An Intern Learns - Developing A Trading System, Part 2
Today I will be looking further into how to make your own trading system. A trading system is really essential as without one a lot of your decisions will be left to guess work. This is not what we want! Last blog I discussed the first step to developing a trading system, choosing the time frame. To briefly recap, this involves looking at your own lifestyle and determining what kind of trading suits you best. Do you want high action & fast decision making, or do you prefer to set your trades out across the whole day? Or perhaps you’re really busy and prefer to let your trades sit for weeks and months, basing your trading decisions on market fundamentals and longer ranging sentiments… Either way, whichever you choose must reflect what you are most comfortable with; this is important as it directly influences the other steps.
I personally like day trading and so will describe the rest of the steps with this in mind. The next step we are going to take is to find some indicators that can help us identify a trend. Basically you will have your chosen currency pair in front of you and you need to try discern which way the trend is going in order to know if you are going to go long or short. In previous blogs I’ve discussed moving averages and how they can be used for this very purpose. An often-used method is to use 2 or 3 Simple Moving Averages (SMA’s) together in order to spot a trend. If you recall, moving averages such as the SMA and EMA are trend following tools that help determine trends by smoothing out past price data. I suggest using 2 in conjunction, setting them at e.g. 10 and 20. However this is your system and you should choose whichever works best for your particular needs. The SMA with the longer period, i.e. the 20, will lag a bit behind the trend and appear smoother, whilst the 10 period SMA will more closely follow the trend. If you put these on a chart now, you will notice that at times these cross each other. The image below is a great example showing how we could do this on a day trade. As the 20 SMA crosses the 10 SMA at about 1pm on October 31st, this would have been an indication that the trend could be headed down and it’s time to sell. Conversely, at 11:30am on November 1st, the 10 SMA crosses the 20 SMA and this would be an indication to buy. In this way you can see that SMA’s are good indicators to help identify trends. Other indicators such as Bollinger Bands and ADX indicators can also help show a trend.
Now the next part of a system is to confirm a trend. You can do this by using another indicator in conjunction with the SMA’s. An indicator that can do this for us is the Relative Strength Index. This can be found on the MahiFX platform in analysis view, under the oscillators tab. The RSI is scaled between 0 and 100. Typically, readings below 30 indicate oversold and readings over 70 indicate overbought. If you see one of these readings, a reversal in price movement may be imminent. However to simply confirm a trend, look if the reading is above or below 50 – with below 50 confirming a downtrend and above 50 indicating an uptrend. Have a look at other indicators that MahiFx’s offers and see which works best for you, and by developing familiarity with them over time you will be able to use them effectively to help confirm trends.
The next step is to define your risk. Determining your risk is quite a detailed topic and I’d like to elaborate on it further at a later stage. However here I’ll give you the basics of risk. The basic concept is that you need to evaluate how much you are prepared to lose on a trade. This is of course closely linked to how much capital you have in your account and what kind of trading you are engaging with. You may be thinking to yourself, ‘well, I obviously want to risk as little as possible!’ But unfortunately very low risk also means a much lower rate of return. So you need to find that balance between not risking too much, and risking enough so that your trades still have the potential to be lucrative.
The next step in making your own trading system is to define your entry and exit points. When determining your entry point, consider zooming in on the charts using the scaling function at the bottom of the screen, or possibly even a smaller time frame. I also suggest using bar or candlesticks styles for your charts as you can see opening and closing prices better. Once again, it’s up to you to exactly how you want to do this – you can either trade as soon as you are happy that your indicators have confirmed a trend, or you can wait for the price to close on a the current candlestick and enter just as the new ones opening. To decide on your exit strategy you can choose a number of options. One idea is to reverse the steps take to this point: as we looked at the SMA’s crossing over to determine the beginning of a trend, when they close together after widening apart, this may signal that it’s time to close your trade. Other options include setting a pip goal, such as closing your trade after 30 pips, or perhaps trailing your Stop Loss, where you would adjust it according to the price movement. You would do this by moving the Stop Loss the same amount as the market has moved in your favour, e.g. 15 pips.
All these decisions you make need to be written down and you need to follow them! You won’t be able to evaluate your trading system if you don’t give use it often enough. When you’ve made a decision on your trading style and all the detail of your new system, try testing it in the following ways: go on the charts and select a currency pair as if you were hoping to trade them. Then click on the chart and drag it back a little while. Insert all your indicators and make an assessment of the situation and write down your entry point. Then slowly drag the charts towards the present one bar at a time, slowly revealing what happened. Use this method to evaluate your system – how successful was your system? Once you’ve made some tweaks here and there, give it a try on an actual trade on a demo account. Make sure you record your trades and review them too. In time you will become more confident with your system and hopefully make consistent winnings.