How to build a trading system (part 1)
This article is part 1 in 'How to build a trading system':
Part 1: Time frame, Universe, Position size
Part 2: Entry, Trade Management, Exit, Test
The idea of a trading system is to help you be more organized in how you approach trading and to set the framework for developing a set of rules and principles.
As you become more experienced you might want to develop your system that would fit your knowledge, personality and risk tolerance.
What is a trading system?
A trading system is a systematic approach you use to find a trading opportunity, executing it and close it. Whether that's with profit, loss or break even.
Bear in mind what we will build here is a simple example. This is designed to give you a solid foundation and, more importantly, a general framework.
Trading system steps
The system we will build has 7 steps:
- Time frame
- Universe
- Position size / Risk
- Entry
- Exit
- Trade management
- Test
1. Time frame
"The time frame you choose to trade should fit your personality."
If you are a day trader and you trade hourly charts you have up to 55 minutes per hour free to do other things, because every new information comes every hour.
On the other hand, if you were to trade 5-minute charts then you have no free time during the market open.
So choosing the time frame is important and depends on how much time you have available for trading.
For this article, we will trade using the daily charts, so we have to be available for 20–30 minutes a day between the market close and the next day reopen.
2. Universe
The universe refers to the assets you wish to trade. It can be stocks (S&P500, AAPL, ADBE, ...), currencies (EURUSD, USDJPY, ...), commodities (OIL, GOLD, ...), etc.
Here you need to have some rules on how do you choose your universe. Let me give you some examples of rules in choosing a universe.
Universe 1:
- only stocks
- only stocks that are in S&P 500
- only stocks with price > ema 50 in the last 30 days
- only stocks with EPS > 2.0
- sort them by EPS
Universe 2:
- only stocks
- only stocks with market cap < \$1B
- only stocks with revenue growth > 10%
- sort them by revenue growth
As you can see you can define the universe depending on many factors and your trading preferences.
Just keep in mind, you do not trade all the assets in the universe. The conditions for which assets you trade and when are described in the "Entry" step.
3. Position size / Risk
How much are you willing to risk on each trade is very important if you want to be successful.
How do you calculate risk for each trade? Let's take an example.
If you want to trade a stock that has a price of $100 and you think the price will go up but if it goes lower than $80 you were wrong and want to close the position (STOP LOSS = \$80), the risk is:
$100 - $80 = \$20
For each 1 share, you buy the risk is \$20.
And only after you know how much you risk on the trade, you can now use a strategy that will tell you how many shares to buy.
To continue with the example if your capital is \$10.000 and your position size strategy is to risk 1% per trade:
$10.000 * 0.01 = $100 (max. risk you can take per trade)
> $100 / $20 (the risk) = 5 shares
Now you know how many shares to buy. What you want is to have a consistent way of sizing your position so you can improve it as you get more experience.
You can find lots of good books and articles on how to size your position and how much risk you should take (google is your friend here).
But for this article we will use a simple strategy, 1% of our capital per trade.
Keep in mind there are better strategies here, my favorite one is to size my position depending on the stock volatility(ATR).
Wanna test your system ? Check our trading journal application were you can see if your system is profitable.