How many types of trading systems are there?

Google this question and you will get several answers. Amazingly – there is no agreement on this question. It appears the answer, as in beauty, is in the eye of the beholder. This is because different authors put different trading systems into different size buckets.

One author had only two trading systems – Technical and Fundamental. This author put all trading systems based on price movements, chart patterns and technical indicators into the same bucket. Another author also said there were two types of trading systems, but that the two types were “Trend following” and “Counter trend”. A third author classified “Breakout” trading systems into three different buckets. This author classified price breakouts, volatility breakouts and band style breakouts all as different.

So Really – How many types of trading systems are there?

First – while some aspects of fundamental analysis can be quantified down to a trading system, these types of systems can not be tested using the normal data available in most trading platforms.  William O’Neil and Investors Business Daily’s CANSLIM system is a combination fundamental/technical analysis trading system.  It’s a good system, but it’s impossible to test by simply using the standard Open, High, Low, Close and Volume data – because – there’s more to the system.  Fundamental analysis does provide the basis for a type of trading system.  It’s the type of trading system that might be preferred by a trader who wants multiple reasons for their trading decisions.  But for me, the fundamental analysis bucket has only one type of trading system – the type I can’t test.

That leaves us with the very large technical analysis bucket – a bucket way to large to be considered one type of trading system in my opinion.  In the next section, we’re going to give you another way of thinking about trading systems.

Trading systems have personalities
Here are a few:

Trading systems that go for regular methodical income, but no home runs

These are the types of trading systems that work well when a market is  range bound.  They tend to signal to sell when a trade approaches the top of its range or has already begun to retreat from the same.  The reverse applies to the buy signal near the bottom of it’s range. Support and resistance areas are often important for these types of trading systems.  Swing trading would fall under this category.

Trading systems that go only for the big trades, but they know they won’t capture it all

Many of these are what are normally termed as Breakout(Breakdown) trading systems.  Breakout trading systems typically refer to “Price Breakouts”, meaning new highs or new lows.  Breakouts are a type of “trend following” trading system, but since the buy signal doesn’t occur until there is a new high, the system doesn’t try to catch the beginning of a trend.

Trading systems that really like to roll the dice, go for the entire swing, bottom to top, top to bottom

Have you ever heard of trying to catch a falling knife?  There are trading systems out there that try to call the “Bottom” or the “Top” of a market.  The lure of these systems is that when a stock has fallen fast, there will be a significant bounce – thus an opportunity to make some fast money.  These trading systems are referred to as “Reversal” systems and they are “Counter Trend”.  You will need a strong stomach for these types of systems since you will almost always be fighting normal human nature. In our article The Success Rate Of A Trading Setup – The Hammer, “The Hammer” is a reversal type setup.

Then there are hybrid trading systems.

Let’s say you like the thought of big trades, but you don’t like to pay full price, you like a bargain. So how about if we use a price breakout type system, but like a swing trading system, you wait for a “Retrace” in the hopes that you will pay less than the price you would have paid buying right at the “New High” breakout.  Or you use a swing trading system, but when your system tells you to sell, you only sell half intending to ride the other half of the trade until the trend ends.  Get the picture! You can mix and match.

Selecting The Right Trading System for You

Are you beginning to see how a trading system might best suit your personality?  Now that you can see a particular trading system can have a personality, you must decide what type of trading system you will be most comfortable with.  All to often new traders go into the financial arena with really big ideas – visions of money floating down from the sky.

These thoughts of grandeur come from various sources

• A friend who did well on a particular investment
• Those penny stock flyers and other ads quoting spectacular returns
• Your own imagination and lack of understanding

Please, please, please – get these thoughts out of your head and get your feet back on the ground.

Not quite sure how this blog will ever become popular “Telling readers about the things they don’t want to hear” – but honestly, reading our blog will help you hang on to your hard earned money. And maybe even make a little in the process.

An easy way to verify realistic expectations for your trading results is research the results of the pro’s.  The book Trend Following by Michael Covel has about 60 pages in the book’s appendix reprinting monthly and yearly results of some of the worlds “Super Traders” – I highly recommend you get this book, if only to help you get your expectations back down to earth.

Once you understand 20% is a really good return for a trading system, and for your trading, you will be in a much better position to decide what type of trading systems might work for you.

In future articles we’ll discuss the trade-offs between your position size risk and your trading system’s average rate of return. This trade-off might make a trading system easier to live with based on your personality.

So how many types of trading systems are there? Does it really matter? Simply try and find a trading system that matches your personality.  However, for those of you who want our answer: Regardless of foundation – fundamental or technical – we believe trading systems have 3 basic personality types 1)Swing 2)Breakout or 3)Reversal.

You Like? Please share! Questions? Put them in the comments below so everyone can learn. Thanks, Gene