What is a Trading System?
A trading system has 3 components. These are the strategy, the psychology and the optimization component. Let’s take a detailed look into each of these components.
The 3 trading system components and its sub components.
Source: MTM training manuals
Component 1 – Strategy Component
The strategy component of a trading system refers to the planning before you get into the trade. As the saying goes, fail to plan, plan to fail. Here, you have to write out all your strategy criteria in a crib sheet.
So your crib sheet must have rules for:
- Entry – Pre and Re-entry(if any)
- Stop Loss(SL) – Initial and trailing SL
- Target – Pre and Intra Target
- Money management – Includes risk management per trade and total portfolio risk at any one time
For your entry, it is ideal to have 3-4 degrees of freedom or criteria to get into the trade. All your rules must be based on quantifiable parameters that will help you place your trades on a steady basis.
Component 2 – Psychology component
This is all about managing your emotions and not allowing fear and greed to interfere so as to achieve consistent execution. This helps you obtain valid stats which can then be used for optimization and can help in achieving regular profits.
Draft a pre and post trader routine that you will do every day to help you with your mind and keep your emotions in balance. This can include meditation, yoga, exercise, reading a book etc. Whatever it may be, it is necessary to have a routine in place to keep your emotions stable as 80% of trading is psychology.
Component 3 – Optimization component
Continual optimization of your trading system is necessary to adapt to the changing market conditions. This would require you to analyze your trading stats. Important stats to look out for are:
- Reliability and
- Profit factor
Reliability refers to the % of winning trades your system generates. For example, if you had 8 out of 10 winning trades, you have a 80% reliability system. Neutral trades would be considered a non-winning trade.
The profit factor is the ratio of your average winning trade to your average losing trade. So for example, if your average win was £450 vs an average loss of £150, the profit factor is 3.
When you know your system stats, you build your statistical conviction which grows your trading confidence. This will help you place your trades without having the fear in a drawdown and pull you to your next profit highs.