How to Build A Trading System

Practical example of how to design your Forex trading system from scratch

by Gonçalo Moreira | September 2012

Material extracted from FXstreet.com Learning Center

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DEFINITION:

A Trading system is a set of rules that formulates buy and sell signals without any ambiguity or any subjective elements.

PRIMARY AIM:Manage risk and increase profitability in any market environment.

Optimal levels of risk and reward are accomplished by modifying the different parameters within each rule of the system.

PRINCIPAL BENEFIT of trading with a system: Removal of emotion from trading

Systematical trader will, for instance, not place an excessively high risk trade due to frustration from a prior losing trade.

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- Read the article “The Pleasure and Pain Game” by Sam Evans on how emotions affect your trading- Listen to Steve Ward's podcast on “Emotions, Decisions and Discipline”

INTRODUCTION

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No system is better than any other

But a good system is one that is adapted to:

✔ your goals✔ your time window✔ your start capital✔ your personality

Read Jody Samuels on how to “Define Your Goals”

INTRODUCTION

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Steps to build a trading system from scratch:

1. Observation2. Hypothesis3. Measuring the Hypothesis4. Selecting the Time Frame5. Developing the Strategy6. Entry Rules7. Exit Rules8. Position Size and Risk Management

STEPS

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We will build together a simple system going through these steps.

It's a real system that has been backtested.

It is particularly appropriate for Beginners and Intermediate traders and to be traded with mini lots or lower.

On our Brokers comparative table, you will find which regulated brokers let you trade with small lot sizes

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LET'S GO!

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If you intend to capitalize on the market behavior, you need a BELIEF SYSTEM on how the markets operate.

Series of ideas you have gathered after observing the market for a while.

Market observations are thus the building blocks of every system and trading method.

Extremely important aspect most novice traders neglect!!!

Read the article “Beliefs: What You Hold as True Will Drive What You Do”by Dr Woody Johnson

1. OBSERVATION

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Let's OBSERVE this chart

This daily chart shows that most of the daily candles have different lengths in terms of pips.

We also notice that they break the high or low price from the previous daily candle most of the time.

The magnitude of the breakouts differs from candle to candle, but in many cases the distance the exchange rate shoots off the previous daily extremes is large enough to be considered a profit potential.

Breakout: Definition

Look at different currency pairs and charts and see what ideas pop up to our mind.

1. OBSERVATION

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This strategy aims to capture part of a breakout movement, starting from the high or low level of the previous day.

The MARKET CONDITIONS to meet in order to capture this event are:

✔ An increased momentum and volatility in the market.

✔ A major underlying trend in the direction of the breakout.

- Momentum: Definition- Check the currency pairs momentum in the Heat Map tool.

Once you have enough evidence that the recurring action-reaction event takes place on a regular basis, then you can formulate the hypothesis.

2. HYPOTHESIS

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Collect enough data to sustain your initial hypothesis. A number of 100 occurrences of the event under observation will provide a good statistical foundation.

Take a sample of past price data and take some rough measures accordingly to your hypothesis.

In order to measure the potential of the breakout, we will take the GBP/USD pair

For its characteristics as a fast moving currency pair, able to break support and resistance levels when it gains in speed and momentum.

WHY this pair?

Other majors would also be suitable for this strategy... we just had to choose one!

In our “Volatility Watch” widget you can observe the volatility measures of the pairs: BBW (Bollinger Bands Width), STD (Standard Deviation) and ATR ( Average True Range)

3. MEASURING THE HYPOTHESIS

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The results could look like this: during 2005, the average magnitude of the breakout was 65 pips in the GBP/USD. Of those breakouts, 92% were more than 10 pips, 38% more than 65 pips, 19% more than 100 pips. As for the frequency, the pair broke out 88% of the days that year.

Now you need to take a sample of past price data and take some rough measures accordingly to one of the above hypothesis. Let's take the one based on the breakout of the previous day high and low.

3. MEASURING THE HYPOTHESIS

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Experiment the system with different time intervals. A hypothesis may work better in a small time frame than in a longer one or vice versa

Although the event of the breakout is visible on the daily charts, we will choose the 1H time frame to start evaluating the strategy with the help of technical indicators.

WHY 1H?The 4H time interval seems too high to visualize the smaller breakouts

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Any time frame below 1H may generate unnecessary signals.

The TIMEZONE used for testing will be GMT, the standardized timezone for the FX market.

- Check the Market Timeline to check the trading sessions times- Volatility Distribution by hour for the GBP/USD

4. SELECTING THE TIME FRAME

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Describe your system. Fully articulate the initial idea. This includes an explanation about the tools to be used and what events provide the conditions to get into and out of positions.

The TOOLS of our strategy:

A price box to mark off the high and low prices of the previous day will be displayed on the 1H chart.

Each 24-hour period will be marked with a vertical line to distinguish the start/end of the day.

1.

5. DEVELOPING THE STRATEGY: THE TOOLS

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2.

- Simple Moving Averages: Definition- Read “A Practical Guide To Moving Averages” by S.A Ghafari

A combination of two moving averages will help to get the direction of the underlying trend.

Those will be the 21 and the 89 Simple Moving Averages, two numbers taken from the Fibonacci sequence which are not contiguous (...,8, 13, 21, 34, 55, 89, 144,...).

5. DEVELOPING THE STRATEGY: THE TOOLS

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Bollinger Bands applied to the 21 SMA will be used as an indicator for volatility.

Book: “Bollinger on Bollinger Bands” by John A. Bollinger, the creator of this technical indicator

3. The higher the standard deviation used in the settings, the more closing prices are contained within the bands. As the breakout movement needs to be aligned with the main trend, we need a parameter that gives some room for price to develop. Therefore the deviation will be initially set to 3. 3 standard deviations contain 99.7% of the closing prices.

This indicator will help us avoid trading breakouts if the previous daily range has been very tiny and the market lacks volatility.

5. DEVELOPING THE STRATEGY: THE TOOLS

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Pivot Points will be used as a tool to manage the positions and to take profits.

Check the Classic Pivot Points levels for GBP/USD

4. The classical Pivot Points and their corresponding Support and Resistance levels - S1, S2, R1, and R2 - are needed for this system.

This indicator will help us to filter some of the less probable breakouts .

It will also help us moving the stop to break even, if any of the Pivot Point levels has been cleared on a close.

5. DEVELOPING THE STRATEGY: THE TOOLS

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The parameters to enter positions are related to the type of system you use. The strategy has to be designed in a way that does not require you to make any subjective decisions whether the signal is valid or not.

The trade entry must be described in detail, including concrete definitions of:

The proper market conditions for entry The optimal trade set-up The final confirmation signal, also known as the “trigger”.

6. ENTRY RULES

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The ENTRY RULES of our system:

The faster 21-period Simple Moving Average is above the slower 89-period Simple Moving Average.

The direction will remain unchanged until the faster 21-period Simple Moving Average crosses below the slower 89-period Simple Moving Average.

In order to start testing the strategy only one trade per day will be taken.

as for the direction of the breakout:

1.

Market Conditions

6. ENTRY RULES

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6. ENTRY RULES

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If a certain day doesn't break a previous day price extreme, the direction of the breakout remains as it was before.

If a certain day breaks the previous day high AND low price extremes, the direction of the breakout will be determined by the position of the Moving Averages as explained in Rule 1. 3.

19Range: Definition

The 21 SMA is above 89 SMA.

The upper Bollinger Band is not contracting to the downside in the last candle before the breakout.

The 161,8% Fibonacci extension is equal or closer than 15% of yesterday's trading range.

LONG ENTRY conditions:

6. ENTRY RULES

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The exchange rate breaks above the high of the previous day.

Adjust the entry level to the previous day high adding one pip and the spread to the upside.

LONG ENTRY trigger:

For example, if yesterday's high was 1.6350 and your spread for the GBP/USD is 3 pip, then the entry level is 1.6354.

6. ENTRY RULES

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The previous day low was lower than the day before (as explained above).

The 21 SMA is under 89 SMA.

The lower Bollinger Band is not contracting to the upside in the last candle before the breakout.

The 161,8% Fibonacci extension is equal or closer than 15% of yesterday's trading range.

SHORT ENTRY conditions:

SHORT ENTRY trigger:

The exchange rate breaks below the low of the previous day. Adjust the entry level to one pip less than the previous day low to the downside.

6. ENTRY RULES

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6. ENTRY RULES

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PRACTICE your entry rules

by MEASURING the price moves after the signals across several time frames

and considering if multiple entries or re-entries would enhance your edge.

Once you are able to spot your exact entry points, then you have to work on the exit plan.

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Exit rules are part of the decision to take a position.

There are two types of exits:

A stop loss to get out of a bad trade. A profit target to realize profits when the market moves in your favor.

- Types of Orders, in the Learning Center

7. EXIT RULES

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Fibonacci extension 161.8%.

Target:

For example, if the 161.8% extension level on a short USD/JPY is 90.00 then the target would be placed at 90.04 if the spread is 4 pips.

The exact take profit order will be placed a few pips before the 161.8% level.

If there is a round number closer than 10 pips to the 161.8% level, take the round number as a target.

Also make sure to add the spread to the target level on short trades.

The EXIT RULES of our system

- Fibonacci Extensions: Definition- Read the article “Fixed Spreads Vs Variable Spreads” by CMS

7. EXIT RULES

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25Watch “The ABCs of Fibonacci” webinar by Andrei Knight

7. EXIT RULES

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C. EXIT RULES

Stop Loss

Conversely, the stop loss on a short trade is placed above the 21 SMA or the 61.8% Fibonacci level, the one that is closer to the entry price.

This way, the worst initial win/loss ratio on every trade is a Phi ratio (61,8 / 38,2 = 1,617801047...).

Long Trade: placed below the 21 SMA or the 68.1% Fibonacci level, which ever is closer to the entry price.

Read “Stop Market Orders: Ideas on Utilization” by Gabe Velázquez

7. EXIT RULES

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27Watch “Developing a Profitable Trading Strategy (Part 1)”, a webinar by Markus Heitkoetter

7. EXIT RULES

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Money management principles serve to determine your position size and risk management, the proportion of your trading account that is risked per trade.

For testing purposes,

Each position will be entered with one mini-lot

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we will limit the risk to 2% of the account balance.

- Read Andrei Knight's advice about Money Management- Read “Portfolio Management - Position Sizing and Stop Losses” by LearningMarkets.com

8. POSITION SIZE AND RISK MANAGEMENT

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For now, just concentrate on following the previous steps and follow the rules mechanically.

Systematically following a set of trading rules will help you grow as a trader (consistency, self-confidence, execution, mind training...)

Read Jody Samuel's advice about the importance of Following a System.

CONCLUSION

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But with time, your goal will be to develop your own unique trading approach

You may start with this system as a guide to develop a different one, you may even start by copying this system.

= a system that serves as a logical frame work for any trading decision you make

Another essential step in building a trading method is to backtest and forwardtest your system before committing real money.

- Read more about Back- and Forwardtesting in the Learning Center- Watch “Backtesting a System or Strategy” by Valeria Bednarik

CONCLUSION

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Backtesting Results of the system

Forex Tester is a powerful software that you can use for your backtesting

BACKTESTING

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Backtesting Results of the system

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EQUITY CURVE

TRADES

BACKTESTING

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Forex Tester is a powerful software that you can use for your backtesting

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This system was presented in a webinar that you can watch whenever you want!

WEBINAR

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How To Build A Trading System

by Gonçalo Moreira | September 2012

Material extracted from FXstreet.com Learning Center