How to build a trading system (part 2)
Mar 22, 2020 in Fundamentals

How to build a trading system (part 2)

By: J. H. Liverstone

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

Let's continue with our trading system.

4. Entry

Trade entry is an important section. It dictates the conditions under which to put your hard-earned money at risk for a trade.

The rules and indicators you use to identify an entry set-up should be part of your trading system.

There can be a lot of indicators to help you identify an entry. There’s no ‘right’ indicator or how many to use. The idea is to have a consistent way of entering a trade that can be analyzed and improved.

The indicators we will use for our example are:

  • daily EMA 50 (daily exponential moving average)
  • RSI

The idea here is that a stock that is in an uptrend has a correction to EMA 50 before going up even more.

So if the price of a stock in our universe comes close to EMA 50 and RSI is over 80 (stock is overbought) we will open a new trade.

Again this is a simple strategy to give you an idea of how you can use technical indicators to create your own entry rules.

5. Exit

When to exit a position is not so simple as you may think.

Most of the beginners make the common mistake of keeping a losing position and closing a winning one.

What you want to have here, are precise rules when you should close the trade and when you should keep it open.

The first rule and most important is the SL (stop loss). Close the trade if your stop-loss is reached.

You should already have the SL because you needed it to calculate the position size. If you remember when you decide what risk to take in the "position size" step you needed to know what is the SL.

Always use a stop loss. This is trading 101

The second rule is when to exit on a profit. Some traders like to have specific targets — usually based on "risk:reward" ratio. But this is not the only exit strategy you can use.

Just as you have indicators to enter a position, you can have ones to exit.

Again, it has to be consistent and you can have a ‘majority rule’.

Let's take some simple rules for our example:

  • exit if is SL is reached
  • exit if we reach 2R (reward is 2 * risk)

6. Trade management

Trade management is how you manage your position after the entry. You don't need to manage your trades at all if that is what you wish. You can leave your setup to play out according to predetermined parameters if you want.

Questions that need to be answered here are:

  • Under what conditions, if any, do you move your SL
  • Do you scale your position
  • Do you sell a part of the position at a specific target

No matter what are you trade management rules as long as you have them and respect them for every trade you can improve and be consistent.

For our example, we will not manage the trades. We will set our SL and profit targets and not touch the position.

But to give you a simple rule example:

  • sell half of the position size if it gets to 1R and the rest at 2R

7. Test

Testing your trading system is the first step you should do before trading with real money.

There are some free backtesting software if you search the internet. Find one that you like and test your system, I personally use Tradingview Pine Script to test my systems.

Now that we have explained all the steps let's see how a simple system looks:

Day Trade System

Timeframe

  • daily time frame

Universe

  • 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

Position size

  • max. risk 1% of our capital per trade

Entry

  • stock price very close to daily EMA 50
  • RSI over 80

Exit

  • exit if is SL is reached
  • exit if we reach 2R (reward is 2 * risk)

Management

  • no management

Conclusion

I hope you understood how to build your own trading system and next time you trade do it using a trading system.

Happy trading…


Wanna test your system ? Check our trading journal application were you can see if your system is profitable.

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