In this post, we are going to discuss how to design and develop your trading system. If you have read my post on how to develop your trading plan, you must have realized the importance of system design in implementing your trading plan and achieving your financial goals. Financial goals are easy to set. The actual thing is how to achieve them. In that post I talked about the three stages of developing your trading plan which are:
1. Goal Setting
2. Strategy Selection
3. System Development
In this post we discuss the system development. This is the most crucial part of your trading plan and can take sometime before you are able to develop the right system for you. Strategy is something in general while system is the detailed set of rules that you need to implement that strategy. So once you have selected a strategy, you need to develop your system rules that tell you how much risk you will take per trade, when to make the entry and when to exit. Now in my view the most important part of a trading system is the risk and money management rules. Always keep this in mind that the simple systems are the best systems. There are many pro traders who let the new trend start. When the new trend has been confirmed, they wait for a pullback. When a pullback takes place, they make the entry. So this is the entry rule of their trading system: Let the trend start. Confirm and then wait for the pullback. When the pullback takes place make the entry.
This was the entry. When the pullback takes place, you need to see how much risk you are taking. If the risk is too much in your view, you can avoid the trade or reduce the lot size so that your risk stays at the level that you want. In the same manner, your trading system should tell when to exit the market. The most important thing as said above is the risk and money management part of the system. What is the level of risk that you will take and what is the expected reward. We measure it with the reward/risk ratio. The performance of a system depends on two things:
1. Reward/Risk Ratio
2. Winrate.
The higher the reward and lower the risk, the better is the system. In the same manner, winrate is important. Many traders thing that it is the most important parameter of a system. In my view reward/risk ratio is more important than the winrate. Let’s take an example to make this clear. So let’s compare three systems A, B and C.
A has a reward to risk ratio of 1:1, B has a reward to risk ratio of 3:1 and C has a reward to risk ratio of 5:1 on average. Suppose A has a winrate of 80%, B has a winrate of 70% and C has a winrate of 60%. Let’s further suppose A has an average stop loss of 30 pips and it makes on average 30 pips, B has an average stop loss of 30 pips and it makes on average 90 pips while C has an average stop loss of 30 pips and it makes 150 pips per trade.
So on average in a series of 10 trades, since A has a winrate of 80% means it will win on average 8 trades and lose 2 trades. So it will make 240 pips and lose 60 pips. B with a winrate of 70% will win 7 trades and lose 3. So it will make 630 pips and lose 90 pips. And C with a winrate of 60% will win 6 trades and lose 4 trades. So it will make on average 900 pips and lose 120 pips. So you can see in a series of 10 trades, on average A made net 180 pips, B made net 540 pips and C made net 780 pips.
The above example clearly illustrates the fact that reward/risk ratio is far more important than the winrate. A system with a lower winrate that has a much higher reward to risk ratio will be more profitable. You will often hear about the profit factor (win/loss). The profit factor for system A is 4, for B it is 7 and for system C it is 7.5. The higher the profit factor the better the system.
Turtle Trading Rules FREE Download
Turtle Trading System had a winrate of only 40% but it had a very high profit factor so it made many millionaires.Read about the Turtle Trading Rules that made many millionaires. Download the PDF that explains the Turtle System in detail. Go through it and you will learn the most important lesson of your trading career. Simple systems are the best systems! So stop chasing expensive software and systems. Most don’t work. You will only waste your money. Go through the Turtle Trading Rules PDF. Turtles used to trade commodity futures mostly. But the rules are the same for forex as well as other markets. Your system should be able to catch the big moves in the market with low risk. This is what you should try to achieve when developing your system. Avoid overtrading. With a good system, you should be able to double your account every month with just 2-5 trades. But there is no compulsion. If you can make 100% return easily good. But don’t try to force yourself and make your life miserable. Whatever you can make comfortably and easily should make you happy. Believe me, I have been able to double my account in the first 10-12 days in few months. When I achieved my goal, I simply took it easy for the rest of the month. Sometimes, you only make 50% return in a month. So make things fun and easy for yourself and you will start enjoying trading the markets. Good Luck!