Building a Trading System Part 1: The Building Blocks

“All I need is one big trade man, that’s it. Just ride it up, make a million and retire.”

Sound like you? I hope not. Plenty of people think this way. Not one of them is wealthy. Sure, those big trades happen. But nobody talks about the hundreds of small wins and even more losses that came first. So before we get into this article series, I want you to stop and ask yourself a question: am I willing to put hundreds of hours in and take hundreds of losses in order to pull money out of the market? If the answer is no, that’s cool. It’s not for everyone. But if you’re willing to put in the time and the effort and the stress and the damage to your psyche (because that will happen), this series of articles will guide you.

What’s in a strategy?

In this series of articles, we’re going to build a complete trading system. Several, actually. Maybe dozens. We’re building from the ground up. Not all of them will work, and that’s part of the process.

Trading systems fall into one of three categories:

• Discretionary systems
• Semi-discretionary systems
• Automated systems

A discretionary system means that the trader decides all criteria (usually in the context of certain patterns on a chart). These are difficult to qualify and backtest. We will talk about them in this series, but not until much later.

A semi-discretionary system relies on indicators or specific triggers. They reduce the amount of human input required by setting criteria automatically, but a human must press the buy or sell buttons. These are the systems we will be focusing on, as they are the easiest for new traders to learn and create.

A fully automated system can be created from a semi-discretionary system and requires no human intervention. They can also include other triggers that humans have difficulty in determining and often encompass much more than chart data. We will not be covering these, as I have little experience in this area.

So where do we start? First, we need to define what we mean by “system”. A trading system is a set of rules, but rules are pointless if no one follows them. Without your rules, you are lost. You will not be able to consistently make money. They are your lifeline to profit. So what do the rules cover?

Every system MUST cover these four bases

• Entry criteria
• Profit-taking criteria
• Loss-taking criteria
• Risk criteria

Each of these work in tandem to ensure that over a large sample of trades, you will make money, keep it and avoid blowing up your account. The rest of this article will explain each of these parts in a bit more detail.

Entry criteria

Every trade has to start with an entry, right? Each system you create must have a “trigger" condition, or set of conditions. When you receive your signal, there can be no doubt or hesitation in your mind. A signal is an entry. There is no debate on whether or not to take it, all the debating was done when you first created and tested your system.

Profit-taking criteria

Every system also has to close trades in profit at some point. Some systems will rely on a percentage or price-based target, others will rely on a set of conditions. The rules are the same as when taking an entry though; when your system says the trade is done, it’s done! Hanging on for that “last leg up” is never an option.

Loss-taking criteria

Your winning system will lose. A lot. Most systems win less than half the time! The key to maintaining profitable is to ensure that your losers are smaller than your winners. That means those losses have to be cut ruthlessly. If you don’t cut losses when signaled, those losses mount and quickly surpass your winners. In every bear trend, across all markets you can find examples of folks who never cut their losses, and are now stuck with a drawdown that could take months or years to recover from, if it ever happens at all! Don’t be one of them.

Risk criteria

This aspect is arguably the most important and often the most overlooked. Your system should define your risk for every trade. Again, there can be no flexibility on this. You will take losses, and it’s your risk parameters that determine how much they’ll hurt. In some systems, your risk parameters may also be linked to your entry and exit parameters, telling you to add to (or subtract from) a position. Risk is calculated based on your position size and your loss-taking criteria. If you’re not sure whether you fully understand how risk works, I’ve written a previous article on the topic, found here.

I will show you how to find and create each of these parameters for yourself

I’m not handing you a trading system. Sure, we’re going to build a bunch of them together and some will be usable, but this series is a rough draft. A lesson on how to write a game plan, if you will. It will be up to you to adapt to the conditions of the markets you trade, and to hone your edge. These lessons will serve you well, but you have to put the work in (and boy, is there a lot of it!)

Self-discipline is what separates a trader from a wannabe. The self discipline to build and maintain your system, to trust it and follow the rules you’ve set for yourself religiously. If you’ve got that, you can trade.

Join me in part two as we start building our first system.

This is the first in a series of articles on building your trading system. If you learned anything or found this article valuable, please leave it some claps (up to 50!), share it on Twitter and other social media and leave a comment! It really helps with visibility. For more like this, follow me here and on twitter!