UNIT C| System Modeling

2. Components of a System

Market Observation and Hypothesis

If you intend to capitalize on the market behavior, first of all you need a belief system on how the markets operate. A belief system is a series of ideas you have gathered after observing the market for a while.
Once you are able to explain how the market works from a personal perspective, then you can elaborate hypothesis to capitalize on those ideas. Market observations are thus the building blocks of every system and trading method. This is an extremely important aspect most novice traders neglect: you can't just copy a trading system or method - if it doesn't emerge out of your belief system or if it doesn't fit into it, it will be very difficult to follow it in tough market conditions.

To start with, look at different currency pairs and charts and see what ideas pop up to our mind. You might look at those big trends and feel like following them is the way to go, or you might look at a specific price action like a reversal or a pullback and want to capitalize on them.
It sounds like you have to be truly unique and original from the beginning, but in reality you don't have to: there are many ideas and common approaches you can take from others. You just have to be convinced that the market operates that way because this is what you see.

Preparing the hypothesis requires you to actually see on the charts if there is enough evidence that a specific action-reaction pattern regularly happens. For example: you may observe that during a trend, pullbacks frequently happen on the 62 period Exponential Moving Average. In this case the action is the pullback and the reaction is the resurgence of the trend.
Another observation would be, for instance, that exchange rates break the previous day high or low price most of the time in most currency pairs.

Once you have enough evidence that the recurring action-reaction event takes place on a regular basis, then you can formulate the hypothesis. For example: “I want to prove that during a trend, the 62 EMA acts as a pullback level and price moves at least 30 pips on the 1Hr chart at least 60% of the time.”
Or, taking the second idea: “I want to prove that prices break out of the previous daily range to a substantial amount of pips at least 70% of the days.”

Other ideas you can use to formulate a hypothesis are:

• The exchange rate stays away from a moving average for a certain maximum time period, then it always returns to it.
• The MCAD, as an open indicator, registers high and low values and price tends to react to these levels by reversing its course.
• When price breaks out of chart formations, such as triangles, pennants, or wedges, it tends to pullback to the broken level before resuming the trend.
• Divergences trigger on the GBPUSD 1H chart on Fridays with increased frequency when London institutional traders liquidate their positions.
• The confluence of a Pivot Point R or S level with a Fibonacci extension level acts as a magnet attracting price.
• When a currency pair is in a strong trend and steps out of the Bollinger Bands while there is no major lever to make it reverse, then it will wait till the bands are more distanced to resume the trend.

There are hundreds observations like those that you can collect from our experts at FXstreet.com. The most important is that the idea you work upon is specific and also measurable. This takes us to the second step.

Measuring the Hypothesis

Now you need to take a sample of past price data and take some rough measures accordingly to one of the above hypothesis. Let's take the one based on the breakout of the previous day high and low.
The results could look like this: for the last 100 days on the GBP/USD, price broke out of the previous daily range 95% of the time. From all breakouts, it moved at least 20 pips 75% of the time, it moved at least 40 pips 45% of the time and it moved more than 40 pips 25% of the time.

The amount of data is relative to the time frame you are using. In any case, you want to collect enough data to sustain your initial hypothesis. A number of 100 occurrences of the event under observation will provide a good statistical foundation. This means that you want to measure 100 breakouts of the previous daily range on the GBP/USD in order to get evaluate better the feasibility of your hypothesis.

Selecting a Time Frame

When developing a trading system, it’s advisable to experiment it with different time intervals because an hypothesis may work better on a small time frame than in a longer one or vice versa. Since you may want to experiment the price and indicators over different lengths of time, you will be able to do it from one minute charts up to monthly charts. Take the above idea of the previous day high and low breakout… and let’s imagine that after experimenting a bit you will notice that indicators displayed in 15M to 1H charts are more sensitive to price action than on a 4H or a 1D chart.

Notice also that using different intervals dramatically changes the view of the data you are looking at. A 5M chart will show up and down movements in price and indicators, while a 4H chart will smooth the picture.
Don't assume that the smoother view detected in a longer interval chart is the true view: remember that the market is fractal in its nature and all time frames print more or less the same patterns. The main difference between different time scales is one of frequency: smaller time frames will produce more trading signals when analyzed with technical indicators than larger time frames.

The most notable difference between a small time frame and a larger one is perhaps the length of the moves: the smaller the time frame is, the smaller the amount of potential pips to be made per trade will be, and the smaller the number of risked pips are. Conversely, the larger the time frame is, the larger the stop loss and the larger the risked amount of pips will be. For this reason, profit taking and stop exists will be conditioned by the time frame.

The duration of the trades may also be conditioned by the time interval: when charting at 1H don't pretend to stay in the market for 2 weeks, as you will mostly experience reversals and whipsaws. A signal on 1H time frame should lead to a movement for the next few hours and will usually close, if not the same day, during the next days.

Once you have an understanding of time intervals and their effect on technical indicators, you can start building a strategy. Usually that means to experiment your hypothesis in different time intervals and also to find which hours of the day, trading session or day of the week will produce the best signals to enter and exit the market.

Developing the Strategy

The fourth step in developing a trading system is to describe it. The trader is forced to fully articulate the initial idea and the strategy to capitalize on it. This includes an explanation about the tools to be used and what events provide the conditions to get into and out of positions.

Any trading strategy should thus clearly determine entry and exit conditions and define the rules and signals which should prompt the immediate execution of a trade.

Any objective trading method should encompass several functions in order to capitalize on a hypothesis. Its basic set-up should provide specific rules for determining:

• Developing trends or reversals (short, intermediate, long);
• The direction of the trend or movement (upwards, downwards, sideways);
• Optimal time to be in the market;
• Exit levels to avoid large losses;
• Exit levels to take profits on favorable positions;

Most successful Forex traders use a handful of diverse trading strategies built into their systems. Which strategies to use may depend on the particular currency pair, recent price action or patterns, market volatility and/or a myriad of other aspects the trader has observed and measured. The strategies should thus be understood as the building blocks of a trading system or model.

Generating the Signals

Signals are events that trigger market entries, market exits, or some forms of adjustments during the life of the trade. They are usually based on technical indicators, and provide traders with a precise, explicit script for their trading.
What indicators you should use, that’s a choice each trader must make. The goal is to make informed choices and stick to them.

The first thing to have in mind when choosing an indicator is to remember that they all have a foundation in price. The second thing to have in mind is that a technical indicator will capture only an aspect of price action and omit the rest of the information contained in price.

Unfortunately, there is no indicator that suits all market conditions. For this reason it's important to search for an indicator that is able to measure the specific price action contained in the hypothesis. Many people start the other way round: experimenting indicators with no idea about what price pattern or action to capture. This inevitably leads to a lot of inconsistent results and frustration. This is not to say you should not experiment... on the contrary! Learn as much as you can about technical indicators and don’t be afraid to try the unconventional tools. But when it comes to build a strategy, start always with an idea - an hypothesis- and then, grab the necessary tools.

If each signal of your strategy represents your particular nuanced view of the market, based on your ideas, then your selection of indicators will be based on the comfort and belief in the signal's ability to guide you through trading decisions. Otherwise you will be mechanically following text book signals, ignoring why you take positions based on those signals.

Popular Types of Signals

Here are the advantages and disadvantages of some of the most common types of signals generated by technical indicators:

• Crossing signals can be generated using MACD, MA’s, DMS and Stochastics. They are formed when two indicators cross each other or when one indicator crosses price. They are explicit and easy to see on charts but, at the same time, they tend to be false signals when the market doesn't move.

• Oscillators like Stochastics, RSI, and DMS generate signals by moving between two fixed values or from positive to negative. They can accurately show reversals, but on the flip side, they tend to get trapped in overbought/oversold conditions for large periods of time.

• Thresholds signals can be generated when price reaches a certain level or a technical indicator reaches a certain value. Examples of thresholds may include Pivot Points, Stochastics, RSI, DMS, CCI and breakouts of chart formations.

These are usually explicit entry/exit targets but can sometimes be meaningless if they don't take into account what the market is doing.

• Conditions can also be used as signals when two indicators form a relationship. For example, when price is greater than a moving average, it might signal a long trend. Combining signals or using conditions with signals helps to improve their performance and reduce the chances of false moves.

Although most of the systems use combinations to create conditions and generate signals, its disadvantage relies on the fact that the more complex conditions are used, the less signals they will generate.
In any case, combining different signals together works like a checking list and helps to make sure the market is doing what you expect it to do before making a trading decision.

Entry Rules

The parameters to enter positions will be related to the type of system, whether it is a trend following system, a breakout system, etc. The trade entry must be described in detail, including concrete definitions of:

• The proper market conditions for entry;
• The optimal trade set-up;
• The final confirmation signal, also known as the “trigger”.

The generated conditions and its signals can be based on various technical indicators, price levels, combinations, time of the day, etc. In general, the best trading strategies have entry rules that you can specify in only two lines. The strategy has to be designed in a way that does not require you to make any subjective decisions whether the signal is valid or not.
Don't worry about exit points at this stage - just mark the entry points on your chart and measure their frequency and how much the market moves after the signal.

Consider splitting your entire position and enter the market at different levels. Many professional traders focus on perfecting their systems by doing so. You may consider a system where several conditions have to be aligned in order to enter the full position - with the possibility to enter a portion of it if only 70% of the conditions are met, for example. Another tactic to enter in several stages is to place an entry every time the market moves in your favor.

Some systems also consider re-entry conditions: when the first attempt to enter the market fails, you get stopped out of the position, and then the market turns around in the direction that favors your old position. Considering if it is appropriate to have a second chance entry in a system will depend on the type of price action that is being captured. A trend following system may be harder to give a second entry chance, specially if the market moves very fast, but a breakout system may offer a second chance with pullbacks to the entry point. Under what conditions would this be feasible and what criteria would trigger your re-entry? These are the questions you need to address when considering re-entries.

Practice your entry rules by measuring the price moves after the signals across several time frames and considering if multiple entries or re-entries would enhance your edge. Once you are able to spot your exact entry points, then you have to use to the exit plan.

Exit Rules

Exits rules are part of the decision to take a position. If the conditions for exiting positions are not fully defined when entering the trade, the trader may hold a losing position for too long in the hope of seeing the market returning. Inversely, the trader may not close a winning position at a high probability target, risking the trade to turn into a loss.

There are two types of exits:

• A stop loss to get out of a bad trade.
• A profit target to realize profits when the market moves in your favor.

Exit rules can take the form of fixed stops or limits, trailing stops, stop and reverse, or signals from technical indicators. If you are short of ideas and need some exit rules, just go to our forum and ask FXWizard. Here is one of the dozens of suggestions he made to a forum member:

Stop Losses

Every strategy has some kind of protective stop loss rules. As a currency trader you have two assets upon which to build your business: one is the knowledge and the other is the money. One of the priorities of a trader is thus to protect the money at all costs.

Stop loss rules can be expressed in a variety of ways, such as:

• A fixed dollar or pip amount. For example, to risk 100 US Dollars or 100 pips for every trade. Usually it's better to let the market structure determine where is the optimum point to leave a position than to use an arbitrary Dollar amount.
• A trailing stop. The same applies here: trailing stops are usually not taking into account what the market is doing.
• A stop adjusted to volatility. This means wider stops with higher volatility and tighter ones in quite markets.
• A time stop to get out of a trade and free your capital if the market is choppy.
• A technical level dictated by an indicator, a combination of indicators or a price level identified on a chart. Although this is the most difficult way to place stops, it's also the smartest.

Take Profits

If stop losses serve to preserve your trading capital, take profits serve to acquire and appreciate it. This is probably the most difficult part to master.

From a technical point of view, the most important advice you can get about exits is probably to avoid using the same rules to exit than to enter the market. As explained before, if you use a specific signal to enter a trade, you are probably trying to capture a specific market event with the most appropriate tool accordingly to the nature of the event.

For example, if a currency pair has entered an overbought condition signaled by the Stochastic and this happens in the context of a downtrend, you want to capture the move as early as possible when it turns down and out of the overbought condition. Entering short after a brief upward correction has a higher chance of accumulating more profit. While this turning point is an excellent signal for a short entry, would it be advisable to wait for the stochastic to come out of oversold to exit the trade? Probably not, because the pair may hit a major target and reverse back up before the Stochastic enters and exits the oversold area.

Take profit rules can also be expressed in a variety of ways relying on:

• Numeric values to determine the exit point;
• A percentage of the current price;
• A percent of volatility (for example, 50% of the daily Average True Range);
• Trailing stops lo lock in profits.;
• Signals from indicators, like a MACD crossover in the opposite direction of the trade, or a trendline break in the RSI;
• Support and resistance levels;
• Win/loss ratios.

Profits can be taken partially using more than one exit level. Let's suppose you have a trade following system: as such, you may have many failed attempts to jump on the trend and some few times when the market rewards you with a large profit gain. In order to enhance your overall performance you may prefer to take small partial profits once a trade develops in your favor. This can be done, for instance, using 50% of the daily ATR to close one third of the trade, the second third you can close at the 100% of the daily ATR, and let the rest of the trade ride the trend until you hit a major support or resistance level.
Other combinations of the above outlined exit rules are also possible. As another example, you could close the half of the position at a fixed pip amount, and let the second half continue to trade without risk: if the stop is triggered, you are still break-even on the entire position. The second half of the trade can use a different rule to take profit, for instance, a 1:2 risk/reward ratio.
The possibilities to perfecting exit rules are endless and you can get ahead of many beginning traders by focusing a little bit more on the exit strategies.

Money and Risk Management

Other important components of any trading system are money and risk management. Money management principles serve to determine your position size, and risk management the proportion of your trading account that is risked per trade.

A good trading strategy with no risk and money management principles in place will not produce consistent or lasting returns. This is a key element of every trading model, and for this reason we will dedicate an entire chapter to it in this unit (Chapter C03).

In order to help you start with position sizing and controlling risk, you should start answering the following questions:

• What is the average pip amount the strategy is able to capture?
• What is the average pip amount loss when the strategy fails to hit the target?
• How often does the strategy reaches take profit targets?
• How often does the strategy reaches the stop loss?

 

Trader's Profile

Every trader should find a trading method which suits his/her own situation and personality. But what does it mean exactly?

On one hand, studying and carefully observing the market will inevitably lead you to define your preferences as for the tools to use and the price patterns upon which to capitalize. The more hours of observation you carry forward, the clearer your preferences will be.

It often happens that the novice trader, in his/her eagerness to learn more and more about the market, manifests special interest in finding the miraculous system, in which sophisticated indicators abound. This creates a dependency that will make your journey a sort of quest for the Holy Grail.

While it's important to experience many tools to determine which is best suited to your style, don't try to learn everything at once. There is a huge variety of indicators, and you will probably need only a small fraction of it to build a system.

On the other hand, it's also important that each trader defines what type of trader he/she intends to be. The following questions help you assess the issue of who you are and what your objectives are:

• Do I prefer to trade short-term or long-term?
• Do I have time to look at charts the whole day, or do I have other priorities that prevent me from doing it?
• What is my risk profile, how much am I willing to risk on each transaction?
• Can I psychologically sustain a system with a very high loss frequency (even if the few winners compensate the losses)?
• Can I go to sleep leaving an open position overnight?
• Am I better following trends or detecting reversals?

• Do I chase price or do I prefer to wait for price coming to a certain level to enter a trade?

The tasks of observation, study and definition of your trading profile are three foundations on which you have to build your system and they have to be part of your overall trading plan. Because you will never stop to observe, to learn and to refine your trading style, we will dedicate an entire chapter (D01) to the trading profile.