A trading system can be simply described as a set of rules that define the entry and exit conditions to go in and out of the market.
In systematic trading, a trading system is based on precise and logical rules. When you use a system that is based on rules you can run a simulation and measure its historical performance. It is very important to be able to measure the performance of a trading system because this is the first step on the path to improvement.
The historical simulation process is known as backtesting. A successful back-test will give you a lot of useful information. First of all, it will show you if the trading system makes any sense at all. Furthermore, the back-test performance will also serve as a baseline you can use for evaluating the system behavior on a later stage.
How does a trading system look like?
A trading system doesn’t need to be complex. As a matter of fact, if it is too complex to be explained, then most probably it is not a system. Every trading system needs to have three predefined components – a trading signal, an entry rule and an exit rule.
The first and most important component is the Trading signal. This is the “When?” of a trading system. The Trading signal is the condition or the conditions which should be observed in order to initiate any further action. For example:
When the 20 period Moving Average crosses the 50 period Moving Average upwards, you have a Long trading signal.
The second component is the Entry rule. This is the “How?” of a trading system. The Entry rule describes the conditions which trigger the system to enter a trade. This can be a direct entry – a market order, or an entry according to a condition – a pending order. For example:
When you have a Long trading signal, you enter at the current market price
When you have a Long trading signal, you place a pending Buy limit order at the low of the previous bar.
The last component is the Exit rule. The Exit rule describes the conditions which trigger an exit from a trade. This can again be direct exit at the market or a pending order. For example:
When you have Long exit signal, you exit at the current market price
You place Take profit and a Stop Loss at the predefined levels.
Trading systems can be simple – having only one or two conditions, or they can be complex – having multiple conditions. But the important part is that these conditions are always predefined, logical and lead to a clear triggers for entry end exit.
Take a look at some trading system examples
Which is the best trading system?
Trading systems can be derived from different types of data, using various approaches. Some of them are based on fundamental data (fundamental analysis), others on historical price movement (technical indicators and technical analysis). There are traders which use advanced mathematical and statistical methods creating complex models to predict the price (quantitative analysis). The truth is that there is no single “holy grail” in trading. Different trading systems have a different approach to the markets, different profiles, context, scale, and capacity.
The best trading system is the one that makes adequate returns on the invested capital, given the constraints imposed by the risk profile of the investor, its scale-ability, and capacity limitations.