You may decide to develop your own trading system or you may prefer to purchase one that has already been developed for use and has a proven track record. In this article we will look at the basics of developing your own trading system. In essence a trading system is any set of rules that must be conformed to when trading, so you could for example detail the following rules.
If a 5 period exponential moving average (EMA) crosses up over a 13 period exponential moving average(EMA), enter a long trade. If a 5 period exponential moving average (EMA) crosses down over a 13 period exponential moving average (EMA), enter a short trade. You have now created the basis of your trading system. Of course this would not be nearly enough to produce a successful trading system, so now you need to enter some safeguards.
If the 5 period EMA crosses up over the 13 period EMA enter a long trade and immediately place a stop loss order at 50 pips below the entry value. If the 5 period EMA crosses down over the 13 period EMA enter a short trade and immediately place a stop loss order at 50 pips above the entry value.
So far you have only one criteria for trade entry and this could lead to many false signals. To help prevent this you might well add one or more technical indicators as a filter, but keep in mind that the more filters, the less trades will be signaled and although this can be a good thing, it is important to maintain a balance. Continuing with the system building process, you might choose to add MACD as a filter.
If the 5 period EMA crosses up over the 13 period EMA AND MACD is rising above the signal line, enter a long trade and immediately place a stop loss order at 50 pips below the entry value.
If the 5 period EMA crosses down over the 13 period EMA AND MACD is falling below the signal line, enter a short trade and immediately place a stop loss order at 50 pips above the entry value. It will be necessary to back test your trading system with various time frames to establish the optimum time frame(s) for the system.
Back testing can be carried out by using a back testing program or by visually looking back at the charts macd histogram and identifying the points at which “your trading system” conformed to the trade entry rules. Then look forward to see if the trade would have been successful. Make sure that you make precise notes regarding each theoretical trade.
Next you will need to develop a rule or set of rules for exiting the trade. There are many ways to do this. Developing a reliable exit method is in many ways more important than developing a reliable trade entry system.
One popular method is to use a trailing stop and to continue to trail price until the trade is eventually “stopped out” in profit. A trading system, no matter how good, will not produce a winning trade for every trade entry. Your goal is to establish a system that is successful more than 50% of the time. The higher the percentage the better the system will be.
If your system checks out favourably during back testing you should proceed to trade it in REAL-TIME but using a DEMO ACCOUNT only. It is most important at this stage not to put any real money at risk, because back testing is not reliable enough to prove a trading system’s worth.
If after a month or two of REAL-TIME testing the system shows a consistent winning average of above 50% then you can consider making further adjustments to improve the average. Each time that you make an adjustment, it is most important to go through the whole testing process again from the beginning, to ensure that the adjustment has made a favourable difference.
There is no reliable short cut to this process. Make sure to only make changes one at a time and carry out the whole testing process for each change. If you make more than one change at a time, you will never be certain which of the changes were beneficial and which were not.
Finally, after all of your testing has been carried out and you are ready to fund a live account, it is essential to apply a system of money management. This needs to be a rigid set of rules that might for example include – Never trade using more than 2-3% of your trading account on any one trade – and so on.