A trading system is simply a program composed of a group of instructions that are responsible for opening or closing trading positions based on the results of technical analysis. One of the main advantages of trading systems is that they simplify the process of making decisions, in addition to excluding randomness from the trading process. Strict commitment to the system is also helpful in isolating the emotional factor from the trading process, and that’s why the trader must comply with all signals of the system even if they don’t result in opening “possible” profitable trades.
The first step the trader is supposed to take when constructing a trading system is choosing the time periods which he will work through. Short periods are characterized by lots of “noise” compared to long periods, also, the long-period technical analysis gives healthier results than those of the short-period analysis, and the technical analysis usually provides fewer false signals on longer periods, consequently, long periods are better than short periods in terms of successful application, but it requires more capital. Accounts with small or normal balances should not use all the money on long-period trading only, it is better to start working on intermediate periods first because the daily price fluctuations may be difficult to predict, besides, the value of these fluctuations may be significant enough to actually fully liquidate the account, and that’s exactly why the first rule in preparing trading systems is to determine the appropriate time frame for trading. There are a lot of limitations in this regard due to many factors like the size of the account, methods of capital management and the trading strategy itself.
The second step is to determine the analytical tools that will be used in all chosen time periods independently and separately. Short-period analysis must be strict as much as possible to avoid false results. Based on that, comes the third step to identify entry and exit points with the help of technical and pattern analysis. Generally, in all trading systems and regardless of the analytical tools used, the analysis process should start from the long time frames down to the shorter frames as it helps determine if there were appropriate trading conditions in the market. For example, if the trade is based on the trend, we should determine the general trend first, and if the system gives us a signal to buy or sell using the long time frame, then we are supposed to confirm the signal and try to determine the optimal entry point by analyzing shorter time frames.
Forth, market conditions are analyzed using periods for those of the trading system, to end up analyzing the whole operational time-frame. This step is taken to reduce the possibilities of trading in the wrong timing and to ease the psychological factor of the trader’s confidence in his trade and his system.
Finally, the trading system is not just signals to open positions, it must provide the trader with all expected levels of return, as the take profit orders will be placed at these levels. It is also necessary to be able to determine the stop loss level proportionally with the expected return. In short, the trading system must assist in determining all levels of take profit and stop loss.