How to build a trading system

How to Build A Trading System
Practical example of how to design
your Forex trading system from scratch

by Gonçalo Moreira | September 2012

Material extracted from
FXstreet.com Learning Center

INTRODUCTION

DEFINITION:
A Trading system is a set of rules that formulates buy and sell
signals without any ambiguity or any subjective elements.

PRIMARY AIM:
Manage risk and increase profitability in
any market environment.

Optimal levels of risk and reward are accomplished by
modifying the different parameters within each rule of
the system.

PRINCIPAL BENEFIT of trading with a system:
Removal of emotion from trading
Systematical trader will, for instance, not place an excessively high risk trade
due to frustration from a prior losing trade.

- Read the article “The Pleasure and Pain Game” by Sam Evans on how
emotions affect your trading 2
- Listen to Steve Ward's podcast on “Emotions, Decisions and Discipline”
Extract of FXstreet.com Learning Center

INTRODUCTION

No system is better than any other

But a good system is one that is adapted to:

✔
your goals
✔
your time window
✔
your start capital
✔
your personality

3
Read Jody Samuels on how to “Define Your Goals”

STEPS

Steps to build a trading system from scratch:

1. Observation
2. Hypothesis
3. Measuring the Hypothesis
4. Selecting the Time Frame
5. Developing the Strategy
6. Entry Rules
7. Exit Rules
8. Position Size and Risk Management

4


LET'S GO!

We will build together a simple system
going through these steps.

It's a real system that has been backtested.

It is particularly appropriate for Beginners
and Intermediate traders and to be traded
with mini lots or lower.

5
On our Brokers comparative table, you will find which
regulated brokers let you trade with small lot sizes

1. OBSERVATION

If you intend to capitalize on the market behavior, you
need a BELIEF SYSTEM on how the markets operate.

Series of ideas you have gathered after
observing the market for a while.

Market observations are thus the building
blocks of every system and trading method.
Extremely important aspect most novice traders neglect!!!

6
Read the article “Beliefs: What You Hold as True Will Drive What You Do”
by Dr Woody Johnson

1. OBSERVATION

Look at different currency pairs and charts and see what
ideas pop up to our mind.

Let's OBSERVE this chart

This daily chart shows that most of the
daily candles have different lengths in
terms of pips.

We also notice that they break the high or
low price from the previous daily candle
most of the time.

The magnitude of the breakouts differs from
candle to candle, but in many cases the
distance the exchange rate shoots off
the previous daily extremes is large
enough to be considered a profit potential.

7
Breakout: Definition

2. HYPOTHESIS

Once you have enough evidence that the recurring action-
reaction event takes place on a regular basis, then you can
formulate the hypothesis.

This strategy aims to capture part of a breakout movement,
starting from the high or low level of the previous day.

The MARKET CONDITIONS to meet in order to capture
this event are:

✔
An increased momentum and volatility in the market.

✔
A major underlying trend in the direction of the breakout.

- Momentum: Definition 8
- Check the currency pairs momentum in the Heat Map tool.

3. MEASURING THE HYPOTHESIS

Take a sample of past price data and take some rough
measures accordingly to your hypothesis.

Collect enough data to sustain your initial hypothesis.
A number of 100 occurrences of the event under observation
will provide a good statistical foundation.

In order to measure the potential of the breakout, we will take the
GBP/USD pair

For its characteristics as a fast moving currency pair,
WHY this pair? able to break support and resistance levels when it
gains in speed and momentum.
Other majors would also be suitable for this strategy... we just had to
choose one!

In our “Volatility Watch” widget you can observe the volatility
9
measures of the pairs: BBW (Bollinger Bands Width), STD
(Standard Deviation) and ATR ( Average True Range)

3. MEASURING THE HYPOTHESIS

Now you need to take a sample of past price data and take some
rough measures accordingly to one of the above hypothesis. Let's take
the one based on the breakout of the previous day high and low.

The results could look like this: during 2005, the average magnitude of the
breakout was 65 pips in the GBP/USD. Of those breakouts, 92% were more
than 10 pips, 38% more than 65 pips, 19% more than 100 pips. As for the
frequency, the pair broke out 88% of the days that year.
10


4. SELECTING THE TIME FRAME

Experiment the system with different time intervals.
A hypothesis may work better in a small time frame than in a
longer one or vice versa

Although the event of the breakout is visible on the daily charts, we will choose the 1H time
frame to start evaluating the strategy with the help of technical indicators.

The 4H time interval seems too high to
WHY 1H? visualize the smaller breakouts

+

Any time frame below 1H may generate
unnecessary signals.

The TIMEZONE used for testing will be GMT, the standardized timezone for the FX market.

11
- Check the Market Timeline to check the trading sessions times
Extract of FXstreet.com Learning Center - Volatility Distribution by hour for the GBP/USD

5. DEVELOPING THE STRATEGY: THE TOOLS

Describe your system. Fully articulate the initial idea.
This includes an explanation about the tools to be used and what
events provide the conditions to get into and out of positions.

The TOOLS of our strategy:

1.
A price box to mark off the high and low prices of
the previous day will be displayed on the 1H chart.

Each 24-hour period will be marked with a vertical
line to distinguish the start/end of the day.

12



2.
A combination of two moving averages will help to get the
direction of the underlying trend.

Those will be the 21 and the 89 Simple Moving Averages, two
numbers taken from the Fibonacci sequence which are not contiguous
(...,8, 13, 21, 34, 55, 89, 144,...).

13
- Simple Moving Averages: Definition
- Read “A Practical Guide To Moving Averages” by S.A Ghafari


3. Bollinger Bands applied to the 21 SMA will be used as an
indicator for volatility.

The higher the standard deviation used in the
settings, the more closing prices are contained
within the bands.
As the breakout movement needs to be aligned
with the main trend, we need a parameter that
gives some room for price to develop.
Therefore the deviation will be initially set
to 3. 3 standard deviations contain 99.7% of
the closing prices.

This indicator will help us avoid trading
breakouts if the previous daily range has been
very tiny and the market lacks volatility.

14
Book: “Bollinger on Bollinger Bands” by John A. Bollinger, the
creator of this technical indicator


4. Pivot Points will be used as a tool to manage the positions and to
take profits.

The classical Pivot Points and their
corresponding Support and Resistance levels -
S1, S2, R1, and R2 - are needed for this
system.

This indicator will help us to filter some of the
less probable breakouts .

It will also help us moving the stop to break
even, if any of the Pivot Point levels has been
cleared on a close.

15
Check the Classic Pivot Points levels for GBP/USD

6. ENTRY RULES

The parameters to enter positions are related to the type of system
you use.
The strategy has to be designed in a way that does not require you
to make any subjective decisions whether the signal is valid or not.

The trade entry must be described in detail, including concrete
definitions of:


The proper market conditions for entry

The optimal trade set-up

The final confirmation signal, also known as the “trigger”.

16


6. ENTRY RULES

The ENTRY RULES of our system:

In order to start testing the strategy only one trade per day will be taken.

Market Conditions
as for the direction of the breakout:

1. The faster 21-period Simple Moving Average is above the slower 89-period Simple
Moving Average.

The direction will remain unchanged until the faster 21-period Simple Moving
Average crosses below the slower 89-period Simple Moving Average.

17


6. ENTRY RULES

If a certain day doesn't break a previous day price
extreme, the direction of the breakout remains as it
was before.

3.
If a certain day breaks the previous day high AND low price
extremes, the direction of the breakout will be determined by
the position of the Moving Averages as explained in Rule 1.

18


6. ENTRY RULES

LONG ENTRY conditions:


The 21 SMA is above 89 SMA.


The upper Bollinger Band is not
contracting to the downside in
the last candle before the
breakout.


The 161,8% Fibonacci
extension is equal or closer than
15% of yesterday's trading
range.

19
Range: Definition

6. ENTRY RULES

LONG ENTRY trigger:


The exchange rate breaks
above the high of the previous
day.


Adjust the entry level to the
previous day high adding one
pip and the spread to the
upside.

For example, if yesterday's high was
1.6350 and your spread for the
GBP/USD is 3 pip, then the entry level
is 1.6354.

20


6. ENTRY RULES

SHORT ENTRY conditions:


The previous day low was lower than the
day before (as explained above).


The 21 SMA is under 89 SMA.


The lower Bollinger Band is not
contracting to the upside in the last candle
before the breakout.


The 161,8% Fibonacci extension is equal
or closer than 15% of yesterday's trading
range.
SHORT ENTRY trigger:

The exchange rate breaks below the low
of the previous day. Adjust the entry level
to one pip less than the previous day low
21
to the downside.

6. ENTRY RULES

PRACTICE your entry rules

by MEASURING the price moves after the signals across
several time frames

and considering if multiple entries or re-entries would
enhance your edge.

Once you are able to spot your exact entry points,
then you have to work on the exit plan.

22


7. EXIT RULES

Exit rules are part of the decision to take a position.

There are two types of exits:


A stop loss to get out of a bad trade.

A profit target to realize profits when the market
moves in your favor.

23
- Types of Orders, in the Learning Center

7. EXIT RULES

The EXIT RULES of our system

Target:
Fibonacci extension 161.8%.

The exact take profit order will be placed a few pips before the 161.8% level.

If there is a round number closer than 10 pips to the 161.8% level,
take the round number as a target.

Also make sure to add the spread to the target level on short trades.

For example, if the 161.8% extension level on a short USD/JPY is 90.00
then the target would be placed at 90.04 if the spread is 4 pips.

24
- Fibonacci Extensions: Definition
- Read the article “Fixed Spreads Vs Variable Spreads” by CMS

7. EXIT RULES

25
Watch “The ABCs of Fibonacci” webinar by Andrei Knight

7. EXIT RULES

C. EXIT RULES

Stop Loss
Long Trade: placed below the 21 SMA
or the 68.1% Fibonacci level,
which ever is closer to the entry price.

Conversely, the stop loss on a short trade is placed above the 21 SMA or the 61.8% Fibonacci level,
the one that is closer to the entry price.

This way, the worst initial win/loss ratio on every trade is a Phi ratio
(61,8 / 38,2 = 1,617801047...).

26
Read “Stop Market Orders: Ideas on Utilization” by Gabe Velázquez

7. EXIT RULES

27
Watch “Developing a Profitable Trading Strategy (Part 1)”, a webinar
by Markus Heitkoetter

8. POSITION SIZE AND RISK MANAGEMENT

Money management principles serve to determine your position
size and risk management, the proportion of your trading
account that is risked per trade.

For testing purposes,

Each position will be entered with one mini-lot

+

we will limit the risk to 2% of the account
balance.

- Read Andrei Knight's advice about Money Management
28
- Read “Portfolio Management - Position Sizing and Stop Losses”
Extract of FXstreet.com Learning Center by LearningMarkets.com

CONCLUSION

For now, just concentrate on following
the previous steps and follow the rules
mechanically.

Systematically following a
set of trading rules will help
you grow as a trader
(consistency, self-confidence, execution,
mind training...)

29
Read Jody Samuel's advice about the importance of
Following a System.

CONCLUSION

You may start with this system as a guide to develop a
different one, you may even start by copying this system.

develop your
But with time, your goal will be to
own unique trading approach
= a system that serves as a logical
frame work for any trading decision
you make

Another essential step in building a trading method is to backtest and
forwardtest your system before committing real money.

30
- Read more about Back- and Forwardtesting in the Learning Center
- Watch “Backtesting a System or Strategy” by Valeria Bednarik

BACKTESTING

Backtesting Results of the system

31
Forex Tester is a powerful software that you can use
for your backtesting

BACKTESTING

Backtesting Results of the system

EQUITY CURVE
$9,000

$8,000

$7,000

$6,000

$5,000

$4,000

$3,000

$2,000

$1,000

$0
11
16
21

36
41
46

61
66
71

91
96
1
6

26
31

51
56

76
81
86

10 1
10 6
11 1
1 16
1 21
12 6
13 1
13 6
1 41
1 46

15 6
16 1
1 66
1 71

18 1
18 6
1 91
1 96

20 6
21 1
2 16
2 21

23 1
23 6
2 41
2 46

25 6
26 1
2 66
2 71

28 1
28 6
2 91
151

176

201

226

251

276
TRADES

32
Forex Tester is a powerful software that you can use
for your backtesting

WEBINAR

This system was presented in a
webinar that you can watch
whenever you want!

33


How To Build A Trading System
by Gonçalo Moreira | September 2012

Material extracted from
FXstreet.com Learning Center

34

How to build a trading system

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