Trading Forex works remarkably easy. But you have to make your own trading system.
A trading system is created by generating signals, setting up a decision making procedure, and incorporating risk management into the system. A trading system is supposed to be objective and mechanical. The analyst combines a set of objective trading rules (usually in a formula or algorithm). As a general rule, good technical analysis indicators are the building blocks of good trading systems. However, as previously mentioned, even good technical analysis indicators can lose their validity when combined in a trading system. Therefore, it is important to not only back-test your system but to also forward-test your system in real time.
Pitfalls of Trading Systems
Trading systems are supposed to be objective and mechanical. They take the intuition out of trading. Buy when the system tells you to and sell when the system tells you to. The problem is that there are not a lot of good trading systems out there. However, some are created for certain institutions to take advantage of arbitrage opportunities, or tricky derivative strategies. They are not at all suitable for the average trader.
Traders tend to lose objectivity when using technical analysis indicators. The trader is not able to remain objective and the subjectivity of using the indicator overwhelms him.
Traders have a tendency to test their trading systems and technical analysis indicators on an insufficient amount of data. Analysts need to test trading systems and technical analysis indicators on a wide array of data in different types of trading markets.
Additionally, many traders and analysts don't forward test their trading systems and technical analysis indicators in real time. They rush to trade based on insufficient back-testing and forward-testing. Thus, they are trading on not a sound, valid basis. Many traders fail to incorporate sound risk management techniques in their trading systems. Additionally, many traders fail to incorporate stop loss orders with their initial orders when using technical analysis indicators only.
Traders also tend to over-optimize their trading systems. They start asking the what-if question and back-test the trading system with different parameters. They are always trying to trade with the parameters which generate the highest amount of wins. However, in real time these over-optimized systems rarely perform well. Another trap traders fall into is to use too many technical analysis indicators. Find the few that work consistently well for you and go with them.
There are basically two types of Forex trading systems, mechanical and discretionary systems. The trading signals that come out of mechanical systems are mainly based off technical analysis applied in a systematic way. On the other hand, discretionary systems use experience, intuition or judgment on entries and exits.
We will first analyze the advantages and disadvantages of each system.
| Advantages | Disadvantages |
| Mechanical systems | |
| This kind of system can be automated and backtested efficiently. It has very rigid rules. Either, there is a trade or there isn’t. Mechanical traders are less susceptible to emotions than discretionary traders. | Most traders backtest Forex trading systems incorrectly. In order to produce accurate results you need tick data. The Forex market is always changing. The Forex market (and all markets) has a random component. The market conditions may look similar, but they are never the same. A system that worked successfully the past year doesn’t necessary mean it will work this year. |
| Discretionary systems | |
| Discretionary systems are easily adaptable to new market conditions. Trading decisions are based on experience. Traders learn to see which trading signals have higher probability of success. | They cannot be backtested or automated, since there is always a thought decision to be made. It takes time to develop the experience required to trade successfully and track trades in a discretionary way. At early stages this can be dangerous. |
Now, which approach is better for Forex traders? The one that fits better your personality. For instance, if you are a trader that finds it hard to follow your trading signals, then you are better off using a mechanical system, where your judgment won’t play an important role in your system. You only take the trades that your system signals.
Your objectives and goals have to be very specific to you, but they must also include the following characteristics if they are going to be useful. They should be measurable within the allotted time frame and be worth the time and effort involved.
Here is a quick outline of a few actual objectives.
1. Create two new positive-expectancy trading systems each and every year.
2. Strive to make fewer errors implementing the trading systems each year.
3. Work to achieve a maximum return of (specific percentage).
4. Take 2 weeks vacation from trading during the year.
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