs in range, and oscillators work the best exactly in wide-band consolidation of price, probably slow stochastic will be not that bad choice. The overall picture of the chart with applied set of instruments of technical analysis will look as follows (see pic. 1).

Pic. 1. Full set of instruments included in the process of TS development is presented at this picture. Indicator “Stochastic”, MA (21. 34), trend lines (red dotted line) limit the model limit the model of investigation, in this case continuation pattern “Pennon”.

 After strategy and instruments of technical analysis are determined, let us start the chart’s analysis and signals’ determination. As it was underlined above, we should start with the history (see pic. 2).

Pic. 2. Adjustment pattern was forming at the market (2), previous price movement and consequently MA (1) shows that it is uptrend. So the most probable is formation of one of the continuation patterns (it appeared to be “pennon” in this case), so we should consider the variants of opening long position, i.e. buying of the asset. Then we should pay attention that both minimums of the adjustment pattern were attended by the divergence formation at stochastic (3). The next signal indicated the contingency of the growth continuation appeared after the breakthrough from downward upward MA (4), signal in the point (5) offers to consider “pennon” as completed pattern and uptrend as continuing because formation of continuation patterns is considered to be completed after the breaking through of the trend lines which clamp them. Signal in the point (6) is confirming because it is reverse movement tested broken trend line concerning support.

 

Now let us make a line of signals as available:

  • Stochastic outcome from the oversold area and formed divergence;
  • Breakthrough of MA from the downward by the price
  • Breakthrough of the trend line which clamp the pennon from the upwards
  • Test by the price of broken trend line concerning support

From these observations the conclusion can be made that we should buy after the signal 4 appearance. Now we should establish where the order limiting the losses, i.e. stop-loss, must be put. The ideal variant is to place it below MA closer to point of breakthrough by the price of the moving averages (at the pic. 2 point (4)), less attractive and more money-losing variant is below the trend line which clam the “pennon” from the downward. Then price target which will be the bound of order execution and signal which will lead to close the position before the planned exit must be determined. As it was said at the lectures about continuation patterns, price target for position retention after the continuation model can be the level equal to the market movement preceding the model formation. We will measure the vertical distance from the previous model to the formed one and plot it upwards, so we will find the target point. Concerning the signal of premature exit, apparently, such signal can be: breakthrough of MA lined from above, breakthrough from above of MA of the short period by MA of the longer period, etc. You can see at the picture 3 that the signal for premature exit appeared earlier. Price broke through MA (7), which became an basis for execution of reversing trade.

Pic. 3. Signal for premature exit appeared earlier, before we hit the target. In point 7 price crossed both MA and gave solid grounds for supposing about probable trend reverse.

You should not extend by analysis of one case, observation of the history should being made until all the variants of possible patterns (flag, triangle) will not be considered and the most number of peculiarities connected with price behavior in the process of models’ formation would not be determined. After that you can start designation of these signals at charts on a real-time basis. During this step more concrete remarks and conclusions about significance of some tools of technical analysis and more liable for real trading points of entering a position. Next step is optimization. Variants for change the data of used tools should be considered – change of stochastic and MA settings (change of simple moving averages to scientific ones is possible), work view of TS at other time periods of the chart, etc. After receiving the optimal results you should start testing your trading system on DEMO accounts. The more tests for TS the better; 70% of positive enters and 30% of negative ones is acceptable result. However, as practice has shown, it is not enough, the last and the most important test will be the trial on the live account. The thing is that only on live trading account important factor appears – psychological or emotional factor, i.e. trader checks how his trading system corresponds with psychological individuality and also receives the opportunity to train the discipline which is very important in trading. Of course, this step is better to hold on accounts with small deposit which would not be so big loss. Probably, someone can say that small deposit will not give you full vision of the psychological pressure and I agree. But you can make some deception, you can consider deposit of 500 USD as deposit of 50 000 USD, opened position with 1000 USD as position with 100 000 USD, i.e. bring the situation to the amount which is planned for future trading.

 Test questions: 

  1. What is trading system?
  2. Specify the steps of trading system creation.
  3. What tools of technical analysis, in your opinion, must be used for building the trading system. Explain why.
  4. How do you explain the term “testing of trading system”?

The list of recommended literature:

http://www.instafxeducation.com/en/trading_systems.php

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Email: support@instaforex.com

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