The trading system is the most interesting trading requirement for professional traders who have been active in the markets for a long period of time, as there are many kinds of systems. While in money management and discipline the respective essentials are defined more or less clearly (also there are personal interpretations), there is a lot of freedom within trading systems. There are numerous trading systems with very different ideas and foundations.
A trading system determines when to enter and to exit a position. Both entry and exit are equally important, since each trade consists equally of both parts.
In general, the exit is easier than the entry, as certain techniques have been established for exits and the number of possible exit types is thus relatively small compared to the number of entry types. Even though there are usually fewer exit options than options for the entry, the exit is just as important as the entry. The best entry is useless, if the exit is not chosen appropriately. In addition, discipline is particularly important when it comes to the exit. Some traders like to enlarge the space of the stop by moving them away, while others increase positions even further when positions start to run against them ('throw good money after bad'). Both mistakes, mostly done by beginners, are consistently resolved by discipline following the rules of the trading system.
The purpose of the exit is to close the position when prices start to run against the trader to secure the maximum profit. Unfortunately, it is not easy to pinpoint or to recognize the best point. The main problem is the nasty habit of a position sometimes to run a short time against the trader, then to swing back into the desired direction and to further increase the profit. Additionally, there are trade fees connected with the entry and exit, so that as few entries and exits as possible should be used to achieve the maximum profit. In principle, it can not be decided with certainty whether a price turn is a short term counter run, or if the price turn lasts for a longer period in the opposite direction and consumes the already gained profit gradually. Therefore, systematic action at the exit is of particular importance.
In principle, each exit is based on waiting for an opposing price movement, and if this is strong enough, the position is closed. However, there are quite different techniques to evaluate the strength of an opposing movement. The two most important exit types are the movement stop and the trend stop.
The movement stop directly measures a particular property of the price, like the momentum or the duration of the counter run, and exits the position once a limit has been exceeded. Simple examples are: Exit after three opposing candles, exit when the difference between current and maximum value is larger then three points, exit when certain averages are crossing, exit when the current value falls below the low of the last candle or simply if a certain candle pattern occurs.
The trend stop also exits a position when an opposing price movement starts, but in this case an additional level of abstraction is introduced: the trend. The position is closed when the trend is broken. A broken trend refers to a geometric pattern: For long positions, this is the point, when the current value falls below the last minimum of the movement. As a result, short term resets do not lead to premature exits from the position and the price movement is followed for a longer time, which achieves higher gains than the movement stop. On the other hand, the trend stop is much more complicated to calculate and sometimes the prolonged pursuit exits the position too late, loosing a lot of the already gained profit.
There are numerous variants of entry types, each of which is based on certain ideas. Basically two types can be distinguished: the trend following entry and the anticyclical entry.
By far most of the entries are trend following entries, and for good reasons. A trend following entry waits until a trend with a certain strength has formed and then opens the position in the direction of the trend. Waiting inevitably results in a certain delay which reduces the profit. For this reason it is not only safer against anticyclical entries, but there are also much more possibilities to recognize a trend than a future course turn. There are different approaches for measuring the strength. Examples are the crossing of two averages (MACD), the momentum or other combinations of several mathematical properties of the price.
The anticyclical entry attempts to enter the market in the opposite direction just before or just when the price is turning into the opposite direction. After the price turn, the price has to run in the direction of the opened position in order to make profit. In this respect, the essential difference between trend following and anticyclical entries is the point in time of the entry: with anticyclic entries, the entry is earlier than in the case of trend following entries, whereby the profit is increased. However, this advantage goes hand in hand with some disadvantages: Recognizing an already existing trend is simpler, safer and there are more recognition possibilities than recognizing a price turn. Detection of price turns is often done by candle pattern recognition or by exceeding the standard deviation (Bollinger bands). Because of the disadvantages, anticyclical entries should not be used by beginners, and even for professional traders this type of entry is very controversially discussed.
Creativity and freedom of decision
To succeed in the financial markets, discipline is essential. This includes, that entries and exits are only traded in accordance with the rules of the trading system. This does not mean that a trader is no longer free to decide by himself. In semi automatic trading systems signals are generated for possible entries without automatically initiating an entry. The trader decides which entry to take manually, whereas the exit is automatically carried out by the system. By manual entry, the dealer takes his own decision and creatively determines which entry to take. In fact, most semi automatic trading systems produce too many entry signals per day (several hundred, some even a thousand entry signals per day), so the dealer must choose which of the many opportunities to use. This shifts the responsibility for success away from the trading system towards the trader. At the same time, automatic back testing and evaluation of the system is not possible any more. Typical examples are entry through MACD, exit through movement stop. Often, the trader is required to be able to distinguish good trend phases from bad trendless phases due to his own experience. However, this is not only difficult, but also very subjective. There are a few indicators which can help to estimate the current market phase. Also geometrical aids, such as chart techniques, are also widely used.