How simple can a trading system be?
When I first encountered the concept of a trading system, my initial feeling was that it was very complex, because with the word "system" in it, it sounded quite challenging.
But when I really stepped out of my comfort zone and got in touch with and used this thing, I found that a trading system is nothing more than a few elements, very simple.
From a practical standpoint, a trading system is about solving a few problems in trading:
What is the direction of the current market trend? Is it bullish or bearish?
Where should I open a position?
After opening a position, where should I set a stop loss if I'm wrong, and where should I take profit if I'm right?
How much should I buy at once for the best results?
All trading systems are created to solve these 4 questions. Next, I will explain 3 very classic trading systems, and everyone will understand what's going on at a glance.
1: Three Trading Systems
Let's start with Livermore's trading system.Levermore is a well-known figure, and he has a book titled "How to Trade in Stocks." In this book, he discusses his trading methods, which essentially form a simple trading system. Let me summarize it for you.
1: Record price increases on the chart with black ink and price declines with red ink to identify the direction of the market trend.
2: Identify key points in the market as entry points (key points are what we now refer to as significant support and resistance levels).
3: After entering a position, set stop losses based on the principle of a six-point turn, and exit with profits when the market trend weakens.
4: Levermore's position sizing is quite aggressive, and he adds to his positions when they are profitable.
During Levermore's era, technical conditions were very limited because there were not many predecessors to pave the way, so everything had to be figured out on his own, which is why the trading system was relatively crude.
His trading strategy mainly involved tracking and analyzing the flow of market numbers. According to his book, he personally recorded and statistically analyzed prices to discover trading opportunities.
According to our current trading logic, this method of trading is known as breakout trading.
Now, let's talk about the trading system in "Trend Trading."
The trading system in "Trend Trading" is also quite simple, and one of them uses the break of a trendline as the standard for determining the direction of long or short positions. Trade in the direction of the trend by going long when above the trendline and short when below it.Let's take a look at his trading system settings:
1: When the K-line crosses above the trendline, it is bullish; when the K-line crosses below the trendline, it is short.
2: When the K-line crosses above the trendline, go long; when the K-line crosses below the trendline, go short.
3: This operation mode is a trade where the order does not exit the market. When a long position is entered, the short position is closed. If the order is at a loss at this time, it is closed with a stop loss; if the order is profitable, it is closed with a take profit. When a short position is entered, the long position is closed, and the stop loss and take profit are the same standards.
4: This trading model requires the use of a fixed position method, with a fixed number of contracts each time, such as 1 contract, 3 contracts, 5 contracts.
The chart is a 1-hour K-line chart of the Euro against the US Dollar. On the hourly chart, draw the trendline, and when the market crosses above the trendline, close the short position and go long; when the market crosses below the trendline, close the long position and go short. The red circles in the chart are all the nodes for the conversion of long and short orders.
The logic of this trading system is also very simple, which is to use the trendline to track the trend, solving the most basic four problems of the trading system.
In addition, the trend-following method discussed in the book "The Turtle Trading Rules" is similar in spirit to this method, but with different indicators. The fundamental logic is the same, which is to use moving averages or channel lines to track the trend.
Finally, let's talk about the triple filter trading system in "Trading for a Living."
The difference between the trading system in this book and the others is the use of multiple time frames, adding an extra step of selecting the time frame.Traders first select a preferred time frame, which can be a large weekly or daily chart, or a smaller 5-minute or 15-minute chart; this period is referred to as the intermediate time frame. Based on this standard, they identify a larger long-term time frame and a smaller short-term time frame.
In the book, the author initially establishes this trading system using the MACD as the technical criterion, but later changes to the Exponential Moving Average (EMA).
(Here we can observe a point: the choice of technical indicators is not crucial, as they are merely used to define standards, and there is no such thing as an absolutely magical indicator.)
Let's also take a look at the settings of this trading system:
1. Determine the direction. Despite the trading time frame, the author emphasizes the importance of first observing the larger time frame to confirm the direction. We can observe the pattern of the EMA in the larger time frame, for example, using the crossover of EMA90 and EMA60 to judge the bullish or bearish trend.
2. Return to the intermediate time frame to determine the entry point and where to set the stop loss. Assuming the larger time frame indicates a bullish trend, in the intermediate time frame, according to the technical criteria of EMA90 and EMA60, choose to enter after the market trend shifts from bearish to bullish, and wait for the market to retrace before entering. The stop loss is set at the low point of the retracement.
3. Finally, enter the smaller time frame, also using EMA90 and EMA60 according to the technical criteria to buy, set the stop loss, and set the profit target at the larger time frame, such as the resistance and support levels of the larger time frame.
4. This trading logic, which focuses on the larger picture while trading the smaller one, spans three time frames, has a small stop loss space, and can also employ a fixed position trading logic. This allows for better profit performance in larger market movements.
There are many examples of trading systems on the market, and although the criteria for defining trends are not uniform, they all address the same four fundamental issues.
Therefore, after seeing these examples, we will have a very clear model of a trading system in our minds.Can these embryonic trading systems be used directly?
Not necessarily. It's like opening a hot pot restaurant; if you set the spiciness to a level suitable for Sichuan people in Guangdong, it would definitely not be well-received, and the business would suffer.
If one can adapt to local conditions and adjust according to their own characteristics, they can create a unique flavor that is both locally adapted and retains its original essence.
I believe that a good trading system doesn't fall from the sky but is fine-tuned by oneself.
Different details of a trading system can have completely different manifestations during the trading process. For example, the frequency of trades, the length of time holding positions, and the profit-to-loss ratio can all have a completely different impact on traders.
Some people prefer more frequent trading, while others prefer a slower pace. Some can wait, while others cannot. Different personalities correspond to different trading styles.
Next, I will explain how to draw on other people's trading systems to fine-tune a system that perfectly matches oneself.
2: How to Fine-Tune Your Own Trading System
Actually, the most effortless way is to find some trading systems online or in books, and through one's own verification and testing, slowly adjust them to match one's own state.
If you come across a trading system, how do you know if it's suitable for you?It's quite simple. Suppose you come across a trading system that seems decent, but you're unsure if it's suitable for you or how to understand and modify it. The easiest way is to test it.
In a previous article, I discussed a trading system where a candlestick stands above the moving average, falls back to the moving average without breaking it, and then enters the market after the price breaks a new high again. The stop loss is set at the low point of the fall, and the risk-reward ratio is set at 2:1. Let's first use an image to briefly explain this logic.
The image shows a 1-hour chart of spot gold. After the market stands above the moving average and retraces to it, a reversal candlestick forms and the price continues to rise. A position is opened after breaking the previous high, with the stop loss set at the low point of the retracement and a 2:1 risk-reward ratio. After four days of fluctuating and rising, the order is taken profit at a high level.
Now that we understand the trading logic, what should we do next? Identify problems, test the system, let the issues surface, and then solve them.
For example, the first question is, can this pattern make money? What is the trading frequency like? We simply operate on the backtesting software for three months to see how it goes.
The trading results are not bad. Over three months, there were 9 trades with 6 correct and 3 wrong, but with only 9 trading opportunities in three months, it averages less than once a week, which is quite low. This frequency is quite demanding to execute.
Of course, to test the true profitability of a trading system, three months is definitely not enough. Here, I'm just demonstrating and providing a reference for everyone.
Now this issue emerges: the trading frequency is too low, and it's not satisfying to trade. How to change it?
The first option is to add another instrument, such as the Euro to US Dollar pair. Theoretically, the trading frequency doubles to 18 times in three months. If you still think it's not enough, add the British Pound to US Dollar pair as well, and you'll have 27 trades in three months, which is a higher frequency and less demanding to execute.
At this point, you put all three instruments into the backtesting software and test the specific trading frequency over three months to see if it matches your expectations, and then continue to look for other issues.Additionally, increasing the frequency of trades can also reduce the time frame of the trading candlesticks, for example, changing from 1-hour to 15-minute candlesticks. Let's also take a look at how the trading system performs after making such a change.
The chart below illustrates a 15-minute trading scenario with a 2:1 profit-to-loss ratio for taking profit. Over a period of three months, there were a total of 26 trades, with 13 correct and 13 incorrect.
This makes it clear that the trading frequency is similar to that of three 1-hour trades over three months.
At this point, it becomes evident that one can either increase the number of traded instruments or reduce the trading time frame, depending on one's own trading habits.
If we wish to change to a 3:1 profit-to-loss ratio for taking profit, hoping to hold positions for a longer duration, we can also examine the results of the 15-minute 3:1 profit-to-loss ratio, which shows 16 losses and 10 wins. The success rate has decreased, but the profit-to-loss ratio has improved, and the overall trading profit is roughly the same.
So, people often ask me, "Teacher, what kind of profit-to-loss ratio should I use?" In fact, this question should not be directed at me but at yourself. Only after you have tested it yourself can you know what the truth is and what is most suitable for you.
Only through such testing and experience can you execute your trading system without fear of loss or gain, without uncertainty about future outcomes, and without a sense of fear. This is the source of confidence in executing your trading system.
During the testing process, you will gradually understand your trading system, yourself, and the market. The larger the data set, the more you can see the full picture of trading. Once you truly see it, you will no longer be afraid.
If you still have doubts, such as what would happen if you change the 60-day moving average to 30 or 90, whether it would affect profitability? Would using a different indicator yield better results? Would adjusting the stop loss lead to higher profits, etc., you can find answers to these questions through your own testing.
After countless tests and modifications, your trading system will gradually be adjusted to the most suitable form for you, truly becoming your own, helping you to forge ahead and carve out a path in trading. You will no longer fear that your trading system will be known by others, because others may not find it easy to use either.So, the trading system itself is not a very complex thing. It addresses all the issues we might encounter in trading. Once you understand its basic framework, you can gradually test and adjust it to find your own exclusive trading system.