Preliminary Steps for Building a Successful Trading System

First Steps for the Successful Development of a Trading System

This article presents some essential preliminary steps toward developing a successful trading system and the key biases you need to avoid. The following information is mainly based on Van Tharp's book "Trade Your Way to Financial Freedom".

 

Step 1: Finding a Concept That Works

Finding a concept that works should be seen as the first step in building any trading system. Among other things, an efficient concept should include detailed setups for entry/exit and money management rules. That means entry conditions, exit strategies, and position sizing. Most traders focus on high-probability entries without any concept of adequate position sizing or exit. This practice usually leads to a negative expectancy.

• Less than 20% of all traders have a system
• Only a small proportion of these traders can understand the concept behind their system
• The key to a successful concept is accepting trades with a high Reward/Risk ratio, and after running your profits
• Traders understanding position sizing and the role of an exit can make money with an entry system that produces only 40% winners and 60% losers

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Step 2: Determining Your Strengths and Weaknesses

The second key step when developing a trading system is to analyze the inventory of your strengths and weaknesses. Without knowing this inventory, developing the right methodology for you will prove impossible. These are some issues you need to consider:

• How much capital can you allocate?
• What is your risk profile and how much losses can you tolerate?
• What are the time constraints that you have?
• Do you have strong computer skills and/or math skills?

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Step 3: Setting Objectives

Setting objectives is the most critical step. Before you begin building a system, you must decide exactly what it is you want to accomplish. Until you know where you want to go, you can never get there.

• Setting the right objectives is about 50% of the tasks you need to accomplish before developing any trading system
• Objectives vary between traders, investors, and money managers
• The methodology you should follow is a low-risk methodology (as explained below)

The Need for a Low-Risk Methodology

• A low-risk methodology refers to a methodology that leads to a limited drawdown ratio, but at the same time, offers a long-term positive expectancy
• A low-risk methodology will protect you from the worst possible conditions in the short term while still allowing you to achieve the long-term expectancy

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Step 4: Mental Planning for the Worst Possible Scenarios

It’s important to consider how well will your system perform under a variety of circumstances. You won’t know what to expect from any trading system unless you consider how it’s likely to perform under every different market condition.

• How will your system behave in highly volatile market conditions?
• How will your system behave during important news releases?
• Will this system be suitable for trading trending as well as ranging market conditions?
• What about trading thin markets with limited interest and low liquidity?
• What happens to your system in case of a liquidity event or even a black-swan event in the market?
• Create a list of unfavorable market conditions and develop several plans that you can implement for each one

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Step 5: Avoid Biases which Affect the Successful Development of any Trading System

These are some biases you need to identify and avoid as you develop your trading system.

□ Trade-wrong sizes bias

Traders usually put too much of their capital at risk in a single trade.

• Most retail traders fail to consider the importance of position sizing
• Professional traders don’t risk more than 1-2% of their trading capital on any position

□ Cutting profits bias

Traders are usually conservative with their profits and risky with their losses, this gives them the illusion of being right.

• Most traders want to take profits quickly and give their losses some room
• The right thing to do is the exact opposite, and that is cutting losses short and letting profits run

□ Pattern-recognition bias

Traders often focus on the wrong patterns. Once a trader has found a pattern, he can easily become convinced that it will work and do everything he can to avoid evidence that this pattern will not work.

• It only takes a few well-chosen examples to convince someone that a pattern has meaning
• Use volume to confirm any pattern formation, especially concerning break-out patterns

□ Randomness bias

Traders attempt to make 'order' out of the market and find reasons for everything. For example, traders like to believe that the markets create tops and bottoms that can be easily traded.

• Traders often see what they expect to see rather than what is happening
• Distributions of prices show that markets over time have infinite variance, something that statisticians call “long tails” at the end of the bell curve
• Traders fail to understand that even random markets can have long streaks and as a result, fishing tops and bottoms becomes the most difficult type of trading

□ Bias of the Gambler’s Fallacy

The gambler’s fallacy is a natural product of the randomness bias. The gambler’s fallacy refers to the misconception that when a trend is established in a random sequence, it will change at any time. Thus, after four consecutive up days in the market, most traders expect a down day. That misconception can lead to opening the wrong positions.

• The gambler’s fallacy bias totally ignores the randomness element and affects position sizing
• The average trader tends to bet more after a series of losses and less after a series of wins
• The rational approach should be betting more during a winning streak and less during a losing streak
• One of the most important trading rules is to run your profits and cut your losses However, when traders have a profit in their hands, are afraid of letting it get away

□ Degrees-of-Freedom Bias

One of the most common mistakes traders make is to perform extended backtesting that ends in manipulating the data to fit history. These traders would be much better if they could understand their trading concept by performing a minimum amount of historical testing. No matter how much traders learn about the hazards of overoptimization, they still want to optimize. It is important to limit the degrees of freedom of your system.

• A degree of freedom is a parameter that yields a different system for every value For example, the length of a moving average represents one degree of freedom
• Traders tend to use as many degrees of freedom as possible in their Unfortunately, the more a system fits the data upon which it was developed, the less likely it will be to produce profits in the future
• The more degrees of freedom you have in a system, the more likely that system will fit itself to a series of prices (over-optimization)
• It is strongly recommended not to use more than 4-5 degrees of freedom in your trade system. Thus, if you apply two indicators (one degree of freedom each) and two filters in your trading system (one degree of freedom each), that’s probably all you can tolerate.

□ Reliability bias

The problem of the reliability of data refers to a situation where data looks accurate when it may not be.

• When backtesting a trading system market data may be filled with errors
• Unless you assume that there might be errors in your data, you may suffer from a lot of mistakes in your trading decisions

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Step-6: Calculating The Expectancy of your Trading System after Developing it

Once you have developed a trading system, you need to calculate its expectancy by considering several issues.

 

a. Calculating the overall expectancy of your system

You can calculate the expectancy of your trading system by simply dividing the total profit by the number of executed trades.

• Expectancy = Total profit / Number of trades

Alternatively, you can calculate the expectancy of a trading system by using the following formula:

• Expectancy of a trading system = (PW * Average Profit) – (PL * Average Loss)

Where:

• PW = Probability of Winning
• PL = Probability of Losing

b. Categorizing Your Trades

By categorizing your trades in several different markets and market conditions, you can make much more accurate estimations regarding your system’s overall expectancy.

• You can categorize your trades in different markets and market conditions
• You can also divide your trades into general groups of winners and losers

c. Eliminating the effects of position sizing

You can eliminate the effects of position sizing by only considering single units.

d. Converting your groupings of trades into a probability matrix

You may convert your groupings of trades into a probability matrix by using your “smallest loss” as a single unit. This will help you find your expectancy per dollar risked.

e. Evaluating the results

If your system includes at least 100 trades and has an expectancy above 50 cents per dollar risked, then it is a good system.

f. Improving your expectancy

Look at the size of the winners and losers in your probability matrix and consider the following questions:

• What do winners and losers can tell you about your system?
• Is there a pattern behind the sequence of winning and losing trades?
• How can you change your system to include more winners?
• How can you change your system to include fewer high-cost losing trades?

Key Notes

• Expectancy and probability of winning are not the same thing
• Always take your risk in the direction of the expectancy of the system
• Even with a high positive expectancy system, you can still lose money

 

□ Preliminary Steps for Building a Successful Trading System

G.P. for ForexAutomatic.com (c)

December 11th, 2024

Main Source: “Van Tharp - Trade Your Way to Financial Freedom”