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Task №7. Trading system as a tool of technical analysis

During previous tutorials we learnt how to make trades, studied methods of technical analysis, and elaborated on the main indices of fundamental analysis. Every trader has to be aware of these basic principles in order to analyze and understand any financial market. However, in many cases it is not enough. It is common that different investors with similar backgrounds implement the same systems and indicators, watch and read the same information, but some quit trading in a few months while others stay in the market and become successful. So, what exactly helps traders make money? What do they spot on charts and why do they make progress? There is no secret at all. Every trader just develops his own trading system.

It is the trading systems that we are going to deal with in this tutorial.

A trading system is the result of a trader’s experience, hard work, and knowledge. Designing a proper trading system comes at a high price. It involves days and nights spent at a computer, critical analysis of past mistakes and the heart you put into it. However, the result is an individual trading system which is a secret formula of success. Two identical systems do not exist. Every trader has certain tools and techniques. He can share them with other traders but will be unable to explain all the details and intricacies of his own view on the market. That is why it is necessary to design a system of your own from the very beginning, from your first steps in trading. If you decided to become a professional trader and trade in the market steadily, efficiently, and for a long time, you need to create an individual trading system.  Today there are a lot of books where famous traders reveal their secrets and give examples of trading systems which helped them achieve success in their careers.  You may find very useful to learn from their experience and follow their advice. But keep in mind that it will not have the desired effect if you follow those systems blindly. You need to dig up the core idea which will help you design a unique trading system.

A trading system is a blend of several important components.

It can be compared to a mechanism. Even if a single cog in the machine is removed, the machine will malfunction or stop working. The same applies to a trading system. If you add up a wrong component, all your work would be for nothing. A system has to be adjusted carefully and customized. Besides, a trading system is not permanent, you must constantly monitor and streamline it. At the same time, a system must minimize risks and ensure maximum accuracy of forecasts. A trading system is a precise calculation, a balance point between several unknown and constantly changing factors. It is extremely important to get the priorities straight, diversify risks, calculate entry and exit points and choose analytical tools.

A trading system is a set of strict rules that determine price levels, time, and conditions for entering and exiting the market. A trader with an elaborated trading system is always ready for any development on the market. Every minute the trader can tell what exactly he is going to do or avoid doing with a certain currency in the market. If he cannot tell for sure, he did not learn to understand the signals provided by the trading system, which is unacceptable. Steady profits are the only measure of the system’s efficiency. As we have already mentioned, a trading system is a set of rules, which stipulate the steps you should take after some important factors have influenced financial markets. More specifically, the system reflects overall results of fundamental and technical analysis, risk management, and capital allocation. An application of a trading system is called a trading plan.

Before adopting a trading system, you have to consider some basics. We refer to the portfolio management, risk management, and trading strategies in the first place. In other words, the trader should take into account

  1. Initial deposit (the size of the account required by the company) or choose a leverage by yourself;
  2. Minimum required level of margin to keep positions open (maintenance margin);
  3. A lot size, overall maximum level of loss;
  4. Maximum loss on one position, possibility of hedging;
  5. Maximum number of open positions;
  6. Average gain included in the trading plan, approximate value of one pip for a particular currency.

Then you need to choose trading instruments. The four most traded currency pairs are: EUR/USD, USD/JPY, GBP/USD, USD/CHF. You can also use other currency pairs which do not involve the US dollar, or cross rates.
Anyways, you must know exchange rates of different currencies and a pip value in the US dollars. Now you can pass on to technical analysis. You need to prepare a set of technical tools that you are going to use in trading. These tools include trend lines and/or levels of resistance and support, trends, automated technical indicators, chart patterns, Elliott waves, Japanese candlesticks, Fibonacci levels, and so on. The choice of the instruments is quite rich. That is why, in order to decide on the necessary instruments, you should have a closer look at them. The most difficult part is selecting appropriate automated technical indicators. Even though there is a great variety of indicators, we recommend using just several simple tools. Your assortment of tools should definitely include both trend indicators and oscillators. The choice of a certain indicator largely depends on the time frame of trading, whether it is intraday trading or mid-term positions. At the same time, the adjustment of the same technical indicators is limited to technical characteristics of the system itself.

Finally, the last step is to work out a sample of a trading plan which you have to fill in every day, one sample for each currency pair or cross rate. Apart from columns comprising technical tools and automated technical indicators, a sample can have a separate column on без fundamental analysis, which includes upcoming economic events, forecasts, and the time when they are slated for release. You can also put down market expectations here. This information is available on our website (www. instaforex.com) in sections devoted to forex trading. In addition, a trading plan should include columns titled Conclusions and Review. In the first one, you write down your thoughts of whether or not you should enter the market. If yes, at what price and under which circumstances, where you have to place a stop-loss and a take profit order etc. The next day, you fill in the Review column to summarize the results of the previous trading day. For example, you indicate whether the trading plan was successful, as well as causes and mistakes if it failed. Don’t forget to put down the balance of your account following the trades you’ve made (or assumed trades at first).
As soon as you designed your own trading plan and the methodology of technical analysis, each time it will be easier for you to make the same everyday job. Discipline is the main thing in such work. A trading plan is the first step to your own trading system. Carefully designed method of your routine work will form the pillar of your own trading system.

The choice of technical tools and instruments is crucial because they signal possible price movements. The main point is to distinguish between major and minor signals.
It is important to know why you need a particular instrument. This is the time when you work out the basics of your own trading strategy.

Technical tools are used to:

  1. determine an ongoing trend (uptrend, downtrend, sideways movement);
  2. calculate key and local entry and exit points (levels).

You may find very useful to employ trend lines, support and resistance levels, continuation and reversal chart patterns, Fibonacci levels in various positions (pullbacks, rebounds, extensions, fans, arcs, etc.), Elliott waves, and Japanese candlesticks.
Automated technical indicators are most widely used to:

  1. get confirmation of entry points;
  2. determine the probability of the price movement to change its direction.

Before studying signals provided by automated technical indicators, you should examine the market with the use of traditional technical analysis. Every trader has to understand that those indicators are nothing else but price derivatives, even though some of them represent leading indicators.

Using the tools of classic technical analysis, you should answer the following questions:

  1. What trend is dominating the market? (uptrend, downtrend, sideways trend).
  2. Which trend is major and which one is minor?
  3. Are there any chart patterns and what do they mean?
  4. Is it necessary to use Fibonacci numbers (after a sharp price movement or in order to identify the future movement)?
  5. Which price levels represent key support and resistance levels and which of them are minor?

As soon as you’ve got an idea of how the market works, you can proceed to automated technical analysis. As we have already mentioned, automated technical analysis is a derivative of the price movement and, therefore, of classic technical analysis.

Automated technical indicators either confirm or deny signals provided by technical tools.

Remember that there is no versatile indicator. Any indicator helps making predictions with relative accuracy. Here is some advice on how to compile your own set of tools, so that you understand where to start.

  1. The tool kit must consist of both trend-following indicators and oscillators. The choice of a particular indicator depends on the type of trades you plan to make. For example, if you are involved in intraday trading, oscillators must prevail in your set of tools. If you prefer medium-term trading, you should equally use trend-following indicators and oscillators. With long-term positions, you should mainly employ trend-following indicators.
  2. Besides dividing those indicators into two large groups, you have to know what they are used for, the meaning and importance of their signals. For example, among trend-following indicators, Average Directional Index (ADX) is considered the best tool to evaluate the beginning of a trend. Meanwhile, Moving average convergence divergence (MACD) is mostly used for identifying the end of the current trend.
  3. It is recommended that you have at least one indicator in your inventory which helps to evaluate the prevailing trend as well the sideways movement, like MACD.
  4. In your set of tools, you need indicators based on different principles. This will help to avoid overlapping of signals. It is good to employ slow stochastics, Relative Strength Index (RSI), Price Rate Of Change (ROC), moving averages, and Bollinger Bands. Similar indicators usually provide overlapping signals. Meanwhile, indicators based on different principles ensure fewer entry and exit signals with higher accuracy.
Optimization and backtesting

The set of tools should not be excessive, because you have to analyze them within different time frames, from an hour to a week. Besides, even three or four indicators can give you controversial signals.

As soon as you choose one or two automated technical indicators, you need to test them. Backtesting is usually carried out in two stages. First, you test them on available. Second, you repeat the procedure in life trading. Backtesting helps to discover the pitfalls rarely mentioned in manuals. You learn how to recognize signals of an indicator. In retrospective, everything seems so clear and simple, but the online trading requires certain skills. Eventually, you will understand that books do not always describe the actual signals, and you will make your own list of signals.

To begin with, you need to find out whether a chosen indicator suits you. You just have to calculate a number of correct signals based on the available data. If you are satisfied with the results, the next step is to optimize those indicators.  In other words, you have to get the highest possible number of correct signals. The most popular method of optimization is to substitute the variables used to calculate the indicator. Mathematical optimization (formulas) is possible, but it is more suitable for those who are very good at mathematics or understand the market perfectly well. Meanwhile, it is not necessary that you use the same values for different time frames. For example, the 10-day moving average on a daily chart is very likely to give correct signals. At the same time, the best period of the moving average for the intraday trading is 5 or 7 days. The most important thing is to identify when the indicator gives the highest number of correct signals. That is the major objective of optimization.

The second stage of the backtesting is carried out with the use of the optimized indicators. By this point, indicators must give correct signals online, and you have to be able to spot them. In real time, the number of correct signals may be different, so you might need to optimize them once again.

Next, you combine signals, indicators and methods of classic technical analysis into an overall signal that determines entry and exit points in the market.

For example, the following development can signal an entry point to go short:

The market is in an uptrend, and the latest price movements formed the Engulfing pattern. When the reversal pattern was formed, MACD does not reach a new high. It means the price divergence is possible, and the further decline confirms that. The breach of the uptrend line once again confirms previous signals of the probable trend reversal. When the stochastic oscillator falls beyond the overbought level, and some downside movement occurs, the signal to open short positions is complete.

Trading systems are rarely optimized up to 90 percent of successful signals. Do not wear yourself out trying to achieve impossible things. The ratio of 70/30 can be considered enough to trade successfully on Forex.

Now try to develop your own trading system. When you create a trading system, you should follow a logical concept based on theoretical knowledge and observations.

While you are still a novice in the market, you’d better stick to a simple rule of trend trading. That is why you have to design a trading system with the use of trend-following indicators. First, you choose the financial instrument you are going to trade. Then you decide on a time frame depending on what kind of trading you prefer. In case of the intraday trading you should pick a short period from five to thirty minutes. If you prefer a longer-term trading, choose a broader period. We recommend that you decide on a period which seems to give as much information as possible. Later, when you adjust your trading system, you can leave the best alternative. Now let’s proceed to choosing tools which will provide basis for your trading system. In theory, a trend is formed with a series of successive highs and lows. These points complete continuation patterns such as Flag, Pennant, and Triangle.
Therefore, continuation patterns can be the first part for analysis with the use of the toolset. We are most interested in completion of the pattern. In addition, you have to implement a trend-following indicator to make sure that the existing trend will continue. You may find useful a moving average (MA) or even two moving averages with different periods like 21 and 34 (Fibonacci numbers). There is no doubt you need at least one oscillator, because the abovementioned patterns are formed in a channel and oscillators are most helpful when the price is consolidating in a range. Slow stochastics will be a perfect choice in this respect.
Here is an example of a chart where several technical indicators are applied:

You can see a full set of tools used to develop an automated trading system. Stochastics, 21 and 34 MA, and trend lines (red dashed lines) indicate the formation of a continuation pattern called the Pennant.

As soon as you have decided on a strategy and an armory of technical indicators, you start analyzing charts and spotting the signals. To begin with, you make analysis in retrospective.

The market goes through a correction (2). The previous price movements together with a moving average (1) indicate that the market is in an uptrend. This means that a continuation pattern is likely to occur on the chart (in this case the Pennant has been formed). That is why you should consider entering a long position, or buying the asset. Please pay attention that both lows of the correction were followed by price divergence on the stochastics (3). When the price broke above the moving average (4), it was giving the confirmation signal that the ongoing trend is set to continue. At point (5) the Pennant is completed and the uptrend is continuing as the formation of the pattern is considered complete after the breakout of the trend lines. At point (6) occurs a confirmation signal because it is a common retracement which was testing the broken trend line for the support.

Now you need to form a chain of signals in order of their appearance:

  1. the stochastics moves away from the overbought territory;
  2. the price breaks below the moving average;
  3. the breakout of the trend line which caps the Pennant;
  4. the price tests the broken trend line for support.

It follows that you should try entering the market as soon as you receive the fourth signal. Now you define the point where to place the stop loss order. The best option is to place it below the moving average, closer to the breakout point (the point where the price breaks the moving average), below the trend line supporting the Pennant. The next step is to set the price targets when you would like to exit your position and the take profit level. In our previous tutorial devoted to continuation patterns, we wrote that the price target to keep the position open can be placed at the level prior to the formation of the pattern.
When the price breaks below a moving average, as well as when a short-term MA crosses below a long-term MA is a signal for early exit. As we see in the Figure below, the exit signal was received sooner than expected. The price broke a MA (7) indicating the time to open a reverse position, i.e. to go short.

The signal to exit the market appeared before the price met the target level. At the point 7 the price crossed both moving averages indicating potential trend reversal.

Your analysis cannot be limited to a single case. You should keep on examining the previous movements until you spot all possible chart patterns (Flag, Triangle) and find out as many examples of price action as possible. After that you can try to recognize the signals on a chart in real time. At this stage you will be able to analyze the importance of a particular signal and determine the most suitable entry points.

The next step is optimization.
This time you can adjust the parameters of the employed technical instruments, such as the stochastics and moving averages, try out your trading system in different time frames and so on. When you get the desired results you can backtest your trading system while trading a demo account. The more tests you give the better.  The ratio of right to wrong signals of 70/30 is considered enough for successful trading.

The next step is optimization.
This time you can adjust the parameters of the employed technical instruments, such as the stochastics and moving averages, try out your trading system in different time frames and so on. When you get the desired results you can backtest your trading system while trading a demo account. The more tests you give the better.  The ratio of right to wrong signals of 70/30 is considered enough for successful trading.

Questions for revision
  1. What is a trading system?
  2. What are the main steps when creating a trading system?
  3. Which technical tools would you use when developing a trading system and why?
  4. What is backtesting of the trading system?

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