System Development

"When I first entered the business of coaching traders most people thought that a trading system was an indicator."

— Van K Tharp

There are folks out there who are obsessed with,
1) Finding the right stock that will make them a fortune and they think there is some magic way to do that.

2) Working on developing a trading system to the point of perfectionism; and never getting around to actually trading.

3) Finding the ideal “system.”

4) Just looking for someone to tell them what to do

Do you relate to any of these scenarios?

Every trader needs a strategy or system to form a framework for their trading. Without a repeatable way to identify and execute trades, one can never be a consistent performer. Basically your system is a roadmap that guides your trading and keeps you from making decisions when you are least able to do so. Meaning that trading can be stressful. It's easy to get distracted. Life goes on regardless of what the market is doing. If you hear news about the market changing or you're running late for your next appointment you are not likely to make good decisions about your trades.

However, many people believe that a trading system is something that is “bought in a box,” something that other people have created with specific technical skills or secret knowledge of the markets that they just don’t have. Well it isn’t.

There are hundreds, if not thousands, of trading systems that work. But most people, after purchasing a system, will not follow the system or trade it exactly as it was intended. Why not? Because the system doesn’t fit them or their style of trading.

One of the biggest secrets of successful trading is finding a trading system that fits you personally. Developing your own system allows compatibility with your own beliefs, objectives, personality, and edges.

Why develop my own system? Isn’t it easier to just go buy a system with proven results?

When someone else develops a system for you, you don't know what biases they might have. Most system development software is designed because people want to know the perfect answer to the markets. They want to be able to predict the markets perfectly. As a result, you can buy software now for a few hundred dollars that will allow you to overlay numerous studies over past market data.

Within a few minutes, you can begin to think that the markets are perfectly predictable. And that belief will stay with you until you attempt to trade the real market instead of the historically optimized market. Many trading accounts have plummeted from this very thinking. One “sure-thing” trade placed without proper position sizing can wipe some traders completely out of the game.

And what if the person peddling the system is just a great marketer who makes their money from selling systems – not from actual trading? How would you know?

In Van’s experience very few people have really good systems and one of his jobs is to teach traders what it takes to develop a complete system for themselves. It isn’t rocket science; it just takes commitment and the right knowledge.

You may be thinking, “But I don’t have the computer or math skills to create a system myself.”

This is one of the biggest misconceptions out there.

If computers, math or anything mechanical terrifies you, that doesn’t mean that you can’t determine how and what you want to trade, which is the basis behind developing your own system. In fact, you’re the ONLY person that really knows what will work for you.

The key thing to remember about system development is that the trading strategy is THOUGHT UP by you because it fits your beliefs, wants, desires and needs. You can hire someone else to computerize your strategy if you want to do that and can’t do it yourself. There are plenty of programmers that will do this for you.

However, not all trading systems have to be computerized! In fact, people have designed and tested successful trading systems for years by hand. Of course computers make things quicker, faster and more efficient, but they are not necessary at all unless you need to use computers to feel comfortable about your trading.

(If you disagree with this, then you probably DO need computer testing to feel comfortable or maybe you believe that when a computer generates numbers, it is more accurate)

If you truly understand what a trading system really is; then this will all make sense. It isn’t complex, unless you choose to make it so!

So What Is a Trading System?

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

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 (if needed).

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. As a result, most people employ a series of screening criteria to reduce that number down to 50 stocks or less. For example, you might want to find 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 you’d use that meets your initial screen to determine when you might enter a position—either long or short. There are all sorts of signals one might use for entry, but it typically involves some sort of move in your 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 was not covered by your original set-up and entry conditions. As a result, you also need to think about re-entry criteria. When might you want to get back into a closed out position.

The exit strategy could be very simple. It is one factor in your trading of which you have total control. It is your exits that 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. This is an important shift in thinking that you will benefit from right now. You don't make money when you enter the market you make your money upon your exit of the market. Far too many people focus only on market entry, or what to buy, rather than when to sell.

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, depending upon how robust your trading system is, you might need multiple trading systems for each type of market. At 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.

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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.

In addition, most people have never really taken the time to think through what they truly want from their trading. 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 of “I want to make a lot of money.” Yet, objectives are 50% of designing a system that fits you.

Examples of possible objectives:

1. I want to become a full time trader making 30% per year for my clients with potential losses no bigger than half of that.

2. I want to spend less than three hours a week on trading and get the maximum yield out of my system. While I’d like to minimize my downside, I’m willing to risk whatever it takes to get maximum returns, including losing it all.

3. I want to limit my draw downs to no more than 20% at all cost. With that in mind, I’d like to make whatever I can, but minimizing the draw downs is my primary objective.

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No system is a money making machine that you turn on and have it print cash forever. Systems must be evaluated and revised to adapt to changing market conditions. And while there are ways to measure the quality of the system, you will never trade a system properly that you don’t feel comfortable trading. In the same way, you might have trouble following the advice of newsletters because you don’t feel comfortable taking certain trades that they recommend.

Improving your trading performance will not come from some indicator that better predicts the market. It comes from learning the art of trading and understanding how to create a trading system that fits your wants, needs, desires and lifestyle.

So ask yourself, how much time and money am I willing to lose trying to trade other people’s systems?

About Van Tharp: Trading coach, and author Dr. Van K. Tharp, is widely recognized for his best-selling book Trade Your Way to Financial Freedom and his outstanding Peak Performance Home Study program - a highly regarded classic that is suitable for all levels of traders and investors. You can learn more about Van Tharp at http://www.iitm.com/.