Section I: Introduction
By now, you should know that it is important to trade based on a trading system; otherwise, it will be very hard to generate consistent profits from the Forex market. Trading systems tell you where to get in and out the market.
When you devise a system, you look for certain moves and what indicators, patterns or price behavior caught that move, then you create a set of rules; when these rules are present in the future they signal a trade.
Most systems are based on price patterns or technical indicator readings (technical patterns). However, we must not forget something: patterns (whether chart or technical patterns) are never the same, they are only similar. In order for two patterns to be the same exact pattern the same traders need to be involved on both patterns, and not only this, they have to be in the same mood so they behave in the exact same way. We know this is almost impossible since there are just too many variables that need to be accounted for. Take for instance, how many traders are waiting in the sidelines? How many traders will get out of the market sooner than they have planned? How many of them will take partial profits? And so on...
This tells us that there are no certainties about the outcome of every single signal. Even though we don't know the outcome of any individual trade, the outcome of a set of trades is predictable; we also know that if we follow rigorously our system we will be ahead of the game in the long run. When our system signals one trade it only tells you that there is a higher probability that the market will go in the intended direction, probabilities will play their part.
So we know two important things:
- We don't know in advance the outcome of any signal
- If we follow our system rigorously, we will be ahead of the game
What is interesting is that we do not need to know what is going to happen next in order to make money in the Forex market, we only need to make sure we have a well-developed system and follow it rigorously.
However, before we apply this knowledge we need to develop our own system. In this lesson we will show you how to effectively develop a system the fits your personality.
The following topics are covered in this lesson:
Section II: Creating a Trading System - Important information about trading systems.
Section III: Types of Trading Systems - There are two types of trading systems; we will review their advantages and disadvantages.
Section IV: Trading Styles - Review of the trading styles you might adopt to develop your trading system.
Section V: Trading Concepts - Not all trading concepts are for every trader, choose the one the better fits you.
Section VI: Trading System Conceptualization - After choosing our trading style and concept, we need to begin our system conceptualization.
Section VII: Testing and Live Trading - Once we created our system we need to test it and see if it really fits our personality, a few tips to do an effective testing.
Section VIII: Some Points to take in Consideration - Before taking any action please take these important points into consideration.
Section II: Creating a Trading System
It is very important to have a system that perfectly fits your personality, otherwise you will find it difficult to follow and it will be hard to generate consistent results. Nevertheless, how do we know if the system we are trading is the right for me? On the last section of this lesson, we will find out the proper steps that need to be followed in order to make sure our system fits us.
Most traders have problems with the system they are using because they did not develop it. A system that works for one trader does not mean that it will work for all traders. The system creator “created it” based on his personality and unique circumstances (trading capital, risk profile, etc).
If this is your case, you need to follow the same rules and re-create and tweak the system until it fits your needs as a trader and personality.
In order to create a successful system you need to take care of the following steps:
1. Types of systems
2. Trading styles
3. Choose the concept of trading
4. System Conceptualization
5. Testing and live trading
We will go through every single step through this lesson.
Section III: Types of Trading Systems
There are basically two types of Forex trading systems, mechanical and discretionary systems. The trading signals that come out of mechanical systems are mainly based on technical analysis applied in a systematic way (technical indicators, chart patterns, etc).
On the other hand, discretionary systems use experience, intuition or judgment on entries and exits.
Which type produces better results? Or more importantly, which one better fits your trading style?
In this section, we will try to answer the question above. We will first analyze the pros and cons of each system approach.
Mechanical Systems
Advantages
- This kind of system can be automated and backtested efficiently.
- They have very rigid rules. Either, there is a trade or there isn’t.
- Mechanical traders are less susceptible to emotions than discretionary traders.
Disadvantages
- Most traders backtest Forex trading systems incorrectly. In order to produce accurate results you need tick data.
- The Forex market is always changing. The Forex market (and all markets) has a random component. The market conditions may look similar, but they are never the same.
- A system that worked successfully in the past doesn’t necessary mean it will work in the future.
Discretionary Systems
Advantages
- Discretionary systems are easily adaptable to new market conditions.
- Trading decisions are based on experience. Traders learn to see which trading signals have a higher probability of success.
Disadvantages
- They cannot be backtested or automated, since there is always a decision to be made based on judgment.
- It takes time to develop the experience required to trade successfully and track trades in a discretionary way. In the early stages this can be dangerous.
Now, which approach is better for Forex traders?
It is advisable to always start trading a mechanical system, as you gain experience, you will realize which signals produce better results but this requires time and experience, so start first with a mechanical system. Another point you should take in consideration is if you are a trader that finds it hard to follow your trading signals, then you are better off using a mechanical system, where your judgment won’t play an important role in your system. You only take the trades that your system signals.
If the psychological barriers that affect every trader (fear, greed, anger, etc.) puts you in unwanted scenarios, you are also better off trading mechanical systems, because you only need to follow what your system is telling you, go short, go long, close a trade. No other decision has to be made.
On the other hand, if you are a disciplined and experienced trader, then you are better off using a discretionary system, because discretionary systems adapt to the market conditions and you are able to change your trading conditions as the market changes. For instance, you have a target of 60 pips on a long trade, the market goes up quickly reaching 50 pips in your favor in a few minutes, allowing you to change the target level to 100 pips. These kinds of decisions are nice to adapt once you have enough experience, however it could be dangerous at early stages.
Does it mean that trading a discretionary system has no rules? This is absolutely incorrect. Trading discretionary systems means that once a trader finds his/her setup, the trader then decides what to do. But every trader still needs certain rules that need to be followed, such as the size of the position, conditions that have to be met before thinking to get into the market, and so on.
Whether you choose to be a discretionary or a mechanical trader there are some important points you should take in consideration:
- You need to make sure the Forex trading system you are using totally fits your personality. Otherwise you will find yourself outguessing your system (develop it yourself).
- You also need to clearly define your rules and most importantly have the discipline to follow them.
- Take your time to build the perfect system for you. It is not easy and requires time and hard work, but in the end, if done correctly, it will give you consistent profitable results
Section IV: Trading Styles
The trading style you choose is directly correlated to the time you are able to devote to trading.
Short-term Trading Styles
· Scalping
· Daytrading
Long-term Trading Styles
· Swing trading
· Position trading
Scalping
Characteristics: · Traders open and close trades within a very short time scale, from seconds to several minutes.
· Scalpers tend to make many trades a day, perhaps even hundreds.
· They look for tiny profits on each trade (10, 5 or even less pips). Losses are also minimal.
· This type of trader often trade large positions.
· Scalpers often trade based on momentum, when there is a sharp move.
Time required devoting to such strategy: Scalping requires staring continuously at the screens for several hours. This strategy also requires constant focus.
Charts to look at: 1 minute
Advantages:
· Minimal risk per trade
· High system accuracy
· No fundamental analysis is required
· No overnight event risk
· Many opportunities each day
Disadvantages:
· Very high level of emotional stress and psychological pressure.
· Broker must have a fast execution service.
· This strategies usually have low RR ratio
· Most brokers don't like scalpers (sometimes the put them into manual execution service, a dealer execute his or her trades)
· High transaction costs. If a scalper makes 20 trades in the Euro and pays 3 pips of spread, he will pay $600 for spread on that day.
Common strategies:
· Breakout strategies (from short term consolidation periods)
· Quick bounces from support and resistance levels
· News and event trading (i.e. at a news announcement report)
Daytrading
Characteristics:
· Trades are opened and closed during the day, these trades last from a couple of minutes to a whole day
· This type of trading requires a high level of discipline and patience to wait for the right moment to enter the market.
· Most daytraders base their trades on technical analysis.
· Frequency of trades can go from one to five trades a day.
· Daytraders try to capitalize from the trend of the day
Time required devoting to such strategy: daytraders are required to monitor constantly the markets to time entries and exits. Not advised for those who have day jobs.
Chart to look at: 5 minute to 30 minute
Advantages:
· High potential for returns
· Daytraders can use a high RR ratio
· Able to capitalize on short term trends
· No overnight risk
· There is always another opportunity to make money
Disadvantages:
· Requires a systematic approach
· A high level of discipline and patience are required to trade this way.
· Different strategies should be used for different market conditions.
· Constant monitoring of news announcements (they can produce an adverse move that could hit your stop loss level.)
· You can be whipsawed by intraday market moves.
Common strategies:
A wide variety of strategies can be used when daytrading including:
· Trading based on chart patterns (double top, triangles, etc.)
· Based on technical indicators (MA, RSI, etc.)
· Based on price behavior
· Breakout trading
· Pullback traders
Swing Trading
Characteristics:
· Trades last from two to five days
· Swing traders attempt to forecast the medium term trend
· Positions are held overnight
Time required devoting to such strategy: Swing traders are only required to monitor their trades a couple times a day.
Charts to look at: 1 hour to 4 hour
Advantages: · High potential for returns
· Swing traders can use a higher RR ratio than daytraders.
· Since trades have a longer time span, they are not likely to be caught by “market noise”.
· Low transaction costs
· Emotional stress and psychological pressure is low in this type of trading
Disadvantages:
· Not able to capitalize the short term trend
· A high level of discipline and patience is required to trade this way.
· This type of trading usually has low system accuracy.
· Overnight risk
Common strategies: A wide variety of strategies can be used when swing trading including:
· Swing traders usually focus on currency pairs that pay interest.
· Trading based on chart patterns (double top, triangles, etc.)
· Based on technical indicators (MA, RSI, etc.)
· Based on price behavior
· Breakout trading
· Pullback traders (from medium term trends)
Position Trading
Characteristics:
· Trades last from a couple days to several months
· Position traders attempt to forecast the long term trend
· Positions are held overnight
Time required devoting to such strategy: Position traders are only required to monitor their trades one or two times a day.
Charts to look at: 4 hour to daily charts
Advantages:
· High potential for returns
· Position traders can use a higher RR ratio than swing traders and daytraders. They usually use 5:1 or even higher.
· Since trades have a longer time span, they are not likely to be caught by intraday market moves.
· Low transaction costs
· Emotional stress and psychological pressure is the lowest in this type of trading
Disadvantages: · Not able to capitalize the short term trend
· A high level of discipline and patience is required to trade this way.
· This type of trading usually has low system accuracy.
· Overnight risk
Common strategies:
A wide variety of strategies can be used when position trading including:
· Position traders usually focus on currency pairs that pay interest.
· Fibonacci levels tend to be very accurate on longer time frames
· Trading based on chart patterns (double top, triangles, etc.)
· Based on technical indicators (MA, RSI, etc.)
· Based on price behavior
· Breakout trading
· Pullback traders (from medium term trends
Which one to choose?
Every trader has different needs, resources, time and objectives. Therefore, the best type of trading is the one that best fits your needs.
For instance, if you have a day job then a swing or position strategy is possibly the way to go. If you however don't have a day job and are able to watch your charts during the day then a daytrading or scalping strategy will better fits your needs.
In addition, if you like to trade based on fundamental analysis then a long-term style will better fit your needs as changes in supply and demand take more time to be reflected in price action.
Whatever you choose, make sure it fits your needs and you are totally comfortable trading such approach, otherwise you are going to have problems trying to follow your system.
Section IV: Trading Concepts
Choosing the right concept is also a large part of system development. Not all concepts of trading are good for every trader. Some traders feel more comfortable trading in direction of the trend while others feel more secure trading against it. This has something to do with the personality of each of us.
It is not unusual for Forex traders to mix concepts, sometimes traders use different concepts for different market conditions (i.e. to have a way to determine whether the market is trending or not, then choose the appropriate system).
Trend-following
This concept simply waits for a significant price movement then buys (or sells) on the hope that the price will maintain its trend so the trader will be able to sell higher (or buy back lower).
The trader must use a systematic approach to measure the trend. The accuracy in which traders measure the trend will dictate the systems performance.
Advantages:
· Trades in direction of the trend have a higher probability of success.
· When a trend is caught, trades usually make large profits.
· Trend-following systems usually have a very high RR ratio.
Disadvantages
· It is said that the market trends only 30% of the time
· Trend-following systems usually have low system accuracy.
· Trend-following systems get whipsawed during consolidation periods.
Common strategies:
· Breakout trading: After a period of consolidation, traders buy new highs or sell new lows (i.e. using entry orders).
· Pullback trading: Traders wait for pullbacks and buy or sell off important levels (Fibonacci retracement, Bollinger lower or upper band, LOPS, HOPS, etc.)
· MA strategies: Some traders use moving averages strategies (crossover, position of price in relation to MA) to trade this systems.
· Chart patterns: Rectangles and triangles are used to trade trends.
· Technical indicator signals: Many technical indicators can be applied to this type of trading (i.e. RSI centerline crossover, CCI extreme levels, ADX, etc.)
Counter-trend
This type of trading tries to profit from either a short-term reversal or a long term reversal. Short-term reversals are often called retracements. This strategy basically tries to buy at a reversal pattern (trend to reverse is a downtrend), or tries to sell at a reversal pattern (trend to reverse is an uptrend).
Advantages
· If the signal is correct, the entry price is close to the high/low of the reversal.
· Usually high RR ratios are used in this concept.
Disadvantages
· Trades against the direction of the trend have a higher rate of failure.
· Sometimes trying to pick the bottom or the top of the trend can lead us to have an even higher rate of failure.
Common strategies:
· Chart reversal patterns: Double tops and bottoms, head and shoulder and other reversal patterns can be used.
· Divergence trading: This signals when combined with price behavior tend to give a high accuracy rate.
Consolidation or Range Trading
A period of consolidation occurs when demand meets supply. It is also called sideways or ranging.
Advantages:
· It is said that the market stays in consolidation periods 70% of the time.
· Stop orders are placed close to the entry price
Disadvantages
· Extreme volatility may occur during these periods
· Sometimes the high and low of the range are not clearly defined
Common strategies:
• Indicator overbought/oversold condition: Stochastics are the most effective indicator to track overbought/oversold conditions.
• Buy at the bottom of the range/sell at the top of the range: When applied in combination with price behavior, this technique usually has a high accuracy.
If you are going to trade different market conditions then it is important that you use different strategies, most trend-following strategies will fail under consolidation periods and most consolidation periods strategies will fail when a trend is in place.
Take for instance: You have decided to use a MA to determine the trend of the market. Therefore, when the market is trending (price above/below the MA) you use a trend-following strategy. In addition, when the market is not trending (the MA line is flat or close to flat) then you use a consolidation strategy.
Also, when you use a counter-trend strategy, for instance a chart reversal pattern, if it was a valid pattern and the trend reverses, then you can use an exit strategy based on a trend-following system so you are able to catch most of the trend.
Section VI: Trading System Phases
In this section we will see the steps you need to take in order to create a successful system. Once you have chosen a type of trading system (mechanical or discretional), chosen a concept and a trading style, follow these steps to create your system.
1. Historical Moves:
While looking at historical charts (the time frame you have chosen and within the concept you have chosen) identify some substantial moves. Find as many as you can so you can have a large sample.
2. Set Up:
See what all these moves have in common. For instance, you may notice that all these moves were formed after a consolidation pattern, or a technical indicator reading was always above 50 for the up-moves and below 50 for the down-moves, or the EMA(50) was always above or below the price action when the move occurred, or the market always traded above LOPS or HOPS, or they all developed at certain time, etc. Set-ups tell you the conditions that have to be present in order for the move to happen. Set-ups are a warning that a possible trade could come. Whenever you see these conditions in the future, you need to get ready because there is a possibility that your system signals a trade.
3. Determine Your Entry Rules:
Find a trigger signal that is present in of the chosen moves most (it will be impossible to find a trigger for all moves). It could be a MA crossover, a specific indicator reading, a price reversal pattern (reversal candlesticks), or it can be a combination of many, like a reversal pattern off an important level (HOPS, LOPS, PP, Fibonacci retracement, etc.), a moving average crossover when the indicator reading is at certain point, etc. Some entry points seem brilliant at first glance since you are not considering how many times your system triggers a signal when the actual move (in your favor) is not present.
4. Risk Management:
Determine at what point you are going to get out of the market because your trade isn’t working, also determine if you are going to use a trailing stop or not (if yes, what kind of trailing stop you are using).
5- Exit and TP Levels:
Sometimes your trade does not reach your take profit nor your stop loss level, in this cases you must use the same concept you used to get in the market to get out of it. For instance, if you used a crossover to get in the market, then a negative crossover will also get you out of the market (if your set-up is not present with the trigger signal, otherwise you would have to open a new contrary position), if you used price reversal patterns, then if you get a reversal pattern against you then you should exit the market. You also need to set your take profit levels. We advise to use a RR ratio at or greater than 2:1.
6. Trade Management:
Determine if you are going to trade multiple lots, scaling out, averaging, etc.
7. Money Management:
What technique of money management you are going to use?
8. System Testing
Trade your system in real time (read next section).
Section VII: Some Other Points to Take in Consideration
Here are some important points you need to take in consideration while creating your trading system.
1. Always be skeptical about your own ideas, focus only on results. Sometimes is easy to track trading opportunities, what is hard is to capitalize on them and make money from them. The performance of any trading system should be measured with actual trading (either demo or an account with limited funds).
2. Sometimes you lose even when you have followed your system to the rules. Losses are part of the game, there is no possible way to avoid them, and we need to learn to lose. So if you have followed your system 100% and took a loss, celebrate it! The only way to stay ahead of the game is by rigorously following your system.
3. Sometimes while trading large positions you can lose control of your emotions. Don't be overly aggressive with the market and follow a well planned money management technique. It should tell you what you are going to risk on your next trade.
4. Try to understand why your system works, this way you will develop the required confidence in yourself and your system.
5. There will always be some “indicator” that could have kept you out of a losing trade. But remember your system is not designed to win all your trades, but to win most of them.
6. When you finally created your system, describe it in simple and logical terms. If a 15 year old kid is not able to understand it, then something is wrong with it.
7. Use only 2-3 indicators: one indicator to identify the trend and one or two indicators or variables for entries and exits. The more indicators you use, the more complicated your system becomes. Most of the time “the simpler the system the better performance it will have”. Also use non-correlated indicators, do not choose two indicators that are supposed to measure the same market condition.
8. Test your system over large data samples (over 50 trades) and in various market conditions, this way you can see under what conditions your system works better.
9. If you decide to trade several currency pairs, try non-correlated pairs. For instance, if you trade long the Euro and long The Pound, your are likely to get the same result on both of them, elevating your risk if the market goes against you.
10. News trading? Determine whether you are going to keep your trades open during important news announcements. If you are trading for the short term you are likely to keep tight stops, and an important news announcement might hit your stop loss level.
11. While you are in a trade, open your mind to every possibility, sometimes you don't see or ignore evidence against your trade.
Summary Report
Ok, now that you have read the lesson material and taken the quiz, please make sure you completely understand and/or do the following:
Now it’s time to develop your system, follow the simple rules outlined in the course material and start developing it. It will take you some time to get to your final system because you are probably going to need to tweak it a little to make it fit you. You also are going to need to test it in real-time, as it is the best way to see if you feel comfortable trading it.
Should you have any questions don't hesitate to use the Q&A Section.
Good luck!
