Follow these seven guidelines and you are more likely to design a profitable trading system, and not fall prey to ridiculous marketing campaigns that promise you riches overnight. These principles can be applied to any research project, and are adapted from Perry Kaufman’s work in the book New Trading Systems and Methods.
Find Your Premise
Most traders start with an idea such as “I want make money.” But this is way too general. What is your premise for trading? Are you are going to trade following news releases? Are you going to buy pullbacks in uptrends? Are you going to trade ranges? You can’t be everything at once. You need one solid strategy before you start developing strategies for everything; you need to fine tune your focus in your mind before any sort of strategy creation can be begin.
Reduce the Premise to Simplest Terms
Your premise is where you will focus your trading energy. Say you want to enter on pullbacks during a trend, and this is how you want to make money. Convert this to a simple question, such as “How do I make more money buying on pullbacks than I stand to lose?” It’s a simple question that gets to the core of developing strategy.
Strip yourself of your assumptions. Prove everything with numbers, and don’t trust other people’s numbers. Someone else may have a method for trading pullbacks during trends, but don’t assume that it works. You need to test it out. Be a scientist, seek proof, and be ok with “disproving” your own or someone else’s strategy. By doing so, you just saved yourself from losing money on that strategy.
Errors of Omission
As your trading system nears completion, consider whether you have missed anything. Throughout this process you are asking yourself questions about your system and how it works. Just because you answered all the questions doesn’t mean it will be profitable system. A question you didn’t ask could cause your system to fail. Try to think of things you didn’t originally consider. Are there additional costs or risks you haven’t factored? Can you actually enter at the price you expect or will the entry price vary from your theoretical model? Under what market conditions will the system fair poorly?
Question Both Good and Bad Results
When you begin testing your trading system in a demo account or the live market, always question your results…even if they are good. Most traders will research why a system is losing, but they won’t ask why it is winning. By doing so you gain a better understanding of what works and what doesn’t. Also, it could simply be good luck or bad luck that you have a winning or losing streak when you start testing. Guidline 3 above still applies; don’t assume anything. A good system can turn bad, so monitor results and continue to think of scenarios or circumstances that could jeopardize those good results.
If you back tested a system on a computer using historical data, look for outliers. These would be trades that had a much larger profit or loss than usual. This may be a result of an error in the historical data. If so, deleting those outliers from your results could significantly change the profitability of the system.
As stated at the beginning you may decide to use someone else’s work or strategy to begin trading. That is not an excuse to take shortcuts or get lazy. You still need to break their system down and see how it works. Test it out with your own calculations, and don’t just take their word for it. When you have done your work, double-check it for accuracy.
Start with the End in Mind
Start with a goal, and then work backwards. This can save some time and help you zero in on the inputs which will help you reach the goal. The goal needs to be precise to be of value.
“Make money” isn’t a goal and won’t help you create a plan. Get specific about how you want to extract profits, control risk and manage your money, then work backwards to find ways to get to that goal. The other principles mentioned above will help you in this regard.
Trading isn’t as simple as reading a book or finding a strategy online. Until you have a solid trading system it takes a lot of work. Once you have a system that works then things relax a little. When I first started trading I put in full days for years, studying the market and developing strategies. Now I can do my trading in 20 minutes a day if I want. But there are no short-cuts. You aren’t going to go from a new trader to making a fortune in 20 minutes a day right off the bat. Following these principles and develop a solid system; it will take time and work, but it pays off eventually.