My ‘sorting machine’ for finding great trading strategies

There’s no shortage of trading systems and strategies available for you to buy. And just like in any industry there are good products and bad products.

Do some careful research before spending your money and you can pick up a great system off the shelf, so why even bother designing your own?

Well, the commercial availability of market-beating systems is great news for two reasons:

  1. Obviously, if it’s good it’s going to make money for you!

But there’s another reason. And it can have an even longer term payoff for you…

  1. Exposing yourself to new systems and strategies can really get your own ideas whirring away.

It can sometimes be as simple as lifting an element from one system – it could be an entry signal from your share trading system – and combining it with a second element from a different system. You might take an idea for a trailing stop loss from a Forex scalping system for example.

Combine the bits and pieces together to give you a new third system and the sum can often be greater than the parts.

You can end up with a kind of Frankenstein’s monster of a system that trades a completely different market, on a completely different timeframe than either of the two systems you started with. And it could end up being even more profitable!

Using systems you already have access to as a kind of launch-pad for your own ideas can be a very valuable educational process. You’ll probably learn more about the markets by taking things to pieces and seeing how they work than just reading about it all in a book.

The key to it all is being open-minded and not boxing yourself in with preconceived beliefs. Try some new things out. The only thing that counts in the end is the amount of money moving in and out of your trading account!

The Dangers of “Frankenstein’s Monster” Trading Systems

Before you start beavering away, there are two dangers with system design you’ll need to keep in mind:

1) Time Cost. You can get lost endlessly tweaking and messing around with your idea and never get it beyond just a vague concept. You’ll obviously start out with a rough idea but you want a quick answer as to whether it’s worth developing further.

The 7-step process I’m giving you is a kind of sorting-machine for trading systems. Put your idea in at the top and it’ll drop out the bottom into the ‘Good-to-Go’ box, or onto the junk pile. Either way, at least you’ll get a quick answer and not waste hours of time you could have spent on your next idea instead!

2) Proving It Works Before Risking Big Money. Once you’ve got your idea fleshed-out you need to prove it works. Backtesting will have been a big part of the sorting-process, but that’s not enough in itself.

Once you’ve got the kernel of a good concept in place it’s over to you to prove it works in real-time, under authentic market conditions. You’ll need to forward-test it! Again, it’s better you know quickly whether the strategy is worth fully developing.

So don’t worry about falling victim to a creation Frankenstein himself would have been embarrassed by. I’ll talk you through how to do all this in a sensible way.

The Four Stages of System Development

Right then, let’s have a look at how you can do this for yourself…

There are four broad stages of system development you’ll move through and each of my 7 steps takes you through them in a logical order.

The four stages are Think, Test, Optimise, Assess.

Think: Because you’ll obviously need an idea to work with in the first place. Through your market observations or knowledge of other systems you’ll start to notice recurring patterns and quirks of the market. It’ll get you thinking… “Hmm, I wonder if there’s a way of creating a profitable edge from that?” This will give you the raw material for your trading concept.

Test: This is all about number crunching and backtesting…can you get your rough idea to show potential?

Optimise: If your idea made it to this stage you can spend a bit more time on it. Test different parameter values to uncover optimal settings.

Assess: You’ll have the complete concept ready at this stage. It’ll still need the rough edges smoothing off, but take a closer look now – is this right for you, is it a system you could happily trade?

If your idea makes it through assessment you then take it through to forward-testing.

7 Steps to Designing Your System

And here we are at the step-by-step approach to getting it all done.

Remember, complete this process thoroughly but don’t waste too much time on any lame-duck ideas.

Here we go…

  1. Gather raw data from your market observations. Keep your mind open and see what repeating patterns and quirks you notice.
  2. Home-in on a pattern with potential. Write it down in a single sentence e.g. “Doji candlestick patterns mark continuation reversals so they could help me trade the medium-term trend” 
  3. State your concept as an objective. Turn the pattern you’ve noticed into a fully-fledged objective: “Buy breakouts above Doji highs when they appear as the second or third retracement bars in an uptrend. Aim for an average 2:1 reward to risk per trade” 
  4. Think if this concept is suitable for YOU – It’s only going to be good if you can actually trade it. Does it play to your strengths? Can you get it to work on a timeframe you can regularly access? Do you have a large enough account size for the margin requirements? Does it suit your personality: is it fast and frenzied trading, or slow and steady?

That’s the thinking stage done.

All good so far? Then take your concept through to testing:

  1. Manual backtesting.Test a period that shows you the results from 50 or 60 historical trades. It’s got to work in current market conditions so start off your testing with relatively recent activity. Figure out a working concept for stop-loss placement and profit target. The important thing at this stage is that you can get positive results to some degree. Your system just needs to prove its worth. Everything can be streamlined and improved at the next stage.

So, is it showing profit potential?

If it is, take your idea through to optimisation. If it isn’t you might need to dump it here and go back to the drawing board with a fresh idea.

  1. Optimization. Your idea has potential, it’s time to tweak and optimise the different parameters. Start off with:
    A) Position sizing – getting the amount risked per trade right can have a massive effect on the bottom line of your system’s results.
    B) Exit Strategy – don’t worry about messing with your entry signal yet. Can you crank up your results by adjusting your profit targets first? Hint: What happens when you aim for huge reward to risk trades? What about multiple exit points on each trade? You might use testing software at this stage, or even employ the services of a system designer to help you.
  2. Final Assessment. You should have the potential of a solid system now. The last thing you need to do is a bit of risk assessment: How would it affect your system if your computer crashed or your internet connection was lost? What if the markets went crazy on news of a terror attack, could your system handle that price-action? What if you fell ill and couldn’t manage your trades for a couple of days? Do you have things like that covered? Plug any obvious holes and you’re ready for forward testing!

Set up a small real-money account (it’s so much more realistic than demo account trading) and set your system free!

Keep an eye on the results your system brings in. Are they in-line with what you expected?

Take things steady. Make your system prove itself. Then scale-up your investment once you’re happy with its performance.

Be Prepared: Market Moving Data Coming This Week (London Time):

Wednesday 28th June:
14:30     GBP     BoE Carney speaks
14:30     EUR     ECB Dragi speaks
15:00     USD     Pending home sales
15:30     USD     Crude Oil Inventories

Thursday 29th June:
13:30    USD     Gross Domestic Product

Friday 30th June:
09:00     EUR     German Unemployment change
09:30     GBP     Gross Domestic Product
10:00     EUR     Consumer Product Index

Monday 3rd July:
08:55     EUR     German Manufacturing PMI
09:30     GBP     Manufacturing PMI
15:00     USD     ISM Manufacturing

Tuesday 4th July:
– US Independence day holiday
02:30     AUD     Retail Sales
05:30     AUD     Interest Rate Decision
09:30     GBP     Construction PMI

Watch out for central banker’s rhetoric moving things around tomorrow (Wednesday) and maybe expect quieter USD markets next Tuesday when America celebrates Independence Day.

Trade safe and I’ll catch up with you next week.

Happy trading,

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