Trading Systems Defined

January 12, 2007

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John Forman - The Essentials of Trading author

In my previous two posts I outlined my thoughts on some topics related to trading systems, especially in regards to performance assessment. It occurs to me, though, that it is worth defining what exactly a trading system is. Here’s something we can use to that end:

A trading system is a set of rules which define when and how we enter and exit trading positions, and the size of the trades involved.

At the most basic of levels, the rules would be framed in this manner:

Go Long if/when . . .
Exit Long if/when . . .
Go Short if/when . . .
Exit Short if/when . . .

The “if/when…” is the actual trigger. It is something like “the market closes above the 10-day moving average”. This is a pretty simplistic set of rules, though. We really should get more specific.

A proper trading system rule includes the full discussion of all elements that go in to a trade. That includes what happens if you get a buy signal when already long, or even when short. It also includes the size of the trade to be executed. A better long entry rule would look something like this:

If not long, go long 1 contract at the market if close is above the 10-day moving average.

I think that is something traders generally have a fairly easy time grasping, so I won’t spend any more time on it, unless you want me to do so. The thing I do want to very quickly bring up, tough, is the difference between Trading System and Trading Plan.

In my view a Trading System is, as described above, the set of rules which dictate the way you enter and exit your positions. The Trading Plan is a broader thing. It is that which defines your trading overall, including the market(s) and instrument(s) you trade. It incorporates your risk tolerance. It incorporates your trading timeframe (day trade, swing trade, position trade, etc.). It incorporates your trading return expectation. All of these things come together in the Trading Plan.

What it comes down to is that your Trading System is part of your Trading Plan. You build it (or select it) based on the other elements of your Plan - risk, market, instrument, timeframe, etc. You are unlikely to get the results you want from your System if you don’t go through the Plan process first.

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