Forex Trading System2.1. What is a Forex Trading System?Forex trading
system is the subsystem of the forex trading plan which governs when and
at which price you open and close your trades. A trading system works
on the signals given by technical analysis and/or fundamental analysis.
The signals are taken to see if the trader should buy or sell a specific
currency pair or must close the open position(s). Any currency trading
system prevents information overload by filtering out the universe of
technical and/or fundamental signals in such a way that only the most
reliable (successful in the past) signals or signal combinations are
acted upon.There are two kinds of trading systems - the discretionary
and the mechanical. Discretionary trading systems expect the trader to
use his or her own judgement to ascertain the importance of each of the
technical or fundamental signals (whose number is potentially infinite)
that he or she gets. Mechanical trading systems operate on a fixed
number of technical or fundamental signals without the participation of
the trader. Discretionary trading systems require the perpetual
application of creativity (flexibility of approach) from the trader in
the understanding of the changing market conditions. Mechanical trading
systems require the creativity from the trader only in the forex system
development phase.Discretionary forex trading systems are best employed
by professional forex traders with a lot of experience (internalized
practical market knowledge) against which they can determine the
validity of any signal that they receive. These traders usually remember
a large number of various signal patterns from the past (just like the
master chessmen) that they can compare to the current market conditions,
to make their analysis more objective. In essence, they use themselves
(i.e. their brain) as their trading system - often very successfully -
because human mind has the best pattern recognition power on the
planet.Starting currency traders are advised to begin by following
professionally created mechanical forex trading systems. Most of these
systems are sold-out in the form of the forex signals that are usually
developed by experienced traders who have found a way to systemize their
knowledge of the markets into a working strategy. At the same time, the
beginning traders can work on building their own knowledge base of the
forex market through the quality forex books, educational courses, bank
reports and newswires on this subject -so that they can too, with time,
create mechanical trading systems from their own insights and intuitions
(using the forex charting packages which allow to do this).Beginning
without a proven mechanical forex trading system (that has positive
mathematical expectation) drastically dilutes the chances of maintaining
the capital. This is because any intuition or a hunch that the traders
experience as a result of some newly gained knowledge of the forex
market is likely to be overridden by one of the two emotional
derivatives of their life-long programming towards the money - the greed
and the fear. In other words, without exact adherence to an existing
mechanical trading system the beginning trader will eventually succumb
to his or her emotions. As a matter of fact, the only way the traders
can acquire discipline in the early phases of their trading careers is
by tight following the signals generated by a proven mechanical forex
trading system.Note: Neural Network Packages (e.g. NeuroShell) emulate
the process of human learning and can be used to accumualte the
knowledge of the past technical and/or fundamental signal patterns (just
like the mind of professional forex traders does) for the purpose of
the future currency price forecasting.Quote: "A mechanical approach to
the markets can be successful and this is backed up by the fact that
approximately 80% of the $30 billion in the managed futures industry is
traded by exact systematic methods", from the "The Ultimate Trading
Guide" by John R. Hill, George Pruitt, and Lundy Hill.2.2. Components of
a Forex Trading System.A regular forex trading system consists of two
subsystems - the entry system and the exit system. These systems can
operate on a different or the same set of inputs. The inputs can be
technical or fundamental signals.A system consists of a number of rules
which interpret the signals that it receives. The entry system evaluates
the signals to determine if and at which level the positions should be
opened. The exit system evaluates the signals to determine if and at
which level the open positions should be closed.The propose of an entry
system is to find market points which allow to open positions with high
potential reward and low potential risk (high reward-to-risk ratio). The
risk is defined as the pip distance from the entry price to the next
support or resistance level lying opposite to the entry direction (above
entry for sell and below entry for buy). The reward is defined as the
pip distance from the entry price to the next support or resistance
level lying in the direction of the entry (above entry for buy and below
entry for sell). It is generally advised that the traders accept only
the trades with the reward-to-risk ratio of over 2 (e.g. risk=60 pips,
reward=130 pips). All the same, depending on the accuracy of a trading
system (i.e. the percentage of the winning trades of all the past
trades) this requirement might be shifted to a lower or a higher value
without sacrificing the profitability of the system. This is because the
true measure of the long term profitability of a forex trading system
is neither the average per-trade reward-to-risk ratio nor the accuracy
of the system but the combination of these two measures which is
calculated as the mathematical expectation of a trading system. In the
absence of the accuracy measure of a trading system (as is the case with
some discretionary trading systems) - the trader ought strive to find
entries with the greatest possible reward-to-risk ratio.Note: Elliott
wave analysis allows to find entries with extremely high reward-to-risk
ratios (e.g. just check some of reports on MTPredictor's site). It is
worth noting that MTPredictor automatically calculates the
reward-to-risk ratios and helps to find optimum entry points based on
these ratios. Some Elliot wave software developers (e.g. Advanced Get)
also supply their subscribers with detailed Elliott wave trading
plans.The aim of an exit system is to protect the capital base and the
unrealized profits. The capital base is shielded by ensuring that the
trades are exited with a fixed loss when the reasons for holding them
are no longer valid. This is done by triggering a stop-loss order on
your forex brokerage account when the price crosses the level which
defined your risk at the entry. If you are a discretionary trader,
forcing yourself to place the slop-loss on each trade and to stick to it
no matter what will make you very selective about your entries - which
ought increase your profitability. The unrealized profits are protected
either by a take-profit order which is triggered on your brokerage
account when the price reaches the level which defined your profit at
the entry or with the help of the trailing stop-loss which gradually
locks in more profits as the price moves in your favour. In fact, the
trailing stop-loss exit can be more suitable than the fixed take-profit
exit if you wish to profit from the extending "character" of some
impulse waves. In such a event the trailing stop-loss can be placed just
a few pips opposite to the trendline which defines impulse wave. There
is one more type of exit which can be used to protect the trader from
missing trading opportunities - the time exit. A time exit is triggered
if a trade hasn't reached either its stop-loss or take-profit level in
the specified period of time. Exiting such trades reduces the chances
that the capital will be tied up when better opportunities appear on the
other currency pairs.Note: Most forex newswires (e.g. Marketnews) are a
great source of real-time information on the location of the major
support and resistance levels and clusters of large orders that are
watched by professional forex traders and which can be used to manually
update the position of your trailing stop-loss.2.3. Development of a
Currency Trading System.Making a mechanical forex trading system
involves a number of steps: 1) Selecting the inputs for the trading
system - technical analysis or fundamental analysis tools which will
generate the signals for the system; 2) Developing the rule-set which
will operate on these signals; 3) Optimizing the parameters of the
analysis tools used to produce the signals; 4) Backtesting and
forwardtesting the system over historical price data. Each of these
steps is covered in more detail below:2.3.1. Selecting the Inputs for
the Trading SystemIt is important to base your selection of inputs to
the system on a sensible premise about the way the currency markets
operate. As an example, you can use 200-day moving average to determine
if the market is in a long-term up or down trend because a large
proportion of professional forex traders use this technical tool to
measure market trendiness. It is also better to combine technical
analysis tools of different type and scale because this increases the
chances of finding high-probability entry points (those that are likely
to be followed by sharp currency price moves in your favour), which
should, in turn, contribute to the overall system accuracy.If you use
technical tools only on the higher time-frame charts like the daily or
the weekly charts this will increase the duration of the trades and the
time periods out of the market - because the signals will take longer to
form. Either of these outcomes can have detrimental impact on the
trader and investor morale during the inevitable losing streaks as is
shown by our forex trading simulator (Please note: The size of this page
is 0,6 Mbs and it requires that you have Flash installed and Javascript
enabled in your browser). which can last longer than they are naturally
prepared to wait. This makes it important to focus on lower time-frame
charts (e.g. hourly charts) for signal generation which will lead to
shorter trade durations and, consequently, to quicker recoveries from
the drawdowns. Shorter trade durations can also help to the trader to
defeat the temptation to overtrade because he or she can expect to see
the next entry signal in the next couple of days - not in the next
couple of weeks.Quote: "Your freedom to choose your time-frame is too
valuable to lose. Investors and margined speculators, on the other hand,
can choose their own time-frames. This is one of their positional
advantages, to use a favourite notion of Larry Hite* , one of the
founders of Mint Investment Corp* - one of the largest of the futures
fund operators. Investors and speculators can choose. Obviously it makes
sense to choose time frames which match any natural rhythms that can be
discerned in the currency markets." John Percival in his book "The Way
of the Dollar".Note: If you are using the Elliott Wave analysis your
average holding period will depend on the degree of the impulse or
corrective waves that you are trading.Choosing which fundamental factors
are best for your forex trading system (e.g. as inputs to your neural
network) can be very hard because the effect of various economic
indicators on the currency prices changes with time. In other words, the
strength of correlation between the price of a currency pair and the
fundamental factors relevant to it is not fixed (even with interest rate
differentials). In contrast, the relationship between the price
patterns (especially the classical price patterns) and trader psychology
(the driving force behind most important price moves) remains fairly
stable over the years. This is the reason why the forex traders are
encouraged to dedicate most of their efforts to building trading systems
around the technical analysis.Another all-important question is the
time horizon of the prediction that the trader is trying to make with
his system. Better not to try to forecast currency prices too far into
the future. This is because the number and the complexity of interaction
of various technical and fundamental factors rises geometrically with
each trading day. It is, therefore, best to "leave" this task to
high-end investment banks and houses which alone have the capacity to
perform the necessary calculations inherent in longer-term currency
course forecasting. It is more practical for the typical currency trader
to concentrate on capturing the so-called "knee-jerk" market reactions
driven by crowd emotionalism through the analysis of the current
technical or fundamental conditions.Quote: "Rule 5: Be prepared for
anything don't try to predict what will happen or when. Investing is a
skill, not a science. The Zen swordsman dicsniplines body and mind to
counter any blow spontaneously; he does not anticipate the moves of an
opponent, for that impedes his ability to react. Likewise, professional
investors know they cannot control the real estate or stock market, let
alone the global economy. Instead, they train themselves to be
financially intelligent, to think confidently and creatively when
opportunities or problems arise." one of the The Seven Rules of
Investing given in Robert Kiyosaki's book "You Can Choose to Be
Rich".You should also try not to include too many indicators (over 12)
in your forex trading system. This is because probability that the
system will perform like it did in the past diminishes as you add more
indicators to your system. As a rule, the larger the number of
indicators in your system the longer the period of historical currency
price data you need to backtest the system on.Note: There is no
necessity to learn all the available indicators and technical analysis
methods before you can start creating your own robust trading systems.
It is usually enough to master just a few "basic" technical indicators
and formations to start combining them to identify high probability
entry and exit points. The fundamental and technical reports issues by
the investment banks are one of the best sources of information on which
technical and/or fundamental signals are watched by the professional
trading community that you can include in your forex trading system. In
the long run it is best to stick to a sound forex trading strategy, that
has high probability of being profitable in the long-run, than to
dissipate your capital among a variety of "promising" methods.2.3.2.
Developing the Rule-Set which will Operate on the SignalsYou can create
these rules based on your observation of how the prices move in relation
to various technical and fundamental indicators. For example, you might
notice that currency prices tend to resume trending behaviour after
they correct toward and touch 200-day moving average. You can use this
observance to formulate a rule which will enter the markets when the
prices bounce off from the 200-day moving average. You could also notice
that the prices tend to stop trending when they touch the outer daily
Bollinger bands. You can use this information to create a rule which
will exit the trades once the prices penetrate the outer daily Bollinger
Band. Because making rule-sets for mechanical trading systems forces
you to quantify your insights about the market this practice aids to
clarify them.The rule-set of a forex trading system is in essence the
clarified version of the weighing algorithms that you naturally create
in your mind as you learn the technical and fundamental analysis and
observe the price action. I say "weighing" because most of the technical
rules are transcribed in your mind as fuzzy patterns (e.g. "The longer
the shadows of a doji the more likely the reversal" or "The steeper the
trendline - the more bullish or bearish the market sentiment."). When
you make the trading system, you transfer your knowledge to the computer
in the form that can be understood by it. Admittedly, the quality of
the computerized model very often will fall short of the actual mental
model that you keep in your head. Nevertheless, the real advantage of
the "mechanicizing" your market knowledge is the power to objectively
determine the validity of your trading ideas by the process of the
backtesting. It should be noted that the closest the computers approach
to simulating the complexity of human comprehension of the market
patterns is in the neural network packages.Neural network packages can
be especially effective if you wish to model your way of weighing the
strength of support or resistance levels. For example, if you believe
that fibonacci retracements are more reliable entry points if they are
confirmed by reversal candlestick patterns and/or RSI divergence you can
"ask" a neural network to search for past occurrences of this pattern
combination and determine the actual numeric weight that should be
placed on each of these technical signals for the entry or exit to
occur. This process is very advantageous because it allows the computer
to extend your natural pattern recognition ability by perfecting (or
objectifying) the weights associated with each technical input/signal.
This way you can objectively measure the strength or the beauty of the
technical setups that you encounter in your trading (e.g. the resultant
model might require the position to be opened if the total sum of signal
weighs is bigger than 0,5 where a reversal candlestick signal is
"worth" 0,15, fibonacci retracement is "worth" 0,3 and the RSI
divergence is "worth" 0,45). In essence, your forex trading system is
the description of how beautiful your trading setups should be, where
"beauty" is defined as the convergence of confirming signals from
different type and/or scale technical analysis tools. Advanced users of
the neural networks can go even further by tying the position size
(within the maximum percentage value set by their money management
system) to the strength or the beauty of the technical setup. If done
decently this practice will allow them to make the most of the best
trading opportunities while simultaneously reducing the exposure on the
less promising setups.Meta4: An fascinating parallel to weighing the
signals in order to determine if the position should be taken or not is
the way people fall in love. Each individual carries a certain number of
unconscious or semi-conscious qualifiers that "describe" in more or
less fuzzy terms the appearance, the character, the temperament of their
likely mate. When you meet the person who posses enough of these traits
(i.e. above some "threshold" or unconscious minimum) the cascade of the
confirming signals sets your mind off into the love state. A similar
process occurs in the mind of discretionary trader when the market
action through all of its technical and/or fundamental signals (i.e.
"when all the pieces fit") activates the hunch or intuition response
from him or her. If you compare the brain of a discretionary trader to a
neural network the hunch finds its direct expression in the output
neuron. The similarity between the process of falling in love and
experiencing a hunch is probably behind such market advices as "do not
marry your trades" or "do not fall in love with your trades". To stretch
the similarity further we can compare a stop-loss order to the practice
employed by some of the married couples called the "boundary". The
boundary is the some form of behaviour unacceptable to the other spouse
which if violated will lead to the end of relationship. Yet another
analogue is between adding to a losing position and trying to win a
favour of an unloving partner - the more you invest the harder it is to
let go and the more likely you are to end up destroyed financially
(emotionally in the relationships). As a final comparison the neural
networks allow to model the connections among the ideas in the human
mind in a similar way that a website through all its external and
internal links permits to express the specific mental idea-network of
its creator.Quote: "I use all forms of technical analysis, but interpret
them through gut feel. I do not believe in mathematical systems that
always approach markets in the same way. Using myself as the "system," I
constantly change the input to achieve the same output—profit!", Mark
Weinstein in Jack D. Schwager's book "Market Wizards".Note: It should be
marked that the effectiveness of your model will always be only as good
as the inputs that you give or "feed" to it (as someone said - "Garbage
in, garbage out"). This is because computers merely extend your pattern
recognition ability and cannot be relied upon to think up a winning
system on their own - if this was false, the markets would have been
cornered long ago by the guy with the most powerful computer.2.3.3.
Optimizing the Parameters of the Analysis Tools used to Produce the
SignalsSome forex charting packages (e.g. TradeStation) permit to
optimize the parameters of the technical indicators that you use in your
forex trading system. Optimization allows to find parameter values of
your indicators that result in the biggest profit (most frequently used
measure of system performance in optimization) from the trading system
over the past data. An good example of the optimization is looking for
the best time-period parameters for a two-moving-averages crossover
system. Commonly the periods of two moving averages are stepped from 1
to 50 in steps of 1 and the trading results for each of around 250
moving average combinations are recorded and then sorted to find the
most profitable combination. Such process of going though all possible
parameter combinations is called brute force optimization. As the number
of indicators used in your system increases arithmetically the number
of potential parameter combinations increases geometrically. The total
number of parameter combinations is, therefore, said to be subject to
combinatorial explosion. For example, to optimize a system with 5
indicators each of which has 50 different parameter values you would
have to cycle through 312 500 000 (50^5) possible parameter
combinations. The only way you can expect to quickly solve such huge
optimization problems in your lifetime is through the use of generic
optimizers (e.g. OptEvolve for the TradeStation or NeuroShell Trader
Professional).Optimization of the time-period parameter of the
cycle-based indicators like Stochastics permits to automatically adapt
them to the cycles present in the market instead of using the default
time-period values - which is the method originally used by the
developer of Stochastics.As a final note, try not to over optimize your
indicators because majority of the professional forex traders use
default indicator settings. You are looking for trading setups where the
smart money will be acting (as opposed to the general investor public)
so it doesn't make much practical sense to use indicator settings that
hardly any professional forex trader is aware of.2.3.4. Backtesting and
Forwardtesting the System over Historical Price Data.Backtesting allows
to see how your system would have performed if it was run during some
period in the past. You optimize indicator parameters using the price
data in the backtesting period. It is crucial that the time period that
you backtest your system on is representative of the currency pair that
you wish to trade - it should include all types of market conditions
(trending, rangebound) and it should be as recent as possible. Once you
are comfortable with the performance of your system you forward test it -
you run it on the out-of-sample price data (the price data that would
be immediate future to the backtesting period). This way you can see if
the system is able to perform likewise to the way it did during the
backtesting. The closer the system's performance during the forward
testing is to its performance during the backtesting the more robust the
system and the more assured you can be that it will continue to trade
in a similar manner during the real-time trading. You could also wish to
trade your system on a forex demo account for some time before
beginning to trade it with the real money.Backtesting aids the trader or
investor to determine if they are prepared psychologically for the live
trading of a forex trading system. By examiningthe past performance of a
system they can decide if the size of the drawdown, the number of the
consecutive losses and the average duration of the trades are acceptable
for them. For the complete list of the performance measures that you
could wish to review before starting to trade with
professionally-created mechanical trading systems please visit the forex
signals page. In contrast to the mechanical trading systems the
discretionary trading systems cannot be backtested because the
discretionary traders cannot guarantee that they will react to a similar
set of signals in the future in the same manner that they did in the
past.2.4. Implementation of a Forex Trading System.There are two ways
you can implement a forex trading system - either manually or
automatically. Discretionary trading systems can only be followed by the
manual placing of the trades. Mechanical trading systems are better
followed though the use of automation.If you are following a
discretionary trading system you will be generally screening the
currency markets for the signals that you have outlined in your
checklist. The checklist is the description of the technical or
fundamental trading signals that your trading system's rule-set operates
on. The checklist could also contain the guidelines on how often you
should check your forex charts/forex newswires for the signals (using
the economic news calendar provided by the forex newswires as your
fundamental signal timing tool); in contrast, the mechanical forex
trading systems will be going through their own checklists with every
second, 24 hours a day - which no human being can possibly do. Having a
elaborate checklist will help you to be more disciplined in the
application of your system. It is better to write your checklist in the
form of the questionnaire. You can automate your search for some
technical signals with the help of those forex charting packages which
allow you to set up the sound or email/SMS alerts to notify you whenever
the technical signal of your interest is generated (e.g. in
Intellicharts). The forex bank reports and the forex newswires
frequently issue mini reports of technical conditions on the market
which most often are merely the "filled-in" versions of the same
checklist.Manual implementation of the mechanical signals is NOT
recommended. Since the signals are generated by the computer you will
always feel compelled to double-check them against you own experience -
since no computer can model your thinking with 100% accuracy. This can
lead to the delays and/or missing of some of the signals which can
potentially undermine the system profitability, that rests on the
principle of taking each signal exactly at the time it is generated. A
lot is being said about the widespread lack of the discipline in taking
the signals of the mechanical forex trading systems. This trouble can be
easily overcome though the use of a reliable signal automation service.
You solve all emotional troubles associated with the manual trading of
the signals by simply automating this process. Elimination of the
emotions from the trading through the use of the automated mechanical
forex trading systems should explain their popularity amidst the
multi-billion dollar hedge fund industry.An crucial aspect of mechanical
system trading is the monitoring of its real-time performance. The
concealed market dynamics (a particular way of reacting to technical or
fundamental signals that an important grouping of forex market
participants shares - or, systematic mass investor impulsiveness) that
your system has captured during the back-testing may be switching or
might already have changed at the time you start to trade your system
with the real money. The single way you can say that the market dynamics
that you are focusing on have changed or not is to compare the
real-time and the past system perofrmance. If the system continues to
perform like it did on the backtesting then you can conclude that the
market dynamics it targets have not yet changed. If you notice important
deviations in such system performance measures like the maximum
peak-to-valley drawdown, the average duration of trades, the average
value of the profits/losses, the maximum number of consecutive
winners/losses, it can signal that an important shift in market dynamics
is taking place (e.g. a group of investment banks have modified their
trading models). The fastest way to update your system to the changes in
market dynamics is available for the neural network packages - which
allow to retrain your model over the most recent price history.
Retraining a neural network involves readjusting its matrix of weighs
which allows it to stay attuned to the current market conditions. If
mechanical trading systems suffer form the paradigm shifts on the market
- the same can be said of the human mind (discretionary trading
systmes) which tends to be very inflexible once a partciluar way of
doing things (i.e. trading style) is ingrained in it.2.5. Mastering
System Trading.To master system trading you ought have the patience to
wait calmly for the entry or the exit signal from your own forex trading
system and act only on them - irregardless of the technical or
fundamental conditions that you see in-between these signals. It is no
wonder why the best traders prefer to compare themselves to skilful
predators when they describe their trading style:Quote: "Top traders
love the hunting metaphor to describe what they do. One of them, for
example, claims he is like a cheetah. The cheetah can outrun any animal,
but it still stalks its prey. It won't attack until it is right on top
of its prey. In addition, the cheetah usually waits for a weak or lame
animal to get close. Another top trader told me that he trades like a
lion. He watches the herd for weeks until something other than his
presence causes the herd to panic. When the herd panics, he then chases a
weak or lame animal that appears most confused. The difference between
an average hunter and a really skilled animal like the swift cheetah or
the cunning lion is that the skilled hunter waits until the odds are
overwhelmingly in his favor", from "The Ten Tasks of Top Trading" by Van
K. Tharp.Quote: "Much of the time, even professionals don't have a
clear picture of what is going on, but they have learned to have the
patience to wait for select, specific setups. You must learn to trade on
only the most recognizable and reliable patterns." from the "Street
Smarts: High Probability Short-Term Trading Strategies".The most
important rule of systematic trading is to take each and every trading
signal that your system generates. Only by taking all the signals at the
time they are generated can you count on replicating the past
performance of your system. If you have the slightest suspicion that you
will not be able to take all the signals - either due to the timing of
the signals or your busy schedule - you should arrange for the signals
to be automatically traded.At the end of the day, a forex trading system
just like the money management system serves to protect yourself from
your own destructive tendencies which very often mask themselves as the
"well-meaning" hunches and gut responses. This doesn't mean that you
shouldn't trust your instincts - only that you should base your trades
on them only if you can eliminate emotions from your decisions. This is
because a trading system is a method to profit from other traders'
emotional instability, therefore, if you do not control your own
emotions you will not be able to profit from any system. Removing the
emotions from your manual trading can take years (!!!)- so it can be
more practical and profitable to simply autotrade your system.Even if
you start your currency trading career by following a professionally
created forex trading system you will receive full satisfaction from the
trading - in terms of profit and self-actualization - only if you make
and trade a successful system of your own. One of the best books which
can help you to start this fascinating journey is "Mechanical Trading
Systems: Pairing Trader Psychology with Technical Analysis" by Richard
L. Weissman.Quote: " In the meantime, it cannot be emphasized enough
that, at the very least, genuine success in trading markets involves the
adoption of a trading system. Without the discipline of such a system,
the very best efforts are likely to be doomed to failure." Tony Plummer
in his book "Forecasting Financial Markets: The Psychology of Successful
Investing".There are no certainties in the forex trading, since the
future will never be exactly the same as the past. There are only
probabilities, which you can systematically put in your favour with the
help of a established forex trading system .
