Principal components of a trading system

All trading system have three major components:

1. Entry and exit (filter optional).

Trading strategy overview

Entries and exits are the engine or driver of trading in a strategy. They can be very simple or extremely complex. They can be filtered by one or many different elements. An entry can be at a specific price level or at the market or on the open or close. A trading strategy can employ more than one entry or exit. It can use one method to enter a trade and an entirely unrelated method to exit. The variety of entries and exits is really without bounds. A strategy typically consists of buy-and-sell conditions that mirror, or are the opposite of, each other. For example, a buy signal occurs when price rises through a three-day high and a sell signal occurs when price breaks through a three-day low. This is an example of what is called a symmetrical trading strategy.

A strategy can also consist of completely different buy-and-sell entry conditions. For example, abuysignal occurswhenafive-day high is broken and asell signal occurs whenafive day moving average falls below a 20-day moving average. This is an example of an asymmetrical trading strategy.

A trading strategy may include risk management in the form of a stoploss order. Risk management is a way to limit the amount of capital at risk during the life of a trade. A typical risk management approach is to set a stop-loss order that is the maximum, yet subject to slippage, loss to be taken on a trade. For example, assume that a long position is initiated at a price of 1,495.00 in S&P futures. The strategy calls for a maximum risk of $1,000 or 4.00 points. Therefore, after the position is entered, a protective sell stop is also entered. If our risk is $1,000, or 4.00 points, then our sell

stop will be 1,491.00 (1,495.00 – 4.00).

A trading strategycan also include profit management. This is a method of protecting the open equity profit that must develop during the life of a winning (and sometime losing) trade. A typical profit management approach for a long position is to set a trailing stop at a fixed dollar amount

below an equity high, that is, the highest price achieved during the trade.

Assume a strategy that calls for a trailing stop of $2,000, or 8.00 S&P points. This point value will trail under progressively higher prices during our long position. Assume that the long position is entered at a price of 1,390.00 and an equity high point of 1,410.00 is reached on the fourth day of the position. A sell stop is entered at 1,402.00 (1,410.00 – 8.00 points). This locks in

a $3,000 profit, subject to slippage (1,402.00 – 1,390.00).

Another type of profit management is the target order. This is a more proactive or aggressive way of capturing trading profits. A typical approach to the target order is to place a price order at a price above or below the position price. Assume a strategy that employs a $2,000, or 8.00 points,

profit target. A long S&P position is taken at 1,375.00. A price order is then entered to sell at 1,383.00 (1,375.00 + 8.00 points). If the market rallies to this price, our sell order will capture a profit of $2,000.

Trading system as entry and exit

A trade is composed

of at least one buy and one sell. A trade begins by entering, that is, taking a position in, the market either by going long (buy) or going short (sell) and ends with an equal and opposite offsetting or liquidating trade that closes the trade out. For example, a long trade starts when the trader buys ten

contracts of S&P index futures and ends when he sells ten contracts of the same future. A short trade takes the opposite course.

A trading strategy with a positive expectancy enters the market on a condition(s) that has proven itself capable of identifying an opportunity to make a trading profit. Such a trading strategy will exit the market when there is nothing left to be gained in the current trade.

theperfect entryisonethatalwaysoccurs

atthebest price(thelowestbuyandhighestsell)andproducesaprofit.The perfect exit extracts the last dollar of profit from a trade. Of course, any trader knows this is a perfect ideal and impossible to attain in practice. It is valuable, however, to hold this concept in mind as a guiding principle when designing a trading strategy. Let us now get into some details, definitions, and examples.

Definition: An entry rule initiates a new long or short position. An entry can occur only when the system has no current position, or is flat. Some examples of buy, or long, entry rules (sell, or short, entry rules are the opposite) are:

A 5-day moving average crosses from below to above a 20-day moving

average;

The Relative Strength Index closes below a reading of 20;

The daily close rises by 1 percent and the weekly close rises by 1 percent;

Today’s close is higher than yesterday’s close plus 50 percent of the daily range;

Today’s close is higher than the previous three closes

Definition: An exit rule closes out a current long or short position. An exit can occur only when a strategy has an open long or short po-sition. A symmetrical trading strategy exits its trades on an opposite entry signal. An example of an exit from a symmetrical moving average trading

strategy that uses opposite entries is:

Close out, or exit from, a long position when the 5-day moving average crosses from above to below the 20-day moving average. A trading strategy can be reversing or non reversing.

Definition: A reversal rule closes out a position and initiates a new and opposite position.

Of course, a reversal can occur only when there is a position. A reversal is an exit of the current position and the entry into a new and opposite position. The current position is exited and enters a new and opposite position. An example of a reversal rule is to close out the current long position

and go short when the 5-day moving average crosses from above to below

the 20-day moving average.

A trading strategy that reverses position on every new entry will, of course, always have a position in the market. Of course, a trading system can have rules that make it reverse only under specific conditions. Under other conditions, it will use the new signal to exit the position.

A trading strategycan also be non reversing. In other words, it uses an opposite entry, or some other rule, to exit the position. Such a strategy will then wait for some other rule signal to initiate a new position. A non reversing rule is simply an entry or some other rule used as an exit rule as defined earlier.