UNIT C| System Modeling

Having studied Units A and B you should be familiarized with the Forex market to the extend that you know who participate in it, the reasons why participants chose this market and how you can emulate them. Moreover, you should also be able to pick the best set-ups, the optimal time to trade those set-ups, and know a lot of guidelines about how to trade them.

However, and because there are exceptions to analytical guidelines without which market analysis would be a science of exactitude - not one of probability-, you need a structured approach, in other words: a trading system.

But what exactly is a system? The point of this chapter will be to give you that information as clearly as possible, and to bring you to the next level in your education showing you what this amazing subject has to offer. Be prepared for a challenge: this learning stage is different than the analytical approach you learned in Unit B. Besides mastering good analytical skills, success in Forex requires a systematic way of making trading decisions.

First we will go through several definitions of trading systems. You will learn that a system is basically a methodology that you adapt to a certain market characteristic.

The second section will help you understand that a structured trading approach is about creating and following rules, with a keen sense of observation and discipline. To consistently make money in the Forex market you want to have a set of trading rules that guide you through your decision making. This will separate you from the market gamblers and give you the structure to become a professional trader.

As always, we will make it simple for you by building a trading system from scratch that you can use for your first tests. This will be the focus of the third section.

New traders are regularly fooled by expensive ???holy grail??? systems and perhaps you're looking for it too. You have to be realistic when searching for a useful system and consider if you really need to buy one. Some systems are very hard or impossible to understand. Only by understanding the methodology of the system, you will be able to effectively use it at your advantage. How can you follow something you don't understand? In the last section you will learn two methods for evaluating and finetune any trading system.

1. Definition of a Trading System

A trading system is a set of rules that formulate buy and sell signals without any ambiguity or any subjective elements. These signals are mostly generated by technical indicators or combinations of technical indicators. The primary aim of a trading system is to manage risk and to increase profitability in any market environment. Optimal levels of risk and reward are accomplished by modifying the different parameters within each rule of the system.

A benefit of trading with a system is the removal of emotion from trading: systematical trader will, for instance, not place an excessively high risk trade due to frustration from a prior losing trade. But there are many other benefits to extract from a methodological approach as you will see later.

No system is better than another, but a good system is one that is adapted to your goals, your time window, your start capital and also to your personality.

Trading systems can be classified in different types:

Trend Following Systems

As the name suggests, trend following systems aim to enter a trend and profit from a continued price movement in the same direction. According to Newtonian physics, an object in motion tends to stay in motion - this is also one of the principles of the Dow Theory. Therefore, if a certain currency pair has developed a powerful trend, that trend is likely to continue until something fundamentally changes.

We have seen in the previous Unit B that determining the trend is an objective process, but the decision to enter the market can be discretionary or mechanical. For example, some traders can pull up a chart and instantly determine if they want to buy or sell - this is a discretionary approach. What we are going to propose you is to use specific indications to guide you through that decision.

Counter-trend or Trend Fading Systems

This type of systems tend to be the riskier ones. They aim to identify reversal points in price making use of overbought/oversold conditions signaled by RSI or other oscillators, crossovers of the outer Bollinger Bands, regular bullish and bearish divergences using MACD, etc.

You need well-defined rules for trend reversals and it certainly requires a certain experience and also a great deal of confidence in your approach. How to gain confidence is something we will explore along the entire Unit C.

A counter-trend may also develop into a trend. Following such a system would imply to account for many small losses until a runner is hit and you pick a new trend from the beginning. That winner usually compensates the many small losses accumulated trying to pick reversals.

Another difficulty of counter-trend systems is that the exchange rate may enter in a ranging condition before it reverses in the opposite direction. Your understanding of the Elliott Wave Principle explained in chapter B04 and PrB will give you a huge insight into that market characteristic.

Range systems

Statistics show that most markets are range bound about 70-80% of the time, that is, they only trend around 20-30% of the time. This happens because of the reversals and corrective moves.

In a 24-hour market as the spot Forex, there is plenty of ???choppy??? price actions, that is, when the market has no clear direction. In fact, if you look at almost any long-term chart of almost any market you can clearly see this phenomenon, even without any statistics. In fact, ranges can be found in all time frames due to the fractal nature of the markets.

Derek Frey's ITC 2008 presentation about ???Trading Ranges??? helps us understand ranges:

Breakout Systems

Breakout systems are based on the idea that if the exchange rate has been contained within a price range, sooner or later it will break out of it. The system will then search for scenarios of increased volatility expecting to capture a continuation of the breakout move based on momentum. This can be for example breakouts of support and resistance levels (horizontal levels, channels, trendlines), chart figures (triangles, flags, etc), volatility breakouts, breakouts of daily high and low prices, etc.

Reverse Breakout Systems

A reverse breakout system is designed to fade the moves described above. Concepts like ???throw-over??? from the Elliott Wave Principle, or false breakouts on chart figures, would be starting points for this methodology. It's based on the idea that a broken support sometimes fails to become a resistance and vice versa. Besides Elliot waves, tools used to spot reverse breakouts can be for instance Bollinger Bands, Parabolic SAR, or Envelopes.

Derek Frey, in the above quoted presentation, goes on by saying: