What is a Trading System? By Van K. Tharp, Ph.D

What is a Trading System?
What most people think of as a trading system, I would call a trading strategy. This would consist of eight parts: 1) a market filter; 2) set up conditions; 3) an entry signal; 4) a worst case stop loss; 5) re-entry when it is appropriate; 6) profit-taking exits; 7) a position sizing algorithm; and 8) you might need multiple systems for different market conditions.

A market filter is a way of looking at the market to determine if the market is
appropriate for your system. For example, we can have quiet trending markets, volatile trending markets, flat quiet markets, and flat volatile markets. And, of course, the trending markets can either be bullish or bearish. Your system might only work well in one of those market conditions. As a result, you need a filter to determine whether your system has a high probability of working. Should you trade your system or not? The set up conditions amount to your screening criteria. For example, if you trade stocks, there are 7,000 plus stocks that you might decide to invest in at any time. As a result, most people employ a series of screening criteria to reduce that number down to 50 stocks or less.
The entry signal would be a unique signal that you’d use on stocks that meet your initial screen to determine when you might enter a position—either long or short. There are all sorts of signals one might use for entry, but it typically involves some sort of move in your direction that occurs after a particular set-up occurs.
The next component of your trading system is your protective stop. This is the worstcase loss that you would want to experience and it defined 1-R (or your initial risk) for you. Your stop might be some value that will keep you in the stock for a long time (i.e., a 10% drop in the price of the stock) or something that will get you out quickly if the market turns against you (i.e., a 10 cent drop). Protective stops are absolutely essential. Markets don’t go up forever and they don’t go down forever. You need stops to protect yourself. As I said in Trade Your Way To Financial Freedom, entering the market without a protective stop is like driving through town ignoring red lights. You might get to your destination eventually, but your chances of doing so successfully and safely are very slim.
The fifth component of a trading system is your re-entry strategy. Quite often when you get stopped out of a position, the stock will turn around in the direction that favors your old position. When this happens, you might have a perfect chance for profits that is not covered by your original set-up and entry conditions. As a result, you also need to think about re-entry criteria. When might you want to get back into a closed out position? Under what conditions would this be feasible and what criteria would trigger your reentry? These are what you need to address in thinking about re-entry.
The sixth component of a trading system is your exit strategy. The exit strategy could be very simple. For example, it might simply be a 25% trailing stop where you adjust the stop to 75% of the closing price whenever a stock makes a new high. The stop is always adjusted up, never down. However, you may have many possible exits in addition to a trailing stop. For example, a large volatility move (i.e., 1.5 times the average daily volatility) against you in a single day is a good exit. Crossing a significant moving average (i.e., the 50 day) might be a great exit. Technical signals are good exits (i.e., breaking a significant trend line.) Exits are one of the more critical parts of your system. It is one factor in your trading of
which you have total control. And it is your exits that control whether or not you make money in the market or have small losses. You should spend a great deal of time and thought on your exit strategies.
The seventh component of your system is your position sizing algorithm. Position sizing is that part of your system that controls how much you trade. It determines how many shares of stock should you buy. A general recommendation would be to continually risk 1% of your portfolio. Thus, if you have a Rs. 25,000 portfolio, you wouldn’t want to risk more than Rs250. Let’s say you wanted to buy a stock at Rs10. You decided to keep a 25% trailing stop, meaning if the stock dropped 25% to Rs.7.50 you would exit your position. Since your stop is your risk per share, you would divide that Rs2.50 risk into Rs250 to determine the number of shares to purchase. SinceRs2.50 goes into Rs250 100 times, you would purchase 100 shares of stock. Notice that you would be buying Rs1,000 worth of stock (100 shares @ Rs10.00 each) or four times your risk of Rs250. This makes sense since your stop is 25% of the purchase price. Thus, your risk would be 25% of your total investment.
Finally, depending upon how robust your trading system is, you might need multiple trading systems for each type of market. At minimum, you might need one system for trending markets and another system for flat markets.

The Entire Trading System: Your Business Plan for Trading
Remember that I said that what most people consider a trading system, is simply a trading strategy that should be part of an overall business plan. Without the overall business plan, many people would still lose money. As a result, let’s look at the overall context in which a trading strategy should be made—your business plan. Nevertheless, here is a summary of what we consider to be essential for a good trading plan.
1) The Executive Summary. This is usually the last section written. It reviews all of the material of the plan and presents it in summary form. It should describe in
detail the objective of the plan and then briefly describe, without a lot of detail,
how the objectives will be achieved.
2) A Business Description. The business description should include the mission of the business, an overview of the business and its history, the products and services you provide (which is growth of capital and risk control as a trader), your
operations, operational considerations such as equipment needed and site location, and your organization and management of employees (if any). All of these topics are fairly self-explanatory, but you should take the time to write them out as part of your plan.
3) An Industry Overview and Competition. In the industry overview you need to
look at the factors influencing the market. For example, Ed Yardeni in his web
site lists ten major factors influencing the market. These include a globally
competitive economy, a revolution in innovation, wireless access to the Internet,
low tech companies having access to high tech tools and changing their
businesses as a result, the need to outsource to increase productivity, and many
other themes. See www.yardeni.com for more information. In addition, you also
need to know who/what your competition is. Who are you trading against? What
are their beliefs? What advantages do they have that you don’t? What
advantages do you have that they don’t?
4) Self-Knowledge Section: You need to know your strengths and your weaknesses and list them in this section. You need to know how to capitalize on your strengths and avoid (or overcome) your weaknesses.
5) Your Trading Plan Itself. The tactical trading plan should be a part of your
trading plan, but it should also include (a) your trading beliefs that form the basis
of your plan, (b) any strategic alliances you may have, and (c) what you plan to do in terms of education and coaching.
6) Your Trading Edges: I believe your trading plan should also include a listing of
all of the trading edges that you have in the market. When you list your edges,
you can review them often and be sure that you capitalize upon them. For
example, your edges might include a) the fact that you don’t have to trade; b) your understanding of R-multiples and position sizing (which give people a huge edge over those who have no idea about these concepts); c) your ability to read a level II screen to get excellent stock trades; d) your sources of information; e) your ability to plan well in advance so that you have a game plan each day; f) your skill in following the ten tasks of trading; g) your knowledge of yourself and your strengths and weaknesses. This is just a sample of the possible edges that you might have over the average trader/investor.
7) Financial Information. This section should include three parts. The first part is
your budget. How much money do you have? What will the trading process cost
you? The second part will be your cash flow statement. Does your plan make
sense in terms of cash flow? And finally, the third part will include profit and
loss statements. If you have no trading record, you need to make estimates based on historical testing and based on paper trading.
8) Worst Case Contingency Planning. Things always happen that you have not
accounted for or planned for in your trading plan. How will you deal with these
elements? What will you do if any of these things come up? How will you make
decisions when these elements come up?

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