4- What is a Trading System?

What is a Trading System? Lesson 4

What most people think of as a trading system, Van would call a trading strategy that consists of seven parts:

Learn the 7 parts of a trading strategy.
  1. Set-up conditions.
  2. An entry signal.
  3. A worst-case stop loss.
  4. Re-entry when appropriate.
  5. Profit-taking exits.
  6. A position sizing algorithm.
  7. Multiple systems for different market conditions (at least three).

The set-up conditions amount to your screening criteria. For example, if you trade stocks, there are 7,000-plus stocks that you might decide to invest in at any time. Most people employ a series of screening criteria to reduce that number down to 50 stocks or less. Perhaps they might look for stocks that are great “value,” or stocks that are making new all-time highs, or stocks that pay high dividends.

The entry signal would be a unique signal that meets your initial screen and that you’d use to determine when you might enter a position—either long or short. There are all sorts of signals that can be used for entry, but they typically involve some sort of move in the direction that occurs after a particular set-up occurs.

The protective stop is the worst-case loss you would want to experience. Your stop might be some value that will keep you in the trade for a long time (i.e., a 25% drop in the price of the stock), or something that will get you out quickly if the market turns against you. Protective stops are absolutely essential. Markets don’t go up forever, and they don’t go down forever. You need stops to protect yourself.

A re-entry strategy. Quite often, when you get stopped out of a position, the stock will turn around in the direction that favors your old position. When this happens, you might have a perfect chance for profits that were not covered by your original set-up and entry conditions. Consequently, you need to think about re-entry criteria.

The exit strategy could be very simple. It is one factor in your trading over which you have total control. Your exits control whether or not you make money in the market or have small losses. You should spend a great deal of time and thought on your exit strategies, for one very good reason: you don’t make money when you enter the market, you make money when you exit the market. Far too many people focus only on market entry, or what to buy, rather than on when to sell. If you approach trading with an exit strategy, it will benefit you right away.

Position sizing is that part of your system that controls how much you trade. It determines how many shares of stock you should buy or “how much” you should invest in any given trade. It is through position sizing that you will meet your objectives.

Finally, you need multiple trading systems for each type of market. At a minimum, you might need one system for trending markets and another system for flat markets. Many professional traders have multiple systems that operate in multiple time frames over many markets to help offset the enormous portfolio dependence of a single trend-following system. Van requires his Super Trader graduates to have three non-correlated systems in order to graduate from the program. He also strongly advises ALL traders to have as many systems as there are market conditions (you’ll learn more about market conditions later in this course, plus the first issue of each month Dr. Tharp updates the market condition and will send that you as part of your inbox mentoring). You’ll want systems for bear, bull and sideways markets at a minimum.

Your system should reflect your beliefs (i.e., who you are as a trader and as a person). Many people are just looking for “any system that works,” but if your trading system doesn’t match your beliefs about the markets, you will eventually find a way to sabotage your trading.

What’s more, most people have never really taken the time to think through what they truly want from their trading in the first place. They don’t have specific objectives in mind. They think they do, but they really don’t. They just have a vague concept in their heads that they “want to make a lot of money,” but objectives are 50% of designing a system that fits you.

What you learned in this course:

  1. What a trading system is
  2. Why you should develop your own trading system
  3. The 7 parts of trading strategy

Next, because you need various systems for various market types, the next course is Market Type.

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