Mechanical Trading Systems

So far, we've taught you how to develop your trading plan. We've also discussed how important it is for you to discover which type of trader you are.

Next, we're gonna teach you how to add some meat to your thin trading plan frame by showing you how to create a trading system.

More specifically, we're gonna teach you all about mechanical trading systems.

Mechanical trading systems are systems that generates trade signals for a trader to take. They are called mechanical because a trader will take the trade regardless of what is happening in the markets.

In theory, this should eliminate all biases and emotions in your trading, because you are supposed to follow the rules of your system NO MATTER WHAT.

If you do a simple search in Google for "forex trading systems" you'll find many many many people out there who claim to have the "Holy Grail" system that you can purchase for "only" a few thousand dollars.

These systems supposedly make thousands of pips a week and never lose. They will show you supposed "results" of their perfect systems and it will make your eyeballs turn into dollar signs as you sit there and say to yourself, "Wow I can make all this money if I just give this guy $3,000. Besides, if his system making thousands of pips a week, I'll be able to make my money back in no time."

Slowww down cowboy. There are some things you should know before you give them your credit card number and make that impulse buy.

The truth is that many of these systems DO in fact work. The problem is that traders lack the discipline to follow the rules that go along with the system.

The second truth (Is there such thing as a second truth?) is that instead of paying thousands of dollars on a system, you can actually spend your time developing your own system for free, and use that money you were going to spend as capital for your trading account.

The third truth is that creating systems isn't that difficult. What is difficult is following the rules that you set when you do develop your system.

There are many articles that sell systems, but we haven't seen any that teach you how to create your own system.

This lesson will guide you through the steps you need to take to develop a system that is right for you. At the end of the lesson, we will give you an example of a system that one of the FX-Men uses just so we can show you how awesome we are! (Insert evil laugh here.) 

Goals of your trading system

We know you're saying, "DUH, the goal of my trading system is to make a billion dollars!"

While that is a wonderful goal, it's not exactly the kind of goal that will make you a successful trader.

When developing your system, you want to achieve 2 very important goals:

1. Your system should be able to identify trends as early as possible.
2. Your system should be able to avoid you from whipsaws.

If you can accomplish those two goals with your trading system, you have a much better chance of being successful.

The hard part about those goals is that they contradict each other.

If you have a system who's primary goals is to catch trends early, then you will probably get faked out many times.

On the other hand, if you have a system that focuses on avoiding whipsaws, then you will be late on many trades and will also probably miss out on a lot of trades.

Your task, when developing your mechanical system, is to find a compromise between the two goals. Find a way to identify trends early, but also find ways that will help you distinguish the fake signals from the real ones.

If you have no idea where to start, drop by our Free Forex Trading Systems thread in our forums. Tons of traders post their ideas for trading systems, so you may find one or two that you can use when you build your own system. 

Design Your Trading System in Six Steps

The main focus of this article is to guide you through the process of developing your system. While it doesn't take long to come up with a system, it does take some time to extensively test it. So be patient; in the long run, a good system can potentially make you a lot of money.

Step 1: Time Frame

The first thing you need to decide when creating your system is what kind of trader you are.

Are you a day trader or a swing trader? Do you like looking at charts every day, every week, every month, or even every year? How long do you want to hold on to your positions?

This will help determine which time frame you will use to trade. Even though you will still look at multiple time frames, this will be the main time frame you will use when looking for a trade signal.

Step 2: Find indicators that help identify a new trend.

Since one of our goals is to identify trends as early as possible, we should use indicators that can accomplish this. Moving averages are one of the most popular indicators that traders use to help them identify a trend.

Specifically, they will use two moving averages (one slow and one fast) and wait until the fast one crosses over or under the slow one. This is the basis for what's known as a "moving average crossover" system.

In its simplest form, moving average crossovers are the fastest ways to identify new trends. It is also the easiest way to spot a new trend.

Of course there are many other ways traders' spot trends, but moving averages are one of the easiest to use.

Step 3: Find indicators that help CONFIRM the trend.

Our second goal for our system is to have the ability to avoid whipsaws, meaning that we don't want to be caught in a "false" trend. The way we do this is by making sure that when we see a signal for a new trend, we can confirm it by using other indicators.

There are many good indicators for confirming trends, but Pipsurfer really likes MACD, Stochastic, and RSI. As you become more familiar with various indicators, you will find ones that you prefer over others, and can incorporate those into your system.

Step 4: Define Your Risk

When developing your system, it is very important that you define how much you are willing to lose on each trade. Not many people like to talk about losing, but in actuality, a good trader thinks about what he or she could potentially lose BEFORE thinking about how much he or she can win.

The amount you are willing to lose will be different than everyone else. You have to decide how much room is enough to give your trade some breathing space, but at the same time, not risk too much on one trade. You'll learn more about money management in a later lesson. Money management plays a big role in how much you should risk in a single trade.

Step 5: Define Entries & Exits

Once you define how much you are willing to lose on a trade, your next step is to find out where you will enter and exit a trade in order to get the most profit.

Some people like to enter as soon as all of their indicators match up and give a good signal, even if the candle hasn't closed. Others like to wait until the close of the candle.

One of the bloggers here in BabyPips.com, Pip Surfer, believes that it is best to wait until a candle closes before entering. He has been in many situations where he will be in the middle of a candle and all of the indicators match up, only to find that by the close of the candle, the trade has totally reversed on him!

It's all really just a matter of trading style. Some people are more aggressive than others and you will eventually find out what kind of trader you are.

For exits, you have a few different options. One way is to trail your stop, meaning that if the price moves in your favor by 'X' amount, you move your stop by 'X' amount.

Another way to exit is to have a set target, and exit when the price hits that target. How you calculate your target is up to you. Some people choose support and resistance levels as their targets.

Others just choose to go for the same amount of pips on every trade. However you decide to calculate your target, just make sure you stick with it. Never exit early no matter what happens. Stick to your system! After all, YOU developed it!

One more way you can exit is to have a set of criteria that, when met, would signal you to exit. For example, you could make it a rule that if your indicators happen to reverse to a certain level, you would then exit out of the trade.

Step 6: Write down your system rules and FOLLOW IT!

This is the most important step of creating your trading system. You MUST write your trading system rules down and ALWAYS follow it.

Discipline is one of the most important characteristics a trader must have, so you must always remember to stick to your system! No system will ever work for you if you don't stick to the rules, so remember to be disciplined.

Oh yeah, did we mention you should ALWAYS stick to your rules?

How to Test Your Trading System

The fastest way to test your system is to find a charting software package where you can go back in time and move the chart forward one candle at a time. When you move your chart forward one candle at a time, you can follow your trading system rules and take your trades accordingly.

Record your trading record, and BE HONEST with yourself! Record your wins, losses, average win, and average loss. If you are happy with your results then you can go on to the next stage of testing: trading live on a demo account.

Trade your new system live on a demo account for at least two months. This will give you a feel for how you can trade your system when the market is moving. Trust us, it is very different trading live than when you're backtesting.

After two months of trading live on a demo account, you will see if your system can truly stand its ground in the market. If you are still getting good results, then you can choose to trade your system live on a REAL account.

At this point, you should feel very confident with your system and feel comfortable taking trades with no hesitation.

YOU'VE MADE IT!

Build Your Trading System in Six Steps

In this section we'll you a rough picture of what a trading system should look like. This should give you an idea of what you should be looking for when you develop your system.

Trading Setup

• Trade on daily chart (swing trading)
• 5 SMA applied to the close
• 10 SMA applied to the close
• Stochastic (14,3,3)
• RSI (9)

Trading Rules

Entry Rules

Enter long if:

• The 5 SMA crosses above the 10 SMA and both stochastic lines are heading up (do not enter if the stochastic lines are already in the overbought territory)
• RSI is greater than 50

Enter short if:

• The 5 SMA crosses below the 10 SMA and both stochastic lines are heading down AND (do not enter if the stochastic lines are already in oversold territory)
• RSI is less than 50

Exit Rules

• Exit when the 5 SMA crosses the 10 SMA in the opposite direction of your trade OR if RSI crosses back to 50
• Exit when trade hits stop loss of 100 pips

Okay, let's take a look at some charts and see this baby in action... 

The 'So Easy It's Ridiculous' System

As you can see, we have all the components of a good trading system.

First, we've decided that this is a swing trading system, and that we will trade on a daily chart. Next, we use simple moving averages to help us identify a new trend as early as possible.

The Stochastic help us determine if it's still ok for us to enter a trade after a moving average crossover, and it also helps us avoid oversold and overbought areas. The RSI is an extra confirmation tool that helps us determine the strength of our trend.

After figuring out our trade setup, we then determined our risk for each trade. For this system, we are willing to risk 100 pips on each trade. Usually, the higher the time frame, the more pips you should be willing to risk because your gains will typically be larger than if you were to trade on a smaller time frame.

Next, we clearly defined our entry and exit rules. At this point, we would begin the testing phase by starting with manual back tests.

Here's an example of a long trade setup:

If we went back in time and looked at this chart, we would see that according to our system rules, this would be a good time to go long.

To backtest, you would write down at what price you would've entered, your stop loss, and your exit strategy. Then you would move the chart one candle at a time to see how the trade unfolds.

In this particular case, you would've made some decent pips! You could've bought yourself something nice after this trade!

You can see that when the moving averages cross in the opposite direction, it was a good time for us to exit. Of course, not all your trades will look this sexy. Some will look like ugly heifers, but you should always remember to stay disciplined and stick to your trading system rules.

Here's an example of a short entry order for the "So Easy It's Ridiculous" system.

We can see that our criteria is met, as there was a moving average crossover, the Stochastic was showing downward momentum and not yet in oversold territory, and RSI was less than 50.

At this point we would enter short. Now we would record our entry price, our stop loss and exit strategy, and then move the chart forward one candle at a time to see what happens.

Boo yeah baby! As it turns out, the trend was pretty strong and pair dropped almost 800 pips before another crossover was made! Now isn't that ridiculously easy?

We know you're probably thinking that this system is too simple to be profitable. Well the truth is that it is simple. You shouldn't be scared of something that's simple.

In fact, there is an acronym that you will often see in the trading world called KISS.

It stands for Keep It Simple Stupid!

It basically means that trading systems don't have to be complicated. You don't have to have a zillion indicators on your chart. In fact, keeping it simple will give you less of a headache.

The most important thing is discipline. We can't stress it enough. Well, yes we can.

YOU MUST ALWAYS STICK TO YOUR TRADING SYSTEM RULES!

If you have tested your system thoroughly through back testing and by trading it live on a demo for at least 2 months, then you should feel confident enough to know that as long as you follow your rules, you will end up profitable in the long run.

Trust your system and trust yourself!