Trading systems are a key element of every solid trading plan. The problem is that traders tend to overfocus on finding the "perfect" setup rather than developing a proper system.
This article offers a guide to solving the issue. It discusses the most important elements of a trading system and explains our four main tips how to create a well-balanced trading system.
Tip #1: Accept Losses and Avoid Chasing the "Perfect" Systems
Most traders focus their attention on trying to create a "flawless" system that encounters zero or hardly any losses. They try to build such a system by combining multiple indicators to remove or filter out all the losing setups.
The problem is that traders will eventually filter out most of the trade setups. A second issue is that traders will test a small period of time and "curve-fit" their strategy to that small window. When the system is exposed to more data, the results usually do not provide the same results as the time frame of the test.
Most traders want to create a system that avoids losses at all costs because taking losses is a painful process for most traders. In fact, it is a natural human reaction to fear losses more than you enjoy the benefits of gains.
However, to be able to gain profits in the financial markets, traders need to be willing to risk capital and lose trade setups before they are able to reap benefits. Avoiding losses for each and every setup is not a long-term solution. Traders should focus on their system's performance in the long run, perhaps after a series of 40 to 50 setups.
Tip #2: Market Structure First
Rather than combining tons of indicators, my preference is to analyse the "market structure" that stands for three core aspects:
- Trend and momentum
- Support and resistance
- Price patterns
Nenad Kerkez and myself rather focus on performing timeless chart analysis that understands the bigger picture and the market structure. Why?
Because the market is fractal in nature, which means that price patterns tend to repeat themselves. Their behaviour and movement are very similar now and in the future, when compared to the past.
Of course, we do use indicators and tools for understanding the market structure in a deeper and better way. But we only use a few of them that add the utmost benefit.
For more information about market structure, please check the video above.
Tip #3: Wait for Clear Decision Zones
Traders tend to enter trade setups too early or too late. This is also known as "jumping the gun" (entering early) and "chasing the trade" (entering late).
Traders are vulnerable to this type of behaviour because of difficulties with trading psychology:
- Traders enter too early because they expect the price to move in their direction anyhow, so they want to beat the market early.
- Traders enter too late because they see the market reacting as they expected, but they failed to enter according to their plan and now try to compensate that by entering after the fact.
Another common problem is that traders tend to enter setups when the price is "floating" in the middle of nowhere. Nenad and I believe that a much better approach is to wait for the price to reach a "decision zone".
A decision zone is a key Support or Resistance area where the price will either break, bounce (reverse), or go sideways:
- Often, the price tends to move away from these zones along with momentum.
- In case the price moves sideways, traders need to be careful and either exit the setup or keep an eye on the breakout direction of the sideways price movement.
Source: EUR/USD 4-hour chart showing 21 December 2017 to 16 February 2018, the blue and green box indicate key decision zones where the price made a bullish bounce (reversal) at support
Tip #4: Don't Give Up Too Soon
Traders tend to exchange trading systems relatively fast. There is nothing wrong with testing and trying out new trading ideas and concepts. But it's also a bad practice when traders give up on all of their progress at the first sign of resistance.
Trading systems need time to be developed, tested, and improved. Traders also need time to become better at understanding their own trading system. However, they will never improve their own personal trading style if they abandon their current system for a new one every few days or weeks.
Don't get me wrong, it is perfectly fine to test and try out new methods, especially when you start out with trading. Eventually, it makes sense, in my experience, to fully focus on one or two methods to acquire a deeper knowledge of one's trading approach. Of course, testing smaller change within the system is always useful, but exchanging the entire system continuously is often counterproductive.
Wishing you a happy week of trading!