- 1999: Volume 8, No. 2 System Development by the Numbers

In developing a trading system or any trading tool we must first have an understanding of what it is we are trying to accomplish. A trading tool or system is nothing more than a set of established rules that a trader follows to determine buying and selling a market.

All trading systems have five common denominators. The five components any successful trading system must have are: 1) what time frame to trade, 2) what price or day to enter the market, 3) what profit target price to exit the market, 4) where to place the protective stop order to exit the market if the trade is incorrect, and 5) money management.

In developing a trading system your first step is to determine what time frame you want to trade in. Are you a day trader interested in day trading a market by getting in during the day and exiting during the day or are you a short-term swing trader looking for a three- to five-day swing trade? Are you more of an intermediate term trader looking for a six- to 10-day trend? Maybe you are a long-term position trader looking for a one month to three month position trade. You have to decide what type of trader you are. Most traders start out as day traders and end up position trading.

OK so you have picked your "time frame" that you will trade. How will you enter the market? Most trading systems are designed to pick tops and bottoms and/or are trend following. Most of these systems are designed around price patterns and/or oscillators that generate overbought/oversold zones in order to pick tops and bottoms or to be trend following using various chart patterns and money management.

Oscillators such as Stochastic and RSI are designed to pick tops and bottoms. As the price moves into the overbought zone, it is "time" to sell and when the market moves into the oversold zone it is "time" to buy. There are a dozen or more oscillators and indicators on the market to choose from and most are contained in many of the popular technical analysis software packages.

A trading system is made up of at least one or more of these trading tools such as oscillators, price patterns or other technical indicators. Price patterns used in trading systems attempt to determine the trend with the analysis of past price history in relation to the most current trading day. There have been many technical price patterns discovered over the years. Some of these are 1-2-3 tops/bottoms, head and shoulder tops/bottoms, triangles, wedges, flags, and channels to name just a few. There are many good books on the market that cover all of the price patterns in greater detail than is allowed in this brief article.

Both indicators and price patterns in and of themselves are not actually systems but trading tools used in the development of a trading system.

Now that you have picked your trading tools and chart patterns to use in your system to identify your entry point, you must now determine how to get out of the trade either at a profit or a loss, if the trade is unsuccessful. First, when entering a trade you must establish a protective stop-loss risk. The stop-loss is determined in advance and placed in the market after you enter the market. Your protective stop order should not be so close that the trade becomes stopped out with the normal price fluctuations of the market. On the other hand, you do not want your protective stop so far away from your entry point that your risk is too great. In most trading systems a protective stop is determined by recent highs/lows in the market either on an intra-day basis or daily or weekly charts using specific high/low points. Another alternative is to place a stop just above/below a moving average such as a 9-,18-,or 40-day moving average. Another way is to simply risk a certain percentage of your trading account on each trade. There are numerous ways to determine your protective stop which have been covered in several books and articles by many of the master traders of our time.

If a trade is not stopped out then you need to determine your profit exit; when will your system take a profit? Will your system keep your trade in the market "X" number of days and then exit or will you arbitrarily exit at a predetermined dollar amount or a specific rate of return on your account? Will you use a predetermined trailing stop and let the market stop you out on a counter-trend move? These are just some of the questions you must ask yourself and determine while developing your trading system.

A system is basically several trading tools or indicators in one. Each of the trading indicators becomes a filter in that your trading system must have all of the trading tools generating either a buy or sell. Maybe your system has ten trading indicators and you have determined that if only six out of the ten trading indicators generates a buy/sell then that is sufficient to determine an all out buy or sell for the market.

Once you have determined your entry, stop loss, profit target you will need to have a money management methodology. Money management is probably more important than the actual trade selection process. Money management can literally turn a losing system into a winning system.

In determining money management rules, you have to take into account two key elements: stop placement and number of contracts traded. I have already covered some of the basics in regard to stop placement, but here are a few more important factors associated with stop placement orders.

When placing a stop loss order you have to determine the level of risk you are willing to take in any given trade. Keep in mind that if you have a system that is poor in trade selection and trade entry then a loss of 50 percent on any given trade or series of trades will take a 100 percent return to recoup that 50 percent loss! If your system is not a good system (and it will not be if you lose 50 percent of your trading account!) then it will be next to impossible to make 100 percent on the next trade or series of trades. On the other hand, if your system is good on entry selection but poor on money management, then a 100 percent gain requires only 50 percent loss to negate the 100 percent gain!

A good trading system will also determine how many contracts to trade. This is determined by three factors, the first of which is the number of contracts traded relative to your account size. The second factor is your stop placement and the third factor is the accuracy of your trading system in terms of percentage of accurate wins to losing trades.

In terms of stop placement, the closer the stop is to your entry price the smaller the potential loss (barring any gap openings above/below your stop price) and the more contracts that can be traded within limits of your account size and exchange rules. The farther the stop price is from your entry price, the greater the stop loss risk and the greater the risk of ruin and the fewer number of contracts that can be traded.

After you have successfully developed your trading system, back test your system on historical data preferably not less than 10 years and not less than 50 buy/sell signals. Then analyze those trades for profit to loss and winning trades to losing trades. By developing your own trading tools, rules, and back testing you will learn more about the markets as well as what type of trader you are (short-, medium-, or long-term).

For a system to be a system itmust be objective and mechanical (no guess work or subjective decisions involved) and you must follow your system! If you design a system that proves to be a winner and you do not follow it, you are throwing in the emotional factor and the emotional factor does not belong in a trading system.

These are just some of the many important factors to consider when developing a trading system. Good luck in your quest for developing your own winning system.

Jeff Rickerson is the developer of the Streamlined Market Optimizer III trading system. Hundreds of traders in over 20 countries have benefited from his ideas. Now, for the first time, the general public can study his trading ideas via the internet at www.findatanet.com/vendor/bt.stm