Five Steps to a Trading System
Here are the 5 components of a trading system, explained in plain English. By John Davies.
We’ve heard it time and again: “If you want to be consistently profitable, you have to trade with a system.”
But how exactly do you go about building a trading system? This can be an overwhelming question, especially for the new trader.
For awhile now I’ve been teaching new traders that trading systems – any and all trading systems – are built from the same 5 basic components.
I usually illustrate what I mean via a simple analogy: trading is a lot like going to a place you’ve never been.
Think of it. Would you get up one morning, randomly select a place on a map, hop on a plane and fly out that afternoon? Well, maybe if you are rich, famous or have no responsibilities you might. But for the rest of us mere mortals, we’d need to make some plans.
Same with trading. Even if you are entirely new to the game, you probably realize how trading just any old random stock, option, or forex pair is essentially gambling. To put the odds in your favor, you have to proceed systematically, and with forethought as to how you will create a trading system.
[Editors note: While these components are listed in numerical order, they work together, and one isn’t more important than another. Each step is important, and requires all the other steps for it to be effective.]
1) 5 Steps to a Trading System – Trading Resources
Let’s say you live in Miami and always wanted to see the Grand Canyon.
You schedule some time off next month and begin planning your trip. What will you need? Well, you don’t have much money, so you’ll need to drive, not fly. You figure you can make it in 3 days. That means selecting a route with accommodations. You also need to choose what to bring, like clothes, food, and whatever else you may need. Obviously, there are many material items you’ll need to obtain just to physically get there and back.
This is not unlike setting out to trade stocks and other financial instruments. You need to consider, for instance, who to use as your broker. But also where you’ll get market data. And how you’ll log your trades and maintain your watch lists. In short, you need to think through the physical means by which you’ll actually conduct your trades. Trading resources is one of the five basic components of a trading system.
2) 5 Steps to a Trading System – Backtesting/Demo Trading
As you contemplate your Grand Canyon trip, you realize you should take your car out for an extended drive, because it’s old and you’re not sure it will make it. Sure enough, a day-trip reveals how it’s in need of a major overhaul.
You also discover that the seat is not as comfortable as you imagined. You purchase a padded seat cover to make the ride more comfortable.
This is similar with trading, where it is equally prudent to test out aspects of your system before you actually start to buy and sell. After all, the last thing you want is to open a brokerage account the day you plan to begin trading and find out it doesn’t have the data feeds, charting, and stock screening utilities you need. Or, that your computer is inadequate for the type of trading you want to do, or that the internet connection keep dropping while you are in trades. Paper trading or demo trading (and backtesting) is a crucial component to any trading system.
3) 5 Steps to a Trading System – Trading Strategy
As the day of your trip approaches, you begin to sweat the details. What exact route will you take? Do you know how to use the car jack if you get a flat? Which music should you bring to help pass the time?
You also need to strategize. What happens if your newly-tuned up car nevertheless breaks down, or a planned road is unexpectedly closed? You need to be prepared for such contingencies.
This is also the case with trading, where you need to know your exact trading method well in advance. When will you enter a trade? Which ones? How will you maintain your open positions, and when will you take profits and cut losses? Having an actionable set of trading rules to strictly abide by will encourage you to trade with utmost discipline, and with as little emotion as possible. It will also force you to think through the ‘what ifs’ that inevitably arise in the financial markets. Without question, a detailed trading strategy is a key component of any trading system.
4) 5 Steps to a Trading System – Live Trading
The big day finally arrives and you happily set out for the Grand Canyon. But you discover the highway you planned to take on day two is tolled.
Wanting to minimize your expenses, you head northward to take another highway for the remainder of the trip. Your planned motel stays are now changed and your total driving time increases. But you learn an important lesson for future trips: have backup plans for each leg of the trip, and understand how those will have a ripple effect on all the other legs.
Same thing when you begin trading with real money. You learn things here that you learn nowhere else. No matter how well you test, strategize, and select your resources nothing can completely prepare you for how the live markets will behave. But regardless of whether they draw your account down or fatten your wallet, make sure you learn your lesson. Use the unexpected as an opportunity to improve future iterations of your trading system. Far from being just the culminating point of the trading venture, live trading is an important component in its own right. Many new traders erroneously view live trading as the end of the road, but it is actually just the beginning. Live trading, and seeing your real results, will often force you to make system adjustments which weren’t apparent during demo trading.
5) 5 Steps to a Trading System – Trading Plan
Sometime after you come home, you recall the moment you initially decided to take the trip many weeks ago. You reflect on how far you’ve come.
At that time, you only had a general sense of how it would all work out. You also see how, each day, that sense became more and more detailed. Until one day it was difficult to think of everything all at once and you were forced to break your thoughts out into more manageable bits. That’s when you began to test your car and plan your route in detail.
A similar process occurs when someone first thinks of becoming a trader. The difference is that serious traders actively maintain these initial thoughts to gain an overview of the entire trading system. This gives you perspective on how trading fits in with the larger aspects of your life. Most professional traders actually find it beneficial to create a physical document where they can, for instance, record their motivations for trading, as well as their attitudes about risk and money management. Trading plans are as important a component of your trading system as any of the other four.
In summary, a complete trading system is built from 5 components: a trading plan, a trading strategy, trading resources, backtesting/demo trading, and live trading.
By John Davies
Co-founder of SwingTradeSystems.com