The 5 Components to Any Trading System
by John Davies
(Niagara Falls, Canada)
When I’m asked by new traders for advice, I often tell them to think of trading like going on a trip to a place they’ve never been before.
“What would you need?” I ask them.
“Where are we going?” they usually answer back.
I immediately respond: “You tell me.”
This brief exercise gets new traders to reflect on the fact that they are ultimately responsible for their own actions - a character trait they’ll need to develop if they hope to profitably trade the markets.
If my lack-of-an-answer is frustrating and not very reassuring to them, I think: even better! The markets show no mercy. The quicker they realize this fact, the better off they will be.
In a wider sense, my advice acts as an analogy for how someone goes about developing a complete trading system. I teach that all trading systems are built from the same 5 basic components.
Consider this: just as few people wake up and decide to trek halfway across the country on a whim to a place they randomly select on a map, most professional traders do not buy and sell just any stock they happen to come across. In other words, both activities deserve to be carefully thought out.
For instance, say you live in Phoenix and always wanted to see Niagara Falls. You schedule a vacation a few months out and begin to plan your trip. What will you need? Well, you don’t have much of money, so you’ll have to drive, not fly. You figure you’ll make it in 3 days. That means selecting a route with motels. You’ll also need to choose what clothes and whatnot to bring, etc. Obviously, there are many material things you’ll need to procure just to physically get to your destination and back.
The same with setting out to trade stocks and other financial instruments. You need to consider, for instance, which broker to use. But also where you will get your market data. And how you will maintain your watch lists, and log your trades, etc. In short, you need to think through the physical means by which you’ll actually conduct your trades. Trading resources is one of the basic components of a trading system.
As you contemplate your trip to Niagara Falls, you realize it’d be prudent to take your car out for an extended drive, since you bought it used and are unsure it will make it. Sure enough, a day-trip reveals it needs a major tune-up. You also discover other things, like how the seat is not as comfortable as you imagined. So you purchase a wooden-bead seat cover.
Likewise with trading, where it is equally prudent to test out aspects of your trading system before you actually trade with it. After all, you wouldn’t want to open a brokerage account the day you plan to begin trading, only to find out it doesn’t have the data feeds, charting and stock screening services you need, or that your computer set-up and workspace is inadequate to the task at hand. Paper trading (and backtesting) is another basic component of a trading system.
As the day of your trip approaches, you begin to fret over the details. What exact route will you take, and which music will you bring along to help pass the time while you drive? You also need to strategize: what happens if your newly-tuned up car nevertheless acts up, or a planned road is unexpectedly closed? You need to prepare for these and other contingencies.
This is not unlike trading, where your exact method of making trades needs to be known well in advance. When and which trades will you enter? How will your positions be maintained, and when will you take profits or cut losses? Having an actionable set of rules to strictly abide by encourages you to trade with the utmost discipline and with little emotion. It also forces you to think through the ‘what ifs’ that inevitably arise in the uncertain markets. Having a detailed trading strategy is a key component of any trading system.
Finally, the big day arrives and you happily set out for Niagara Falls. Only, the highway you planned to take the second day is unexpectedly tolled. Wanting to keep your expenses down, you opt to shift northward to another highway for the remainder of the trip. This, of course, causes you to deviate from your planned motel stays and negatively impacts your total driving time. But the lesson is learned for future trips: have backup plans for entire legs of the trip, and understand how this will have a ripple effect on all the other legs.
Such is the case when you actually trade with real money. You learn things here that you learn nowhere else. No matter how well you test, strategize and select your resources, nothing can completely prepare you for what you’ll encounter in the live markets. But regardless of whether these surprises fatten your wallet or draw your account down, make sure to learn from them. Use it as an opportunity to improve future iterations of your trading system. Far from being just its culminating point, live trading should be treated as its own, unique component.
Once the trip is over, you recall the moment you initially decided to take the trip many months ago. You reflect on how far you have come. At the time you had only a general sense of how it would all work out. But you also see how, each day, that sense became more and more detailed. Eventually, it became difficult to think of everything all at once and you were forced to break all those thoughts out into more manageable bits. That’s when you began to test your car, plan your route in detail, etc.
This is much like what occurs when you first have the idea to become a trader. The difference is that for a trader, it’s important to actively maintain these initial thoughts as an overview of your entire trading system. It gives you perspective on how trading fits into the bigger picture of your life. In fact, most professional traders find it pays to create a physical document where you can, for instance, record your motivations for trading, as well as your attitudes about money and risk. Trading plans are as important a component of your trading system as any of the other four.
In sum, a trading system is composed of 5 components: a trading plan, a trading strategy, trading resources, backtesting/paper trading, and live trading.
For more details on each of these components and how they interact with each other, please visit www.SwingTradeSystems.com.