Step 3a: Develop a FOREX Trading System Part 1

To develop a decent FOREX Trading System is quite easy, sticking to it a different issue. In this step we will start developing a FOREX Trading System that you can actually trade profitably later on. There is no magic involved, you just need to know the different components and assemble them in the correct way.In this and the next Step, we will build a Trading Plan, entering the parts step by step.

The data available in spot FOREX is only price, as opposed to stocks, futures etc. where we also can access volume data. If your data provider is supplying volume data, which is rarely the case, it is likely to be tick volume, i.e order volume (not contract volume as with stocks and futures).

A FOREX Tading System is then limited to deal with price action only and we must here try to extract as much as possible from this data.

A trading system is made up of three components:

• Raw Price (Open, High, Low, Close)
• Indicators (Moving Averages, Fibonacci Retracements, Trendlines, RSI, Stochastic etc)
• Trade Management (Stop-Loss, Price Target etc)

From the above three components we construct Entry and Exit Rules. Some traders work only with one entry and one exit rule, and others have several. Some have complex systems where each rule has several conditions that must be fulfilled, others just one basic rule. During my years as a trader I have found that simplicity is preferable. Do not try to complicate things to much, you are breeding confusion and frustration and this is very counterproductive. I assume you prefer to get started sooner rather than later, thus simplicity is the way to go.

Now we take these components and assemble them into a FOREX trading system. Our criteria of success is of course profitability. But before we start looking at how we will put it all together it is important that you thoroughly think through what kind of trader you are and the time available. If you have a full time job then you can realistically only trade daily bars. If you are located in North or South America, you could go up early in the morning and trade the London session until 09:00 EST. If you are located in Asia or Australia you could trade the London session starting at 19:00 Tokyo time. Yes, I know FOREX is a 24 hour market, but by the time you get home from work the best trading hours a likely gone and the market will be prone to manipulation, thus putting you at an immediate disadvantage.

Further any FOREX Trading System usually have to make a compromise between high winning to losing trades ratio or high dollar winning average to losing average ratio. Basically, you have to choose a system that either has many winners and small profit per trade or a system which has few winners but when it wins it hits the jackpot. Psychologically it is much easier to deal with a system with many winners and it is preferable for a novice to start with such a system. Do not underestimate the psychological strain trading can create.

It would be possible to construct a FOREX Trading System solely from raw price data, for example a system using raw price velocity. I am certain that someone is trading profitably using such an approach, but it can only be done through a massive amount of experience. Thus it is not recommended for novices. Even long before the advent of personal computers, traders were using simple indicators to help them determine entry and exit points. Then trendlines, moving averages and support & resistance levels were common tools to create rules. By the late 70-ties such studies as RSI and Stochastic had appeared and since then we have not made much progress in terms of how well these indicators model the market. Any of the indicators now available in most charting packages can be used in developing a profitable FOREX Trading System.

Developing a FOREX Trading System is like putting together a jigsaw puzzle. By finding the parts that fits each other we will in the end have a holistic view of the market instead of just bits and pieces without much sense or meaning. Each part must fit the others, but contrary to a jigsaw puzzle perfection does not exist and to strive towards perfection is pointless. Trading is not an exact science. We need instead to find a fair approximation of the market that is workable towards our goal of consistent profits.

In the beginning of this course I mention my three Pillars to Profits. Remember Pillar number one - The Right Trading System? What we want is a FOREX Trading System that produces consistent profits assembled from the three components referred to above. If you are reading this, you should have all the required knowledge to put together one yourself.

Here are some points to consider:

• Keep it simple (as few indicators as possible).
• Use indicators that complement each other.
• Expand the system by adding trade set-ups, not indicators.
• Learn to filter out fake signal by experience, not by adding an indicator as filter.
• Put twice the time and effort into your Trade Management rules compared to Trading System rules.

The Forex Trading System presented in the next Step is fairly complex. I have done it in this way for educational purposes, so that you will get an idea of what is possible. It features three different trade set-ups with several rules that needs to be fulfilled before a signal is generated. If you want to trade that system, focus on one trade set-up at a time. Become an expert at that particular trade set-up and only then proceed to learn a second trade setup. Capice?

Tip: Almost without exception, traders come to trading from being employed or start trading as they are employed. As I mentioned in the previous step, employee mentality can be a severe obstacle to consistent profits. Why is that? Well, first of all an employee not performing 100% still gets his paycheck at the end of the month (or whenever you are paid). Not so in trading – bad performance means loss of income or even worse (negative income). Second, an employee usually lives from paycheck to paycheck, ie your life runs on a monthly (or biweekly) basis. This is dangerous practice in trading – you need to look at each and every trade as an integral part of a business, a business with income and expenses. Third, since trading is a business, we are not looking to be right when we trade, but rather to make good trades executed according to our written and validated plan or system. If we make a losing trade, but it was executed exactly according to our written and validated system, then that is still a good trade. May the good trades be with you!

Action Step: In the previous step we focused on raw price data and its behavior related to moving averages and an oscillator. In this action step we will focus on an oscillator of your choice. You should by now have fiddled around with a few different oscillators in order to learn which appeals to you the most. The appeal is very important. If you like the oscillator you are definitely more inclined to stick with it for an extended period of time. It takes time and effort to study and learn the intrinsic behavior of an oscillator. If you don't know the minute twists and turns of your chosen oscillator, how will you be able to trade it successfully? All of them have advantages and disadvantages. At the end of the day they are all about the same (derived from the same data), but the appeal to you might be different because of your personal trading style. I also suggest that you take a look at the graphical tools offered by your software. Perhaps you like to use graphical tools more, like Fibonacci levels or Gann fans, than oscillators. It is imperative for your success to know your trading style and what tools you prefer to use. If you have traded for a while and you are losing money, this could be an area you have overlooked.

Go to the next part, Step 3b.


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