Tips on Developing a Technical Trading System

Technical analysis can be a very powerful tool for traders. It has the potential to greatly increase the probability of entering and exiting trades at the appropriate times required to make a profit. That being said the use of technical analysis can also be overwhelming because of the sheer number and variety of technical indicators, chart patterns, and other technical analysis methods (i.e. candlestick charts, Elliott Wave analysis etc..). Thus for one to be a successful technical trader it is very beneficial to develop a trading system before risking money in the markets. A trading system can be defined as a set of rules which are followed to make decisions on when to enter a market position (long or short) and when to close or exit a position. A trading system does not necessarily have to be a set of rules that can be automated and executed by a computer, but in fact can involve human judgment (such as drawing trendlines, detecting chart patterns etc..). On the other hand what a trading system must do is provide the trader with a set of rules that determine when traders enter and exit positions, while at the same time limiting ones risk and ultimately increasing the probability of executing profitable trades.

The primary reason that using a trading system is so beneficial for technical traders is that it helps limit the negative effects that emotions have on trading, and anyone who has ever traded certainly knows the emotional intensity that accompanies it. When emotions become involved traders often make irrational decisions based purely on the emotional impulses they are feeling at that moment. Sometimes a trader will make a decision too quickly, or other times without a system a trader will freeze up while observing all the contradictory information technical indicators can provide and subsequently miss crucial opportunities. With the sheer amount of information that technical analysis can convey, unless one has a well thought out set of rules of how they are going to interpret and react to price action, then when emotions run high, and fear and greed become involved, a trader will often not take the quick, decisive, and logical action that is required to trade the fast moving markets. When using a system that one has confidence in, emotion will not play such an adverse role in an individual's trading decisions as it would if one chose not to use a system.

While it is fairly easy to see the benefits of using a trading system, developing a profitable system is a completely different matter. As was said earlier technical analysis offers a massive array of tools (i.e. indicators, patters, moving averages etc..), and because of this the number of possible systems is virtually limitless. However, one should realize that profitable systems are like needles in haystacks, with the majority likely to lose money. Thus it is extremely important to test a system before using it or risking too much of one's trading capital on it. When testing and developing a system there are a number of important criteria that one should pay attention to as doing so can improve the chances of finding a profitable system. These criteria are the following; does the system work in the past, does the system work for multiple financial instruments, what type of market does the system work in, and finally do the rules for entry and exit make logical and intuitive sense.

The first criteria, determining whether the system worked in the past, is relatively easy to do if one has access to historical data. However, there is certainly a lot of misunderstanding on historical system testing among traders. First of all it is important to realize that just because something has worked in the past does not invariably mean that it will work in the future. That being said one should also realize that if a system does produce a profit in the past, it is more likely to work in the future then something that historically has produced a loss. The reason for this is because while markets do not repeat in specifics they do repeat in generalities. Furthermore, in relation to historical testing one should remember that a goal of all systems should be robustness, which means developing a system that works in more than one type of market and over more than one period of time. The robustness of a system can be greatly improved by not over optimizing variables to maximize returns on historical data, but instead optimizing the variable to create more consistent returns over time. (Optimizing can basically be defined as "finding the best set of parameters for a given market or time period"). One can improve robustness and increase the consistency of returns by using the following testing technique on historical data; let's say that you have a year of historical data to work with, instead of optimizing the whole year of data at once, one should select a portion of it, let's say six months, optimize the system to that time frame and then apply the optimized variables to the next six months to see how it performs. This is a much more realistic method of testing and helps the trader determine if they are over optimizing, or over-fitting their system to one time frame.

The criteria of whether the system works for multiple financial instruments relates back to the over optimization problem that so many traders run into. Very often a trader will develop a system tested specifically on a single equity, ETF, or future over a single time period, and then when they trade they end up losing money. The reason that this happens is because essentially all that the trader has done is fit a system to a specific instruments past price movements (over optimization). To avoid this scenario, along with using the suggestions on testing historical data mentioned earlier, it is important that one test and validate a system on different financial instruments. However, it should be understood that because different instruments have different price characteristics (i.e. price level, volume, average volatility) certain variables of the system will need to be changed when being applied to a different instrument (i.e. protective stop loss amounts). Although the overall structure of the system should remain the same, or in other words the rules stay the same but the variables within the rules might need to be changed. Another important point in relation to testing multiple financial instruments is that if one creates a system that works well on a highly volatile future, such as oil for example, attempting to confirm the system on a lightly traded penny stock will not make sense or be helpful. The various equities used for confirmation should be somewhat similar in terms of average volatility and volume. Furthermore, testing a system on different instruments will allow a trader to remove certain rules or criteria which may be very helpful for one instrument but make the others perform much worse. Scenarios like these likely mean that that the criteria is not robust and probably just worked on that market during the time frame it was initially tested for. Overall testing multiple financial instruments can be very helpful in increasing the robustness of the system as well as the overall success or profitability in the long-run.

When creating a system it is important to understand what type of market the system works best in and this is the third criteria. This criterion refers to market in the sense of how the market is moving, not whether it is a bond market or stock market for example. The three main types of markets one should be aware of are; trending markets, consolidating markets, and high volatility markets. Trending markets are those that move primarily in one direction. If trending down then price should form a series of lower lows and lower highs, if trending up, higher highs and higher lows should be seen. Many systems are oriented to and work very well in trending markets, however, markets do not trend all the time and there are often long stretches where trending system will not work. The second type of market, consolidations are believed to consume more market time then trends, and this type of market experiences primarily sideways movement. Often a financial instrument experiencing a consolidation will trade in a range, bounded by an upper level of resistance and a lower level of support. Trending system do not work well during consolidation periods, but other technical trading methods do. The third type of market which has been experienced during 2009, are those of extremely high volatility. This type of market is usually seen when the level of indecision and uncertainty is extremely high and is often associated with market bottoms or transition periods. This type of market is the most difficult to trade as it can see incredible price moves in both directions in very short periods of time, while also seeing periods of temporary consolidation or trending before reverting back to high levels of volatility. Determining what type of market your system works well in is crucial as it allows a trader to look for financial instruments which are moving in the optimal manner for their system, while at the same time avoiding markets which are not moving in a manner which is suitable for the system. Even better, a good understanding of the various types of market movement can allow a trader to develop a series of systems that are all profitable in the aggregate, but that individually perform better during different market types.

The final criteria, whether the entry and exit rules make intuitive sense to the trader is more important than most realize, and this is for a few primary reasons. First of all if one understands why their system works, and also understands intuitively why they enter and exit at the levels the systems rules require, then then they will be much more confident and comfortable with trading the system. A system that is not understood by the trader can be very difficult to trade, especially during times of drawdown or after a series of losing trades. Also understanding ones system will allow the trader to notice if it is not working as they had anticipated, for example if the system is creating a much lower ratio of winners to losers than testing had suggested or producing a lot more drawdown then expected. There is a very fine line between stopping trading a system too early when in fact it is just experiencing normal drawdown and trading a system too long when the drawdown is actually revealing that the system is not working. But the better one understands their system the more likely they will be able to make the correct call. Finally, it is important to understand how and why your system works because this will better allow you to make improvements as time goes on. For example if one does not understand why the levels where they enter and exit create an overall profitable system, then it will be very difficult to make further improvements. This is also why it is much better for one to develop their own system rather than using one that has been developed by another person, as the development process is what provides the trader with a true understanding of the system.

To conclude, the criteria discussed in this article are important to pay attention to when developing a system. However, by far the most crucial part of system development is hard, dedicated, and focused work. Creating a long-term profitable system is an extremely difficult task, and anyone who thinks otherwise is fooling themselves. Creating a system which is profitable in the long-term requires a very strong understanding of price movement, trader psychology, technical analysis, as well as a level of creativity for developing innovative criteria. Furthermore, even after one develops and starts trading a system it need to be realized that the trader cannot just sit back and expect to pull in money for the rest of their life, systems continually need to be tweaked, altered, and adapted to the ever changing complex system that is the financial markets. However, as daunting as the task is, if one really enjoys the work that is required then the opportunities are truly endless.