Trading System building blocks – for a complete trading plan
How to create or discover the trading system that is right for you?
Let’s have a look at the building blocks of the trading system, i.e. its elements, so that you are clear on what you need to decide on and write down as you create your own trading system. [ You may have a look at my trading system ]
Building blocks of the trading system
Without getting into discussion on what element is the most important, e.g. trade opening criteria, or the way to close the trade, or position sizing method or psychology, let me just say that ALL the things mentioned below are CRITICAL. Really.
- Trade opening setup. This is WHY you open a trade. This includes the “setup” that you need to see on the chart, or a fundamental news that you may use to trigger the decision to open a position.
- Examples: bullish outside bar price action setup, RSI below 30 and turned up, triangle pattern breakout, MACD divergence, RSI trendline break, retest of the area of previous volume spike, retest of the area where previously there was a very strong move away from it (supply & demand), news event, inter-market analysis outcome, random coin toss, any other.
- a full blog post on trade opening setups is here
- Trade opening filter. Additional CRITERIA to be met before you open a trade. Some systems may not use any filter.
- Examples: higher timeframe trend, price above EMA 200, or EMA 9 above EMA 21, MACD histogram slope up on weekly timeframe, no upcoming high impact news event, etc.
- Some things can be both a filter and setup, i.e. a filter for one trading system and an opening setup for some other system, e.g. price cross above EMA 200 can be used as a condition (i.e. enter long trades only if the price is above EMA) or as a setup (i.e. open a long trade of the price crosses above EMA)
- a full blog post on filters is here
- Trade confluence items. Additional REASONS or confirmations to open a trade. This can be the same things as opening setup or filters.
- Examples: the setup is pinbar and a confluence if that it is at a key support or resistance level, or a fibo retracement level, or that some indicator behaves in a certain way.
- Generally the more confluences the trade has, the higher quality it is. However, waiting for everything to line up mean missing trades. That’s Ok, just need to find the right balance.
- a full blog post on confluence is here
- Trade entry method. This is HOW you open a trade. This includes specific order type to be used.
- At Market on close of the last bar (immediate execution at a current market price) on close of the last bar (when the new bar opens, be it daily, hourly or any other one),
- At Market immediately once the setup is visible (without even waiting for a bar close, but risk is that by a bar close the setup will be invalid),
- Limit Order (i.e. to buy at a lower price to get a better R ratio, but risk is you will not be filled at all, and will always be filled if the trade is to be a loser). Limit can be placed e.g. at 50% retracement of the last bar, or 0.2*daily ATR(14) below, or in the middle of the S/R level, or at a top of the Demand level, etc.
- Stop Order (i.e. enter only after a certain price is reached, i.e. buy at a higher price, which is an additional confirmation and you may not even enter the trade at all if it should be a loser, and you will never miss a trade, but the entry level will be not as good, so R ratio worse (assuming same stop level). Stop order can be placed for example above the last bar high to enter long, i.e. entry “on the break of the high”
- optional plan to pyramid the trade, i.e. add to a winning position.
- optional plan to average, i.e. add to a losing position. This should be used with extreme care, if at all, because this is increasing the risk on the trade.
- Initial stop loss placement. This is WHERE your STOP LOSS is. In my opinion this is very important and a good practice to set a stop loss order, at your broker. This enables you to upfront define your risk, i.e. how much money you are willing to lose on this trade, defined by the right position size (i.e. how many lots to trade). It also helps psychologically: once the stop is hit the trade is “done”, gone, you can “forget” it vs. keep seeing a loser.
- Examples: last bar low, last swing low, last fractal down, few pips below support, 5 pips below demand level, 0.2*daily ATR (14), 0.5 * ATR(14) of trading timeframe, parabolic SAR level, on close below support (but this type of stop cannot be placed at a broker, needs to be executed manually, which is at risk of discipline), one pip below last low, “a few” pips below last low. [examples were for long positions, reverse for short]
- The Stop Loss order should never be moved against the position.
- Note that where to place a stop should not be driven by how much money you are OK to lose. How much money you are putting at risk is controlled by the position size. Where the stop is should be driven by the market structure (how a chart looks like).
- Position size setting method. This is HOW MANY lots or contracts you will trade. This is critically important for risk management and is closely related with stop loss placement and your accepted risk level. Position sizing method is how you define how many lots to trade. Position size combined with stop loss placement lets you control your risk per trade.
- Examples: equal dollar risk per trade (e.g. you always risk $50 per trade), equal account balance percentage per trade (e.g. you risk 2% of your account, so as it grows you risk more), method based on variability of the market, etc.
- There is also a method of fixed number of lots or contracts (e.g. always 1 lot), but I am finding it has little sense because in this method the risked amount is determined randomly by a stop distance
- Use broker with microlots to be able to precisely determine position size and risk small comfortable amount of money even if stop loss distance is big
- Position size should also consider other positions / orders you have open, especially on correlated pairs / markets
- Whatever method you choose, the risk you take should be comfortable, i.e. it should be an amount that you are OK to lose, you accept it.
- Trade exit plan. This is how you will MANAGE the trade. This is how you will close the position. Position can be closed if your stop loss order is triggered, which is always one of the options OR it can be closed manually once certain criteria are met OR it can be closed automatically once your trailing stop order is hit.
- Examples: take profit at 2R (i.e. 2 times the stop loss distance), take profit at next resistance level, exit manually if there is a reverse trade setup, exit if RSI is above 80, trail the stop behind each bar low, behind last swing low
- optionally you may scale out, e.g. close half of the position at 1R or 2R, and use trailing stop on the other half, to enable potentially larger profit, but accept a scenario where you will give back some unrealized profits
- you can use any filters or trade setups used for trade opening, also for trade closing
Additional building blocks to have a complete trading plan
- List of markets to trade. As simple as that. WHAT markets to trade using this system.
- Example: just EURUSD, forex top 10 majors, forex top 15-20 pairs, forex all pairs, S&P500 index, all stock indices, specific stock, industry or all stocks, bonds, commodities, interest rates, anything else that moves 😉
- in general, a market to be tradeable should be liquid (always able to close the position, no big spreads), volatile (there should be some movements to capitalize), actively traded (similar to liquid)
- consider market open hours and hours when there is volatility vs. hours when you can trade it
- take note of correlated markets
- Broker. Needed for your orders EXECUTION.
- broker selection criteria choice here.
- Time. That is WHEN you trade, when you analyze the market and place orders, what days, hours, e.g. daily around 10 pm local time, or Tue-Wed, 8.00 – 12.00.
- Trading room and computer. This is how you are ORGANIZED, i.e. your trading platform, screen, maybe a mobile phone app, broker phone number just in case, comfortable place with no distractions, software for screenshots, trading journal, system description readily available, etc.
- Preparation. This is about YOU. What you do to be READY to trade. This is also known as trading psychology or mindset. Our mind is the most important factor in our trading result. It is our decisions that create the result. We are fully accountable for our trading performance. Stress makes us less effective. Consider relaxing techniques or breathing exercises. You can try things like meditation or visualizations of success. It is difficult to say if it works, many people recommend this, some are sceptical, and I am pretty certain it does not hurt. 😉 I am sure that how we feel (physically, mentally, emotionally) has an impact on trading. In short, trade only if you are in a good shape!
- Emergency plan. If something goes WRONG, and we are under stress, our decision-making quality goes down. It is good to have a written plan what to do in case of emergency such as power loss, computer crash, broker bankruptcy, account confiscation, password loss, hacked computer or account, etc.
- Your system description. This is a document that defines ALL the points mentioned in this post. With a lots of examples: charts of entries and exits according to your system rules. Winners and losers. Specific steps of market analysis and order entry, i.e. action plan. This is your checklist. High quality trade is only if all boxes are checked.
All are important
I wanted to provide a complete list of elements needed to build a trading system and your trading plan. That is why this is a long post.
What do I mean by saying that you need to discover the trading system that is right for you? The point is, no one can give you a trading plan. You need experience, try many things, and discover what works FOR YOU, and even then, keep learning. When I first heard this I did not agree. I thought: “come on, give me the system list of rules and I can trade it, and if your rules are good, I will make money”. Now after a few years I see it does not work this way. Although trying to explain why it is so requires another post, this is long enough already 😉
I hope this list of elements needed to have a complete trading system and a trading plan is helpful. The job of a trader is to create their own plan, using the building blocks listed above, and then backtst test it, forward test it, adjust if needed, and then execute it consistently, live and with high quality.
Feel free to post your comments or question. I am learning all the time and I can add to this list.
Thanks for reading.