Creating a trading system IV - The basics

What are the absolute minimum needed to create a trading system?

The answer is:

• Trade management methodology
• Risk management system
• A methodical way to enter the market (even if its a coin toss)

My system of trade management is fairly mechanical. I prefer fixed stops and a fixed scalp exit that is twice the stop size. Some discretion may be applied for any additional contracts. They may be held until a price target is hit such as high or low of today or prior day, or the trend terminates (by breaking a trendline), or a climax bar or simply when the profits are too large to be left on the table. The first step in creating a trading system therefore is to determine an acceptable stop size. If the stop size is too small, you will probably be stopped out before reaching twice the risk. If your stop size is too large, it may never reach twice your risk. Somewhere in between is a band where stop size is acceptable.

Risk management is also pretty simple. I have maximum loss limits per trade (stop size), and per day (maximum number of failed trades) and in case I run into unexpected price action, I will also have amortized loss limits per month. I have posted extensively on risk management and those rules are universal regardless of what you trade.

There is a broad choice of ways to enter the market based on indicators, price action, support and resistance levels and possibly countless others that I haven't even heard of. I have the strongest confidence in price action, having tried many others which resulted in utter failure and bafflement. 

However, for the purposes of stop size determination, I may choose a mix of random entries and price action. Once stop size is determined, I'll only trade price action.

Creating a Trading System III - Price Action Trading

Over the years I have tried nearly every system of trading. Nearly all of them have failed to generate consistent profit (although many did work for a few months). Some of this may be simply because the systems were not suited to my style of thinking but I believe most systems are biased towards a perma-bull market and will fail during any sharp bear move. And most such failures are spectacular.

One of the reasons for this is that newcomers are attracted to trading when they hear success stories from their friends and family. Such success stories, especially dramatic trades usually occur near the top of a bull market. Systems that have recently proven to be working in the past year or two are likely to be biased towards a bull market. This attracts newcomers right before an impending crash.

Systems that cannot work in both bull and bear markets are terrible choices for a trader. The best and largest moves occur in bear markets but bull markets last longer. Any system that cannot trade both is likely to be a poor performer unless you happen to start your trading career in a lucky decade.

After trying out indicators, buy and hold and all manner of fundamental trading, I finally settled on price action trading as a framework for my system. Price action fit well into my understanding of demand and supply and my observation that one cannot consistently predict at what price the market is likely to turn. Trends can be dramatic and sharp and last much longer than anyone can predict.

One of my early discoveries was that anything you may know about any system is probably incomplete. There will always be subtleties that you need to pay and learn over time. There will always be edge cases where a certain setup may not be valid and even after you have detailed experience trading a single setup, a good percentage of the time, the setup will simply fail to reach target before taking out your stop.

Another observation is that some setups are likely to give a large gain if they are successful. For example, the 1st pullback after a trend breakout early in the day is likely to give a large move lasting for at least an hour. Even if the setup here is weak, its often worth taking the risk of a small loss since the win will usually be very large and more than make up for a few losing trades.

There is simply no way around the fact that trading is a system of probabilities and you need to find and press your edge. When the winning probability of a setup is high, you can take the trade even when the expected gain is smaller.

Price action trading provides a general framework where I experiment, learn and build my trading system. Unlike a system that uses indicators which really has no framework but simply magic math that tries to convert a price movement into a binary buy/sell decision, a price action framework can keep you on the right side of the market, enable you to anticipate large moves or chop and act accordingly.

This general framework is a springboard from which you can refine your trading and market reading skills on your journey to be a profitable trader.

Creating a trading system II - Trading versus investing

There is an inherent distinction between traders and investors. Depending on how you think, you may be suited for one versus the other.

An investor likes to think there is an inherent value for an instrument (stock, index, future) and any price below it is cheap and any price above is expensive. The actual value could be determined in a variety of ways.

For example, the simplest way of looking at a stock investment is to look at it as an alternative to buying bonds. Assuming that you could have a stop at 10% below your entry price, a stock that gives a dividend yield of 10% is worth at least breakeven. There are not many stocks that give such a good yield unless they are so cheap due to recent devaluation that owning them is high risk.

In a bull market, a stock expected to perform with the market, i.e. at 7 to 11% annual gain is possibly worth breakeven if it gives a 3% yield with a 10% stop.

When price falls below the current price, the yield and the expected gains increase, and the stock is said to be value for money. Similarly, when the stock makes a large price gain, the expected remainder of the gain and the dividend yield decrease and therefore its expensive.

In reality, no one pays attention to this very common sense way of investing. Most investors buy or sell based on recent strength or weakness or financial advisors or media. Part of the reason is that the best performing stocks often do not pay dividends, but rather reinvest their cash into developing their business.

To account for this situation, there are a variety of fundamental data that investors use to determine value based on PE, earnings growth, revenue to debt ratio, price to sales and so on. The problem with this is that these values are totally disregarded in a strong bull or bear market.

In any case, investment is primarily about determining fair value based on earnings, dividend, growth potential, etc. and buying below and selling above.

A value price may be $10 and there is no sense buying above $10. An investor may want a minimum return of 10% and therefore will only buy at $9 or better. He is likely to sell at $11 since it represents greater than market expectation of gain. He will continue to buy near $9 and sell near $11.

Traders on the other hand, do not think in terms of value but in terms of demand and supply. Fundamentals are but one factor in demand and supply but there are many others such as irrational exuberance and news.

While some traders have successfully married the concept of value in trading using market profile, most traders are better off trading pure demand and supply and disregard all notions of value. Institutional value fluctuations usually do not happen at the minute levels and frequency of day trading. For traders, price is about demand and supply and this is translated to concepts such as support and resistance, trends, legs, etc. In other words, traders trade patterns, investors trade prices.

Creating a trading system I - A new beginning

From January 2013, I'll go through the steps of creating a new trading system to trade CL contract (oil futures.) My goal is to go through the steps of creating the risk management and trade management system for CL and publicly log all my trades, including experimental trades.

Initially, I will work on figuring out ideal stop sizes, scalp and swing targets and the system will run on SIM. As the system picks up consistency, I will start trading the system live.

This will serve as a template or guide for me and my readers to create their own price action trading systems on anything they may wish to trade.

Why CL?

From recent experience, I believe there may be a case for accelerated consistent profitability for new traders in CL compared to ES or any other equities contracts. CL also does not usually suffer from the lunchtime lull and traps that ES traders need to be wary of. CL does have its own dangers, namely slippage and whipsaw during news events. These are part of what makes stop size determination a bit harder on CL.

For the rest of December, I will attempt to describe my overall trading principles and the reason I believe they are universally applicable.