Wednesday, December 23, 2009

Trading Systems

A trading system is a set of rules, usually based on technical indicators, that defines when a trader enters and exits trades. In addition to increasing profitability and limiting risk, a trading system removes emotion and subjectivity from trading decisions.

All traders should use a trading system. However, no one system works in all types of market conditions. As a result, the Forex trader needs two or three systems at their disposal and must know when to switch among them.

The main types of trading systems are trend-following, counter-trend or range, breakout or counter-breakout, and pattern recognition.

Trend following systems are the most common type of system that traders use. They can be very profitable because within a strong trend, moves are often large ones. Trend following systems buy high and sell higher as prices move upwards. One example of a trend following system is a moving average (MA) crossover approach. A trader would buy when a faster MA crosses above a slower MA. In this example on the three-hour Euro chart, you can see three buy points as the 20 EMA (in purple) crosses up above the 50 EMA (in red). You also have one sell point where the 20 EMA crossed below the 50 EMA. All these trades would have been profitable had you trailed your stop.

While trend following systems work well within a strong trend, they cause whipsaws when the market is moving sideways. Notice the circled area on the chart in November. Following the system would have resulted in four unprofitable trades.

In a market moving sideways, the trader needs to switch to a range or counter-trend system. Ranges can be horizontal, ascending, or descending, but they all have a definable top and bottom. There’s greater risk in this approach because you’re trying to pick tops and bottoms—in other words, you’re trying to buy-low and sell-high. Counter-trend systems often involve the use of such indicators as RSI, MACD, and the stochastic, looking for overbought and oversold conditions. They can also use divergences between price and indicators, or crossovers in Bollinger Bands.

Look at the Euro chart below. I’ve added Bollinger Bands to the same three-hour chart during the sideways period in November. Here you’d sell when price touched the upper band and buy when it touched the lower one. It looks simple enough. Remember, though, that counter trend trading carries significantly more risk. As a result, you should always look for other, confirming evidence. (Frankly, even with trend following systems I look for additional evidence for entries.) In this case, note the difference in candle behavior on the last trade that failed. Instead of the upper shadows that the prior candles displayed when they touched the top of the bands, you see stronger candles forming with no upper shadows.

Breakout systems trade breakouts from ranges. The philosophy is that prices don’t stay in a range forever—eventually they break out of them. Counter-breakout systems trade an assumption that many breakouts fail. One example of a breakout system is on the chart above where the last failure for the range trading system was actually a signal for a breakout system. In this case, the breakout was from the Bollinger Bands.

Pattern recognition systems can be the most challenging because there’s the need to recognize the pattern. They include such patterns as inside and outside bars, candlestick patterns, flags, triangles, head and shoulders, and others.

To be useful, trading systems need to have well-defined and simple rules. In addition, the trader must be aware of the market environment and use the appropriate system at the correct time. Determining whether a market is trending or in a sideways range often requires the use of an indicator such as ADX, which I’ll cover in a future article. As always, the trader should look for confirming evidence before entering a trade and should use stop losses to limit risk.

© Dianne Fecteau, 2009.

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