Why do we need a trading system?
If you are an active trader and not making money on the stock market, it is time for you to slow down and think about what you did wrong and investigate on the trading system that you are using.
Building a profitable trading system requires time and patient. One trading system may work for some people, but fail for others. It is ok if a trading system fails on you, but it is not ok for you to move on to the next system without investigate it and find out why it doesn’t work.
There is no trading system that will work forever. You will need to adjust or change a trading system under different economic circumferences. If a trading system consistently worked for you in the past and it is not working anymore, it is time to investigate it.
In this tutorial, I’m going to show you the basics on how to build your own trading system. Following are some steps that I take.
How to build a trading system in 5 steps?
1. Make it simple – choose 1 or 2 technical indicators to start with.
2. Test it against historical data
3. Set stop loss and exit strategy
4. Backtest this method and try to break it. Add additional indicators when necessary.
5. Paper trade this trading system.
Let’s look at the trading system in detail.
Trading System Step 1 – Technical Indicators
Starts with 1 or 2 technical indicators. I will use Macd crossover and Bullish Engulfing (Candlestick) pattern for this tutorial
Trading System Step 2 – Test the technical patterns
Test the pattern against historical data and study stocks that match these 2 criteria. Let’s pick a random day in the recent past. I picked 2/22/2010 which is about 20 trading days earlier from today. To assist me finding stocks that match these 2 patterns quickly, I did a stock screen using Dojispace’s advanced stock screener and found MPG. MPG is the only stock that matched these 2 patterns that day. Let’s look at the chart.
2/22/10 close price: 1.64
Today (3/16/10) close price: 2.59
This is a 58% gain in 20 days.
Trading System Step 3 – Set Stop Loss
We must set stop loss on all trades that we enter to avoid big losses. There are people who lost their fortune on one stock because they don’t exit a losing trade. Please note, if you are going to buy stocks with a price less than $2, your stop loss must be greater than usual because they are very volatile stocks. Let’s set our initial stop loss to 5%. If a trade is going our way, we should adjust the stop loss to match the latest closing date, so that we don’t lose all the profit when the trend reverse. Let’s look at the MPG stock data.
Date Open High Low Close Volume
Mar 16, 2010 2.52 2.68 2.46 2.59 2,115,671
Mar 15, 2010 2.60 2.68 2.50 2.51 2,541,316
Mar 12, 2010 2.44 2.55 2.36 2.47 1,425,172
Mar 11, 2010 2.38 2.49 2.21 2.40 2,090,530
Mar 10, 2010 2.54 2.69 2.30 2.43 5,019,694
Mar 9, 2010 2.12 2.57 2.05 2.47 7,795,768
Mar 8, 2010 1.89 2.25 1.88 2.16 7,372,701
Mar 5, 2010 1.83 1.90 1.76 1.86 1,922,729
Mar 4, 2010 1.80 1.84 1.73 1.78 898,551
Mar 3, 2010 1.68 1.81 1.67 1.74 1,641,841
Mar 2, 2010 1.74 1.74 1.62 1.69 2,044,427
Mar 1, 2010 1.55 1.64 1.53 1.60 1,519,886
Feb 26, 2010 1.51 1.59 1.48 1.50 1,602,606
Feb 25, 2010 1.55 1.57 1.48 1.50 1,170,756
Feb 24, 2010 1.73 1.75 1.53 1.60 1,716,731
Feb 23, 2010 1.63 1.75 1.57 1.69 1,801,794
Feb 22, 2010 1.45 1.68 1.45 1.64 1,719,168
Notice if we bought the stock on open at $1.63 the next day (2/23) after the pattern was formed, it would hit our 5% stop loss on the day after (2/24) and we would have a failed trade. We have 3 options.
a) Set a bigger stop loss when trading with stocks under $2
b) Hit 5% stop loss and buy it back when the trend start to go back up.
c) Skip stocks with a price under $2 and volatile stocks completely.
Let鈥檚 look at each option in details.
a) Set a bigger stop loss
For this trade to be successful, a 9.5% stop loss is required. The stock hit a new low on 2/25 at $1.48. Let’s do the math.
Entry price: $1.63
Lowest price: $1.48
(1.63-1.48)/1.63 = 9.2%, so we must set a stop loss greater than 9.2%
I don’t like this option because a 9.5% stop loss is simply too big for a swing trade.
b) Hit 5% stop loss and buy it back when the trend start to go back up.
When this stock hit our stop loss at 5%, we sell it and buy back at a later time. So when should we buy it back? Notice on the 2/22 when the Bullish Engulfing pattern is formed, I consider the stock open ($1.45) to be a support. If the stock stays above this support level, I will try to get back in when the stock turn positive. However, if the stock breaks this support level, I won’t consider buying it back until the stock moves back up above that level.
A doji is formed on the 2/26 which is a good sign. (A doji signals a reversal trend). The stock gapped up on the next trading day on 3/1 confirming the trend reverse. This is the day I will buy back this stock and set my stop loss to 5% again. For cautious traders, you may want to wait until the stock break it’s resistance level at $1.69.
The stock keep moving higher after 3/1, we must adjust the stop loss on a daily basis. Our initial stop loss was 5% from our entry price. We must reset this entry price to the latest closing price to avoid giving back too much on a winning trade.
The stock eventually hit our stop loss on 3/10.
Let’s calculate our profit roughly. Let’s say we invest $10,000 worth of stock each time we trade.
Trade 1: 5% lost on $10,000 = $500
Trade 2: Entry price: $1.55 on 3/1
Exit price: around $2.35 on 3/10 ($2.35 is 5% stop loss base on 3/9’s close price of $2.47)
(2.35 -1.55)/1.55 = 51.5% of $10,000 = $5100 (Note: we don’t subtract $500 from the $10,000 because we
assume we invest $10,000 on each trade, not on each stock.)
Total profit = $5,100 – $500 = $4,600
c) Skip stocks with a price under $2 and volatile stocks completely
This option is obvious but I don’t like this option because I will miss out a lot of profitable trading opportunities.
Trading System Step 4 – Backtest this method and try to break it. Add additional indicators when necessary.
Now let’s test our trading system against a bunch of dates in the past starting 2/23/2010 which is the day after our initial date.
2/23/2010. The only stock that matched bullish engulfing and macd crossover on that date is CLRT. Again, this is a low price stock, so we expect it to be very volatile. The stock hit our 5% stop loss in 3 days and again if we re-buy the stock a day later, we get a nice profit. The stock is still rising as of today and it is sitting at $2.8. Assume if we bought back the stock at $2.1, we are up 33% on this trade and if we subtract the 5% loss from our previous trade, we still make a profit of 28% on this stock.
Note 1: In both trades, we would make even more money without the stop loss or with a bigger stop loss. However, I don’t recommend doing that because some bad trades may keep trading lower and you will end up losing more money on those trades.
Note 2: If you didn’t re-buy the stocks, then you end up with 2 losing trades, each cost you $500 + transaction fees. Two people may end up with totally different results using the same trading system, one with a loss and another with a huge gain. The failed trader then move on to the next trading system and hoping that it will work out for him, and keep moving as there is no perfect trading system that works for everybody. That’s why it is very important that you study why a trading system failed on you when you made a bad trade.
Ok, let’s move on to the next day.
2/24/2010 – no stock
2/25/2010 鈥?FSYS
- Again this stock hit a stop loss and then rebound the next day with 28%-5% = 23% gain in a week.
Now we started to see a pattern here. It seems that we can avoid our first 5% loss by waiting a couple of days after the patterns are form. So we will add this restriction to our trading system.
Restriction 1: Wait for 2 days and to see if there is a pull back so that we can get in at an even cheaper price and make sure that the trend doesn’t break the support level. (Please note: with this restriction, we will miss out profit if the trend is strong enough that it doesn’t pull back.)
2/26/2010 – no stock
Anyway, I think you got the idea. Just keep testing it and add restrictions to the trading system as necessary.
Trading System Step 5 – Paper trade this trading system
- Now we have our trading system ready and we should paper trade it for a while until we are fully comfortable with it. This step uses the same approach as step 4 except now we are using live data rather than past data and add restrictions to the trading system if necessary.
That’s it, I hope this tutorial helps some of you to trade a little better in the stock market.
