Building a Trading System

A trading system is a specific set of rules for trading stocks, options, futures, mutual funds, or other trading vehicles. It tells you what to buy, when to buy, and when to sell.

Trading systems generally consist of two major components:

• A market timing component: Generates trading signals that tell you whether to go long or short, or to stay in cash. Signals are generally generated based on a set of rules pertaining to various technical indicators, critical support and resistance levels, and other factors;
• Ancillary components: A set of further rules to define what to trade, what stop loss strategy to apply, how long to remain in a position, what profit you expect to take from a trade, what losses are you comfortable with.

Building a trading system is a multi-step process that typically involves the following stages:

1. Defining your Trading Style: Many traders use their own specific trading styles. Some make several trades per day, some only a few over the course of several months. Some trade only a single category of options (such as on the QQQ) or focus on a few equities while others tend to diversify. Traders playing mutual funds are restricted to trading during bull markets. Defining your personal trading parameters allows you to be more selective in choosing a trading system appropriate for you;
2. Building a Model: Select the technical indicators to be included in the system. These might include parameters used to determine future market trends. Research these indicators. For each parameter, determine critical levels that may be applied to generate trading signals (to enter and exit positions). The signal frequency of your system should match your trading style: Contrast a system that generates 1 - 5 signals per day with one that produces only a single signal per month;
3. Back-Testing: Each trading model should be back-tested in order to assess its probable risk. This step assists in defining an appropriate stop-loss strategy. It also allows you to adjust each technical indicator's critical level, again to minimize your trading risk;
4. Adjusting: After back-testing, every new trading system or model requires some adjustments - in some cases even a complete rebuild. Every adjustment in turn necessitates additional back-testing. This process ensures that fine-tuning a system actually lead to tangible improvements;
5. Paper Trading: Once a trading system has been built, paper trade it to evaluate how well it performs under actual market conditions;
6. Auto-Trading: If you are satisfied with the paper-trading results, you are ready to auto-trade the new system. This requires a broker (and a trading platform) that permits the placement of auto-trades - based on the signals generated by the system. Initially investing only a small part of your portfolio into a newly built trading system is good risk management;
7. Monitoring: Trading systems require more or less constant monitoring. Depending on the technical indicators incorporated, further adjustments may be required. The market is in constant flux - critical levels that were appropriate a year ago may now be too risky or too conservative.

As you can see, building a trading system is a complicated, time-consuming process that requires constant monitoring and that may involve frequent fine-tuning. Not nearly everyone who wishes to trade has the time nor the inclination to go through the steps outlined above. For most, using a professional trading advisory service that generates its own in-house trading signals (based on a mechanical trading system) is a much better solution.