Characteristics of a Sound Trading methodology
  and System

By Dr. Ned Gandevani, Ph.D.

Studying successful traders reveals that they all have a trading system. Jack D. Schwager in his book "Market Wizards", identifies a set of "common denominators" shared by top traders. Among them, he writes: " Each trader had found a methodology that worked for him and remained true to that approach." It is significant that discipline was the word most frequently mentioned [in his interviews with successful traders.] Success in trading is based on two particular pillars; Methodology (or System) and the Trader’s Psychology. These two factors are so intertwined that they create a virtual circle. A better trading methodology and system will result in improving the trader’s psychology and self-confidence. A better psychology will help the trader adhere to his/her methodology which will consequently create better results in the trader’s performance. It’s difficult to build a successful trading environment with only one of these pillars. An opposing and undesired reaction is also possible in the trading virtual circle - poor trading results may occur when a trader’s method is not compatible with his psychology. Poor results can discourage a trader from being consistent with the application of his method and might discourage him from acting on all system created signals, thus creating lost opportunities and unfulfilled expectations, which in turn would reduce the trader’s self confidence. It is therefore imperative that a serious trader consider both of these crucial trading pillars before he or she engages in trading activity.

What is a Trading Methodology or System?

Whether you decide to employ a subjective methodology or a mechanical system (either basic rule-based or advanced machine-intelligence-based ), when selecting or creating a trading method you should consider the followings topics: Entry Point, Exit Point, Money Management, Market Focus and Personalization of the Method.

Entry Point - The entry point is based on a particular time or price where the trader would initiate his trading position in the market. Entry points are created based on a set of rules or calculations that are determined by the trading method. A trading system should tell us the precise point where we should enter the market. This entry point could be either based on a particular market set-up, a signal, or a hybrid of these two. An entry point is a crucial and integral part of any trading system.

1. Market Set-Up - An entry point can be generated based on a market set-up or specific and quantified price pattern. For example: "when the close of the second bar is higher than the close of the two previous bars on a 30 minute chart, Buy at the open of the next bar." This rule for an entry point was generated by a specific market set-up. A market set- up can also be based on a price pattern or chart formation. "Buy the market at the break out of an inverted head and shoulder before 12:00 noon" would be an example of this concept.

2. Signal - An entry point can be generated based on a particular signal. We will define a signal as an entry point to Buy or Sell, which has been created by a computer program designed specifically for generating trading entries. In Trade Station signals are displayed by an upward arrow (buy) or downward arrow (sell), which is usually accompanied by an audible tone. A signal therefore, is generated based on a series of calculations or conditions in the market place which may include technical as well as market sentiment indicators. For example "if our 5 day moving average crosses over our 10 day moving average we place a buy order."

3. Hybrid of Market Set-Up and Signal - An entry point can be generated by a hybrid of a signal and market set-up. For example, enter the market when you get a signal from your mechanical system and a confirming chart formation. A moving average crossover might give the trader his signal, while the double bottom chart formation gives him the market set-up confirmation to then enter.

Exit Point - The exit point is a trading method’s criteria to exit the market and close out the existing open position. Before we enter the market, we should be aware of where our exit point will be or what will cause us to exit our position. This can be accomplished based on one the following:

1. Target Profit - Our exit point can be linked to a target profit. In other words, as soon as we make our intended profit, we can exit the market. The target profit should be a derivative of our risk-to-reward ratio. The risk-reward ratio is a predetermined amount of how much we are willing to risk versus how much we want to make. A ratio of 3:1 would imply that we are willing to risk no more than one unit when attempting to make at least 3 units. This ratio should be based on your own observations and experiments, as well as psychological requirements. Without a properly set ratio, the game of probabilities is hard to win. To better assess the profit potential in a market, we need to study that market and set our profit target based on its potential. For example, the bond market’s daily fluctuation is usually about 16 ticks. It would unrealistic to set our target profit for one full point (32 ticks) while day trading. In the case of the S&P market, the daily average swing between its high and low is about 10 to 12 full points. Of course, there are exceptions on certain days when volatility causes extreme price ranges, but we can’t base our methodology on the extremes.

2. Stop Loss - An inherent part of the trading process is loss. Some of our trades will be winners and others will be losers. But we want to make sure that we don’t risk our total equity capital on one or even just a few trades. That’s why we place a stop loss exit point for every trade we take. We can have two types of stop losses. One is a monetary or Price Stop. In this type of stop loss we decide on the amount of money we’re willing to risk for our trade. This dollar value can be as little as one tick or as big as our total equity capital. The monetary stop can also be based on the average volatility (price range) of the market. Another type of stop loss is a technical stop. This is the type of stop that I prefer. Technical stops should be derived from proven technical indicators or market set-ups.

3. Abrupt Change - It always amazes me to know that many traders will open a position and then leave it unattended until they get stopped out or make a profit. They take a very passive approach towards their positions. If they don’t make a profit, they’ll just wait until the market hits their stop. The astute trader will observe any abrupt changes that occur in the market and act accordingly. An abrupt change in the market will certainly give rise to new or different stop loss plans. If we see that market conditions change (volatility for example) we should exit our trades immediately, regardless of any loss or profit. At this point profit or loss doesn’t matter - we must simply get out.

4. Timing - After studying the character and internal dynamics of a market, one may learn how long it takes for a particular market to travel from point A to point B. With this knowledge in mind, we can determine if our position is making the appropriate amount of dollars per units of time, to determine if the trade is progressing at a speed consistent with our expectations. If our open position moves at an unacceptable pace compared to our past observations, we may have to exit early. This concept can be invaluable to our trading. On numerous occasions, I have exited a trade utilizing this type of timing technique, prior to the market hitting my technical or money stop point - resulting in a winning or break even trade, as opposed to a loser . I was able to retain money by monitoring the market through my timing indications. In some of the financial markets such as S&P’s, one can monitor market movements based on fractal movements. These fractal movements are the result of the general public’s (retail) thresholds of pain or pleasure. Since the majority of retail traders in the S&P market are undercapitalized, as the market moves one to two points for or against them, they jump out of their trades to cover with a small loss or gain. This constant flow of retail entry and exit activity has created a unique price fractal in S&P market. An astute trader can easily capitalize on this idea. Understanding this concept can provide you with easy and stress free trades that are quite profitable.

Money Management - When the vast majority of available trading books discuss the subject of money management, they usually refer to the use of protective stop orders. But I believe that money management in trading should be viewed from a different angle. In my opinion, money management should deal more with optimization of one’s trading account and equity. What I mean is that if someone has an equity of $10,000 in his account, he shouldn’t trade more than one contract at a time in the S&P market, assuming that the margin for day trading is not more than $8,000. But in the bond market, the same trader needs to trade at least 2 to 5 contracts, unless of course he does not possess a satisfactory confidence level in his trading system and methodology. A trader who overuses or does not properly utilize the available capital in his account is guilty of poor money management. Another important point about money management is that as one trades a system and assesses the resulting win/loss ratio produced, he should then adjust the trade size and stops to optimize return on investment. If for example you place one lot trades in the S&P and your account equity is about $7,000, you should not allow your technical or monetary stop to exceed more than $250 or so. If that’s not possible, then simply pass on the trade. There are plenty of opportunities in the market. You don’t need to take extra and unnecessary risks to be profitable. Look at trading as a long run endurance and not as a short-lived kamikaze attack. Don’t beat yourself up if you miss a good trade, because it is you and your system that perceive trade opportunities. The same market conditions might be perceived by many other traders as unfavorable. What this means is that if you’ve been able to recognize one good trade by following your trading system, then by definition your system will show and signal more winning trades and opportunities in the market. Money management also refers to full utilization of your money in your trading account. If you’re not able to fully utilize your money in the beginning, don’t let your money sit idly in your account - work it. Buy 3 or 6 month T-bills and let the account earn some interest.

Another important aspect of money management is to never leave excess money in your margin account. This surplus can be potentially harmful to your trading. When traders have extra funds in their account, they tend to become lax with their stop placement. They may possibly increase their stop loss amounts, with the justification that they need to "give the market room to breathe". Or, some might fall into "mental stop" trap. They simply don’t place any protective stop in the market with the justification that the "locals (floor traders) will run our stops and then the market will move in our favor". Following this train of thought can create a still bigger and deeper problem. As the market goes against their position, they begin to start hoping and praying for God’s mercy. Hope and fear are magnified with each minor tick that justifies or opposes the trader’s position. Anguish and jubilation are the emotions encountered with every price print. The end result is an extremely distressful trade. If by chance you made money on that type of trade, that gain can be your worst trading enemy and poison. Why? Because the next time you employ the "hope and pray" strategy, a losing trade may very well cause irreparable damage to your trading account. My advice is that as soon as you begin to "hope and wish" for the market to move in your favor, you should exit immediately. Hoping and wishing is the same as trading without a plan at all and must be avoided at all times. Therefore, money management refers to the methods of optimizing one’s equity through the proper utilization and preservation of trading capital, as well as the correct placement and employment of protective stop loss orders.

Market Focus - Contrary to a popular belief that one trading system and methodology should work in all markets, I believe that a good trading system is geared for one particular market. Each market exhibits its own behavior and internal dynamics, illustrated by its daily range, degree of volatility, overall risk and required trading capital. Your system or methodology should be a personal system which has been designed for your own mentality, psychology and market of choice. This is essential in order to trade your system consistently through both good times and bad. A subjective methodology is usually created by an intense study of a particular market. To apply the same subjective method to other markets, is to assume the premise that all markets behave in a like manner. Accepting the notion that all the markets behave in the same manner day in and day out, would eliminate the time factor, dynamics and conditions of every trading day and therefore ignore new and different market conditions and experiences. Furthermore, considering only price action in a market would negate your observations and research on a market’s internal dynamics. In my opinion, each market shares a set of characteristics common to its group member markets. A market will also behave uniquely according to its own unique internal dynamics. For example, although the S&P market shares a set of common characteristics with other financial market group members (like the bonds, currencies, etc.), its behavior is based on its own internal dynamics and personality. If interest rates change, the S&P would react almost in the same fashion as the bonds, since they are both a part of the financial market group. Components of the group will tend to all react the same way to external factors. However, the extent of reaction will be ultimately shaped by the S&P’s internal dynamics and indigenous factors. The inter-market relationship should only be considered with a long term perspective. Trying to utilize inter-market relationships for intraday activities would not prove to be profitable to a day trader in the long run. ( In future articles, I’ll discuss this point more in detail.)

Personalized System - It’s been observed by many good traders over the course of time that a successful career in trading depends more on the psychology of a trader, than the trading system employed. As a trader, you have to feel comfortable with whatever trading system or methodology you use. This comfort level can be evaluated by your system’s draw down, time consumption, number of trades and signals it produces and so on. In brief, to ensure the success of a trading system or methodology, you must select or create a system that is compatible with your personality and individuality. A system that is custom fit for you, is more easily adhered to, resulting in less "second guessing" or other discipline related problems.