A trading system is a set of rules that can be based on technical indicators or fundamental analysis. A trading system tells the trader when and how to trade. In many cases, a trading system is like a blueprint for trading.
A trading system is important for a trader because without it, there is no way a trader can expect to trade. Despite getting lucky a few times, one cannot expect to remain consistently profitable without following a trading system or a strategy.
Trading systems can be broadly classified into two types:
- Mechanical trading system
- Discretionary trading system
Everything else is either a clone of one of the above two. You can have a trading system based on technical indicators and you can also have a trading system that focuses on the fundamentals.
Mechanical trading system
As the name suggests a mechanical trading system is based on a set of trading rules. The trading rules are developed when several technical or fundamental indicators trigger a buy or a sell.
A mechanical trading system is the easiest to automate as there is not much of discretion involved.
A buy or a sell trade is initiated when the trading conditions are met.
An example of a mechanical trading system could be something as simple as a moving average cross over.
Now instead of having to wait for the 50 and 200 day moving average to trigger a bullish or a bearish crossover to buy or sell, a trader can simply code these rules into an algorithm which will constantly monitor the markets.
As and when the trading conditions are met, the appropriate trade is taken.
You can see in Figure 1, the stock chart for Apple Inc. (NYSE: AAPL). Here, the thick line is the 200-day moving average and the thin line is the 50-day moving average.
A simple mechanical trading system here would be buy on a bullish crossover and to either book profits after price moves a certain percentage or to exit after price moves a fixed amount.
Pros and Cons of a mechanical trading system
A mechanical trading system is good when:
- The rules are very clear and leaves no room for any discretion
- It can be easily coded or programmed
- It can be easily back tested to check the past performance of the trading system
- Traders can view the back testing and forward testing data to further fine tune the trading system
- A mechanical trading system leaves out any room for emotions and is purely based on logic
- There is no need for human interference for a mechanical trading system
A mechanical trading system is not always ideal in conditions such as:
- Uncertain markets where fundamentals can cloud the trading system’s ability to trade
- Using too complex or custom indicators or trading rules
- Coding or programming errors
- Curve-fitting the trading system to show favorable results on past performance
Discretionary Trading system
A discretionary trading system is where the trades are based on a mix of trading rules and experience. In some cases, discretionary trading systems can easily trump mechanical trading systems.
The discretionary trading system is comparatively complex than a rule based trading system.
Pros and Cons of a discretionary trading system
A discretionary trading system also has its pros and cons.
Trading with a discretionary trading system is ideal when:
- A trader is manually trading and analyzing the charts
- A significant amount of fundamentals play a role in shaping the outcome
- A trader needs to be adept in the discretionary trading system that they use
Many beginners to day trading often shun the idea of using a discretionary trading system and here’s why.
- A discretionary trading system requires years of practice so the trader is familiar with the strengths and weaknesses
- You can expect to take losses in the early stages of trading with a discretionary trading system
- Because there are no clear rules, a trader must focus on all the available information and gauge what the markets will do
The Auto-Trading system
The auto-trading system is no doubt one of the most popular ways to day trade. It can be particularly beneficial in certain markets such as futures which allows you trade on leverage with low margin requirements.
Since the market is nothing more than the emotional sum of its participants, an auto trading system will allow a trader to separate themselves from the noise and emotions.
Reviewing a Trading system
Whether it is a discretionary or a mechanical trading system being used, one must thoroughly examine the strategy. Presently, there are many solutions that offer to analyze your trading systems for you, giving you a detailed report on the pros and cons.
This is a huge timesaver compared to having to analyze the trading system all by yourself.
It is ultimately up to the individual investor to perform his or her due diligence on the trading system that they want to use.
The key thing to remember is to not only focus on the gains over a specified period of time, but also the maximum drawdown and risk exposure of the system.
For example, if a trading system that trades during a bear market is making a lot of profits when the markets are falling, it doesn’t mean much. The trading system should also be tested during a market uptrend as well.
Other factors to consider include understanding what assets to use the trading system on, and the time frame for holding the trades as well.
Remember, it’s not the system, but rather your blind belief in the strategy that will ultimately lead to success.