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How to develop your trading system?

First of all, let us ask ourselves. Do we need to develop a personalized trading system when there are tons of trading systems being marketed by successful traders?


yesterday, I was watching the final episode of season 4 of Cobra Kai on Netflix. In a nutshell, this show is all about personal conflicts between the karate dojos in a valley. One dojo named Miyagi believes in a defense-based approach whereas the other dojos believe in an offense-based approach. There is a karate competition happening and the dojos compete to validate their supremacy. Winning the competition comes down to a fight between two girls who have personal differences. In the previous episodes, Samantha, daughter of Sensei of Miyagi, learns also how to attack offensively in addition to the defensive techniques taught by her father.


Before entering the final fight for the championship, Samantha asks Sensei what techniques should she use in the fight. Sensei replies that he is proud of her for having developed her karate style ( offense and defense) and should trust her instincts to fight with conviction.



Photo by Tima Miroshnichenko from Pexels


Trading Mindset (60%)

What sensei said resonates with developing a trading system. Every trader is unique with his beliefs formed out of his experiences in life. As I mentioned in my new year's resolutions post, we take actions based on our beliefs formed out of experiences in life. For example, in the trading world, if you believe strongly in value trading, how would you be able to follow a system that is based on trends - where the price keeps going higher and higher.


Trading is an amazing vehicle and there are plenty of ways to trade equity especially with options. Some traders believe in income-based trades and only focus on selling options whereas others might believe in price action trading for more profits. Some traders only trade upside whereas some traders trade only downside but few traders trade both directions.


The point is there is nothing right or wrong as long as you have a system that is churning you consistent profits. But, the key is, we need to believe in this system and trade with conviction. How do we develop this belief? By staying long enough and figuring out what our beliefs are and developing a system that is aligned with your beliefs. I promise that it will be an amazing journey and will figure out

  1. beliefs about yourself

  2. beliefs about money

  3. beliefs about markets

These beliefs are the core of the trading mindset that one needs to develop. As I have mentioned earlier in my training webinars, once we figure out the trading mindset ( it takes the longest as it involves introspection), it becomes much easier to develop other 2 components - position management and systems.


Position Management (30%)

It is proven that you can make money in these markets by just managing positions. As mentioned in the trading psychology post, markets are designed to be a zero-sum game and operate in such a way that one can either break even or even lose money. So, we must manage the risk of losing money at all times.


There are many mathematical models based on CPR ( cost, price, and risk) out there. A simple and static way that traders use to manage risk is to allocate 2% of the portfolio for every trade. As the portfolio increases, so is the allocation for every trade. Some traders use dynamic allocation - increase the allocation for trade after a winning trade and decrease the allocation after a losing trade


Some traders also use a tier-based approach even in their allocation for a trade which is a great way to manage risk. For example, if your portfolio is 10000 and you are allocating 2000 for a trade, you can allocate $500 (1/4 lot) initially and keep adding more lots as the price is moving in the intended direction.


System (10%)

Once we have our trading mindset and position management in place, we can focus on developing a system that is aligned with our trading mindset. Generally speaking, A system should define

  1. the morning rituals ( example - What will be checked before the market opens. What is your source for the news. Do you keep track of VIX and SPY all the time?)

  2. the criteria to choose a trade

  3. the entry criteria for the trade ( example - breakout trading strategy)

  4. the stop-loss criteria for the trade ( example - breakout stop loss)

  5. target exit for the trade

Let us not make this system very complicated. All we need is a system that is successful 51% of the time. For example, your entry criteria could be entering the trade when it is above EMA8 and EMA21 and exiting the trade when it is below both EMAs. There are metrics out there that can measure the system such as the Sharpe ratio( will reserve it for another post).


Also, I have seen traders jumping from one system to the other not giving enough time to test a single system. Traders should test a system with at least 50 trades to check the effectiveness. System effectiveness cannot be measured with smaller lots like 5-10 trades. So, while testing these systems, I would recommend paper trade. If you want to earn while testing the system, it is important to have a decent-sized portfolio and follow position management diligently.


Also, it will be helpful to automate the system to the maximum extent possible to avoid human errors.


Trading Plan

I would highly recommend having a document listing down your trading beliefs, position management rules, and system principles and place it where you can view it regularly. In addition, the trading plan can also talk about your deposit and withdrawal cycles. For example, some traders might want to transfer money consistently from their short-term trading account to long-term accounts.


This is work in progress document that will be updated as you embark on the trading journey. I would also recommend having a journal documenting your thought process throughout the day to understand yourself and to become a better trader. The purpose of the journal and trading plan is to document your trading process and help you learn from your mistakes.


Final Thoughts

  • Identify your beliefs and align with the trading psychology needed to be a trader

  • Position management is critical and should be in place for managing risk

  • Just focus on one system at a time and see if you can trade with conviction. Develop the metrics for the system. Sometimes, we can have more than one system to cater to different market conditions

  • Create a work in progress document called a trading plan that documents trading beliefs, position management rules, and system principles. Expect this document to change in the process of developing a system

  • Fail fast and learn quickly by journaling your trading experiences every day.

If you like this post, you might also like the top 5 reasons why traders fail. Also, did you know that the Breakout trading strategy is one strategy that can be used for trading cryptos, stocks, options, and other derivatives and gives you the best risk-reward ratio (RRR) for the trades placed?


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