Six Basic Elements of a Trading System

To answer this question – let start with what the basic elements of a trading system are:

• The Financial Market it’s designed for

  • the market volatility, financial instruments  (equities, commodities, forex)

• Time Frame for trading system

  • day, short-term, intermediate-term, long-term

• Entry Signal

  • complete description of the entry signal and entry timing (immediately, next day, etc)

• Exit Signal – Exit at a loss

  • describes stop loss, stop loss method and exit timing (immediately, next day, etc)

• Exit Signal – Exit at a profit

  • describes successful end of the trade and exit timing (immediately, next day, etc)

• Position Size Algorithm

  • how to determine how much money you will risk on this trade

Now, there are more elements than this to actually designing a trading system and for someone to actually choose to use a trading system they would want to know all about the probabilities – BUT  – for someone to successfully execute a trading system, the above elements are enough for anyone to execute the trading system.

So Let’s Talk About the Entry Signal

“Buy Low and Sell High” – That’s the way to sure profits – That’s what they tell us!  Well, doesn’t that magic formula require that a trading system describe a minimum of two things – 1)When To Buy and 2)When to Sell.  Yet over the years, as I’ve sought out information on trading, everyone always talks about the Entry Signal.  If you’re talking to a Contrarian, they talk about getting in when it’s the toughest, when everyone else is getting out.  If you’re talking to a Technical Trader, they talk about getting in when this line crosses that one or this bar goes above such in such. But no one really spends much, if any, time talking about exits.

There are a couple of reasons why I think entry signals are over emphasized.  First, it seems to be more exciting to talk about entry signals because you always get to look at a “great chart in the example illustration”.  The example is always this wonderful V and there’s always an arrow pointing to the bottom of the V where the entry signal was triggered.  Enough said, now your imagination can take care of the rest.  And here’s where my second point comes in – if you don’t have another arrow pointing to where this system would have exited, your mind will actually assume that you would have exited at the very top!!!  Try it, look up some trading system, definition of a technical indicator, a chart in an old book – if it points to an entry signal, but no exit signal – Where does your mind think you will be able to exit from that trade?

The Exit Signal

Again, the magic formula says – “Buy Low and Sell High” – so you have to have at least one Exit Signal - it’s the second half of the magic formula.  The exit signal can take many forms, and a particular system can have several exits signals in place at the same time.  In the first system I ever designed, there was only one Exit Signal, it was a trailing stop that (in a long trade) would go higher over time as the price of the stock rose higher, but would never decrease.  The trick was to use a stop price calculation that would give the price action enough room to move and would only trigger when the price decrease was large enough where most trades would not recover and continue upward if left alone.

So, Entry Signal or Exit Signal?

Okay, so now we’re to the crux of the article – Which is more important, Entry Signal or Exit Signal?  It’s the Exit Signal.  While, the entry signal and the exit signal go hand in hand and neither makes much sense without the other, it’s the exit signal that I feel is the winner by far.  Most traders don’t have much trouble understanding when to get out of a trade when it goes against them right away and hits their stop loss.  The real trouble comes when the trade actually goes in their favor.  When a trade goes in your favor, you need an exit strategy to allow enough room for normal price action, but that will be triggered when there’s trouble.  Without a decent exit signal you can watch your profits disappear in the hopes a price retreat is temporary.  Unfortunately, before you know it, the price has gone too far south and now you have that sinking feeling – and you really wish you would have had that exit signal.

You MUST have an exit signal designed for when the trade goes in your favor, even if it doesn’t get triggered for a long time, because sooner or later it will get triggered.  This doesn’t necessarily mean you need a “target price” for an exit, often that type of strategy will cut your winners short (remember, let your profits run), but it could simply mean a trailing stop as I’ve described previously.

Can a System Be Profitable with a Random Entry Signal?

In the book “Trade Your Way To Financial Freedom” by Van Tharp, the author describes how a trader performed a random entry test, where a coin flip determined whether the trade was long or short, the risk formula was 1% and the exit signal was provided by a trailing stop.  This simple system made money in all versions of their tests.  I guess that’s one way to prove that entry signals aren’t as important as you might think they are.

You can find the complete description of this trading system test in Chapter 9, “Entry or Market Timing” of Van Tharp’s book.  Although I’m not real keen on the name, “Trade Your Way To Financial Freedom” is a book that will walk you through how to develop your own trading system and I highly recommend it.

Any Comments? Entry Signal or Exit Signal?

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