Trading System Development – The Right Way
The conditions that define the situation for actually taking a position may be seen as the final confirmation: the signal that determines that the time for entering a trade is as good as it gets. Your base asset is BTC, thus, you come up with a trend-following strategy based on the Bollinger bands indicator. Your goal is to accumulate bitcoin selling BTC as the price starts dropping and re-buying BTC at a lower price when the price stabilizes. One of the situations you wish to identify to trigger on the strategy is, for instance, when you detect what you may call an Incipient down-trend or to be clear, a situation where a down-trend is developing.
How would you describe the Incipient down-trend situation with a specific set of conditions? Condition 1 : The percentage bandwidth moving average of the Bollinger bands is going down…. Condition 2 : The percentage bandwidth is smaller than the previous for two consecutive periods 2 candles …. Condition 3 : The minimum candle value is less than the previous minimum for two consecutive periods….
The framework dictates that when those three conditions are met at any moment in time, the strategy is triggered on. So you keep looking and waiting for the final confirmation to take a position that is also defined by a situation embodied by its own set of conditions. You will probably want to give the situation a significant name, such as Down-trend entry signal.
Edited by Daniel Bethlehem, Isabelle Van Damme, Donald McRae, and Rodney Neufeld
Condition 1 : The percentage bandwidth is smaller than the previous for the third consecutive period 3 candles …. Condition 2 : The minimum candle value is less than the lower Bollinger band for the last two periods 2 candles …. The conditions are met and you are finally ready to take the position. In that sense, the next step is defining two separate rule-sets for exiting the position: take profit and stop. These formulas will allow us to do just that: take the profit when the trade hits a target or stop and exit the position in case things are not going as expected.
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The simplest approach is fixing a constant value as a percentage of the price at the time of the take position event. There certainly are many considerations as of how to set these two formulas, and several variables like market volatility, your risk profile, quality of the signal, long-term targets and so on will be part of the criterion you will want to consider.
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However, such considerations are beyond the scope of this article. That said, it is important to note that setting constant values for take profit and stop is certainly a simplistic approach and that a lot more efficiency can be obtained with more dynamic formulas. Such formulas may take into consideration the actual price movement, momentum, and as many indicators as you may wish to factor in the analysis.
For starters, there are further decisions to be made: are you placing a market order or a limit order? Moreover, the complexity of the execution depends on several factors, the most relevant being the size of the trade and the liquidity of the market. The order would probably take some time to fill, get partially filled or not get filled at all, right? Also, placing such a big order in the book may affect the market and substantially affect the price, which is undesirable.
Large orders need to be fragmented, sometimes even across different exchanges. Also, the position may be taken at different prices, or along a certain period. The aforementioned tactics are the subject of a higher level of the framework which I may cover in future articles. As you may now see, there are considerations to be made at the time of execution, and the task itself is quite different from monitoring the market , hence the view of the two as belonging to separate stages.
As hinted earlier, what you have read so far is the basis of the framework to develop your trading system. As you may have noticed, a trading system corresponds to a lower level logic concerning the strategic aspects of trading.
Developing Your Own Trading System: A Step by Step Logical Guide
The system serves to structure the processes and methods that you will use to implement your trading strategies. What follows are considerations that aim to increase the efficiency of your system. In Stages 1 and 2, I described the fundamental components of the take position , take profit and stop events of a trade. I already discussed how setting the take profit and stop with dynamic formulas that take into consideration several relevant parameters such as current price or other indicators is preferred over the simplistic approach of setting a constant value considering the price at the take position event only.
It means that the formulas to determine the take profit and stop may change as the trade develops. The key point to take home is that there is a development or evolution attached to a trade. A trade is not an instantaneous event. It matures over time.
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What could happen that would make you want to change your take profit and stop formulas? But, most importantly, you analyze the market with a focus in your current targets, embodied by the originally defined take profit and stop. Therefore, the typical situation in which you may want to change your original take profit and stop formulas is when the trade seems to be going well in your favor. That is, the market is moving in the expected direction and you seem to be making a profit. Why would you want to change anything at all if things are going according to your expectations?
Even if you seem to be winning, the market may reverse before hitting the take profit and may go all the way back to your stop. In such case, if you were playing by the book of Stage 2 with initial take profit and stop , you would end up with a loss even though you were temporarily winning at some point. Under the Stage 3 paradigm, you would be interested in moving your stop as the price moves in the expected direction in such a way that even if the market reverses before hitting the take profit , you would end up with a smaller loss, with zero loss or even with a profit, depending on how much you manage to move the stop.
A second potential scenario is that the market moves in the desired direction and does not reverse. In such a case, if you did nothing to manage the trade, you would hit the original take profit. Now, what if the market keeps going way beyond the initial take profit? Indeed, you would have missed a good opportunity to surf a big market move and make a much larger profit than originally expected.
The conclusion is that it may be in your best interest to manage both stops and take profit , moving them in the direction of the trade as the market moves, allowing some leeway for a larger profit than expected and at the same time cutting the potential for a loss. Remember, greed is not the point of managing the trade; the point is optimization. You need to be careful not to increase the risk as you move the take profit , and make sure you are always tightening your stop at the same time too. In fact, the best practice is to move only part of your take profit , but again, the specifics of the tactics are beyond the scope of this article.
Changes to take profit and stop formulas respond to the same kind of logic you used to set the original values. When a situation defined by a set of conditions is met, the event indicates that take profit or stop formulas shall be changed. At the moment those predefined conditions are met, you enter the next phase. Keep in mind that the trade is in constant development, so there may be as many phases as you deem appropriate for your particular strategy. In the animated image above, you may see chart notations indicating changes of phases on take profit green and stop red.
Horizontal red lines represent a dynamic stop at each candle interval while horizontal green lines represent a dynamic take profit. The idea of having different phases comes from the notion that big market moves tend to provide clues as of what may come up next. For instance, rallies may accelerate as more traders join the move. Recognizable patterns may emerge. Signs of exhaustion may be identified. All of these considerations should feed the dynamic analysis performed as the trade develops, and may be contrasted with the predefined conditions that may push take profit or stop further, entering one phase after the next.
The Closing Stage has very similar implications to what I explained in the Open Stage in regards to execution. While it is true that the trade management process takes care of making the decisions as of when to close the position by managing the take profit and stop , the actual execution of the exit may require further considerations when dealing with substantial amounts of capital. It is for that reason that I propose to understand execution as a separate stage, while it may not be required in practical terms if you are trading a small capital. As hinted earlier, I may review more complex execution tactics in a separate article later on.
While it is sometimes disregarded as a boring task, record keeping is a fundamental part of the process and should be implemented in your trading system. Remember that markets evolve and strategies perform well for limited periods.
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Therefore, you should implement a procedure that will evaluate the efficiency of your strategies over time. Such procedures are out of the scope of this piece and I may cover them in a future article.
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I would argue that if you manage to implement the framework up to this Level One, you will have built a solid base for becoming a successful trader. That said, it is what comes after Level One what will put you higher in the food chain.