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Subjective or Rule-Based Trading System?
There are two main streams of thought when it comes to trading systems and strategies. There are those who believe an entirely rule-based system works best. There are others who believe a more flexible approach to trading is required, where guidelines are used, but not fixed rules. Then there are traders, like myself, who fall in the middle, using rules and guidelines to come to come up with strategies that have some flexibility, but also have a discernible edge over time. Here we look at these different trading styles, which approach works best for certain types of traders and the advantage and disadvantages of each. By understanding the differences, hopefully you’ll be better able to find or fine-tune strategies to suit your preferences and personality.
Rule-Based Trading Systems
A rule based system is one which precisely defines a trade set-up, determines exactly how much money will be placed on the trade (position size), as well as what the risk and profit will be.
Basically, once a trade signal occurs, a stop and profit target are placed (which may possibly be moved based on other rules) and there are no further decisions to make. The trade stays on until either the stop or profit target have been hit, or in the case of binary options, the trade expires.
The simplest rule based system is one where a profit target and stop are placed at the outset of the trade, and do not move. There is nothing for the trader to do once the trade is on, except wait for the trade to close via the stop, profit target or expiry.
New traders should typically start with this approach. Everything is defined so there is less emotional involvement (although it can still be emotionally difficult to implement a rule based system). It is also possible to “automate” rule-based strategies by writing a program so that it can essentially run without human involvement. Of course this requires coding skills and a deep understanding of the strategy being employed.
The advantages are that you can precisely define your risk and reward. You know exactly when to take trades, and once the trade is on, there is nothing left to do. By backtesting and using your strategy you’ll gain confidence in seeing that the strategy makes money (if it is a good system) as long as you follow the rules of the system.
The downside is that during a trade you may see market conditions change. During the trade it may become evident that your stop is going to get hit before you target (although it is never a certainty). The rules do not allow you to get out though–you must let your stop get hit.
Since most new traders get quite emotionally while trading, this downside is not typically a major problem since following the rules allows them to be more profitable than if they used a subjective system.
Subjective trading systems are “guideline” based, not rule based. It is up the trader to discern when to take trades, and when to get out.
This type of system is typically by used by experienced traders who have a keen understanding of how the market moves are able to trade with a clear mind, which isn’t too swayed by emotional distractions.
Subjective systems are harder, if not impossible, to backtest. Traders, must simply trade a demo account or real account to get a sense of their success. Subjective systems should still be rigorously tested in this manner. Just because it is a “subjective” system doesn’t mean the trader can do whatever they want. There should still be guidelines, and the trade setups and exit methods used should show profitability over many trades, preferably in a demo account, before real money is put at risk.
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Subjective systems have the advantage of being adaptable to changing market conditions. This may allow for slightly more profit potential or a higher win rate than a rule-based system (although not necessarily, as each rule-based and subjective system is different).
The downside is that these systems are hard to backtest, and therefore require the trader simply practice their approach over and over again to get a baseline for how they perform. Emotions may play a larger role in a subjective system, which is why this type of system is typically used only by experienced traders.
Experienced traders typically begin with a rule based system, and then see some potential areas of improvement over months of trading and therefore allow for some flexibility of the system (rule-based to subjective).
Subjective and Rule-Based
As indicated, many experienced traders began as rule-based traders and then later allow for some flexibility as they realize there are areas of their strategy that could be improved by allowing flexibility.
For example, a fixed stop or target may be used at the outset of a trade, but the profit can be increased if the price is running well. Certain trade signals may be skipped if a specific price pattern is present or absent. If conditions change while a trade is underway, the guidelines may allow the trader to take profit or losses early, instead of waiting for the original stop or target to get hit.
In this way there are rules for some aspects of the trade, but other parts of the trade are under the discretion of the trader. Which aspects are ruled based and which are discretionary will be up the individual trader and how they trade.
The advantage is that traders get the best of both worlds, at least theoretically. New traders will typically find they do best with a rule-bases system, simply because they don’t have the market knowledge or discipline to take advantage of discretionary decisions or real-time market changes. But as they progress, implementing some discretionary aspects may yield better performance.
One type of trading system isn’t better than another. It depends on the trader, their experience and their personality/emotional makeup. Some traders will do better with a rule-based system, while others can improve on that performance by incorporating some subjective decisions into their trading. No matter what type of system is used, traders should seek to only risk a small amount of capital on each trade, since even the best traders can experience a string of losses, and if too much is risked a few losses can cripple a trading account.
6 Steps To A Rule-Based Forex Trading System
A trading system is more than just having a rule or set of rules for when to enter and when to exit a trade. It is a comprehensive strategy that takes into account six very important factors, not the least of which is your own personality. In this article, we will cover the general approach to creating a rule-based trading system. (To learn more, check out our guide on Trading Systems.)
Step 1: Examine Your Mindset(A) Know who you are: When trading the markets, your first priority is to take a look at yourself and note your own personality traits. Examine your strengths and your weaknesses, then ask yourself how you might react if you perceive an opportunity or how you might react if your position is threatened. This is also known as a personal SWOT analysis. But do not lie to yourself. If you are not sure how you would act, ask the opinion of someone who knows you well. (To learn more, see Does Your Personality Match Your Trading Methods?)
(B) Match your personality to your trading: Be sure that you are comfortable with the type of trading conditions you will experience in different time frames. For example, if you have determined that you are not the kind of person who likes to go to sleep with open positions in a market that is trading while you sleep, perhaps you should consider day trading so that you can close out your positions before you go home. However, you must then be the kind of person who likes the adrenalin rush of constantly watching the computer throughout the day. Do you enjoy being computer-bound? Are you an addictive or compulsive person? Will you drive yourself crazy watching your positions and become afraid to go to the bathroom in case you miss a tick? If you are not sure, go back and re-audit your personality to be certain. Unless your trading style matches your personality, you will not enjoy what you are doing and you will quickly lose your passion for trading. (For more, see Day Trading: An Introduction.)
(C) Be prepared: Plan your trade so you can trade your plan. Preparation is the mental dry run of your potential trades – a kind of dress rehearsal. By planning your trade in advance, you are setting the ground rules, as well as your limits. If you know what you are looking for and how you plan to act if the market does what you anticipate, you will be able to be objective and stand aside from the fear/greed cycle.
(D) Be objective: Do not become emotionally involved in your trade. It does not matter whether you are wrong or right. What matters, as George Soros says, is that “you make more money when you are right than what you lose when you are wrong.” Trading is not about ego, although for most of us it can be disconcerting when we plan a trade, apply our entire logical prowess and then find out that the market does not agree. It is a matter of training yourself to accept that not every trade can be a winning trade, and that you must accept small losses gracefully and move on to the next trade.
(E) Be disciplined: This means that you have to know when to buy and sell. Base your decisions on your pre-planned strategy and stick to it. Sometimes you will cut out of a position only to find that it turns around and would have been profitable had you held on to it. But this is the basis of a very bad habit. Don’t ignore your stop losses – you can always get back into a position. You will find it more reassuring to cut out and accept a small loss than to start wishing that your large loss will be recouped when the market rebounds. This would more resemble trading your ego than trading the market.
(F) Be patient: When it comes to trading, patience truly is a virtue. Learn to sit on your hands until the market gets to the point where you have drawn your line in the sand. If it does not get to your entry point, what have you lost? There is always going to be an opportunity to make gains another day. (For tips on patient investing, read Patience Is A Trader’s Virtue.)
(G) Have realistic expectations: This means that you won’t lose your focus on reality and miraculously expect to turn $1,000 into $1 million 10 trades. What is a realistic expectation? Consider what some of the best fund managers in the world are capable of achieving – perhaps anywhere from 20-50% per annum. Most of them achieve much less than that and are well-paid to do so. Go into trading expecting a realistic rate of return on a consistent basis; if you manage to achieve a growth rate of 20% or better every year, you will be able to outperform many of the professional fund managers. (For more, see Gauge Portfolio Performance By Measuring Returns.)
Step 2: Identify Your Mission and Set Your Goals(A) With anything in life, if you don’t know where you are going, any road will take you there. In terms of investing, this means you must sit down with your calculator and determine what kind of returns you need to reach your financial goals.
(B) Next, you must start to understand how much you need to earn in a trade and how often you will have to trade to achieve your goals. Don’t forget to factor in losing trades. This can bring you to the realization that your trading methodology may be in conflict with your goals. Therefore, it is critical to align your methodology with your goals. If you are trading in standard 100,000 lots, your average value of a pip is around $10. So how many pips can you expect to earn per trade? Take your last 20 trades and add up the winners and losers and then determine your profits. Use this to forecast the returns on your current methodology. Once you know this information, you can figure out if you can achieve your goals and whether or not you are being realistic. (To learn more, see How Does Leverage Affect Pip Value?)
Step 3: Ensure You Have Enough Money(A) Cash is the fuel needed to start trading and without enough cash, your trading will be hampered by a lack of liquidity. But more important, cash is a cushion against losing trades. Without a cushion, you will not be able to withstand a temporary drawdown or be able to give your position enough breathing space while the market moves back and forth with new trends.
(B) Cash cannot come from sources that you need for other important events in your life, such as your savings plan for your children’s college education. Cash in trading accounts is “risk” money. Also known as risk capital, this money is an amount that you can afford to lose without affecting your lifestyle. Consider trading money as you would vacation savings. You know that when the vacation is over the money will be spent and you are OK with that. Trading carries a high degree of risk. Treating your trading capital as vacation money does not mean that you are not serious about protecting your capital, rather it means freeing yourself psychologically from the fear of losing so that you can actually make the trades that will be necessary to grow your capital. Again, perform a personal SWOT analysis to be sure the necessary trading positions aren’t contrasting with your personality profile.
Step 4: Select a Market That Trades Harmoniously(A) Pick a currency pair and test it over different time frames. Start with the weekly charts, then proceed to daily, four-hour, two-hour, one-hour, 30-minute, 10-minute and five-minute charts. Try to determine whether the market turns at strategic points most of the time, such as at Fibonacci levels, trendlines or moving averages. This will give you a feeling of how the currency trades in the different time frames.
(B) Set up support and resistance levels in different time frames to see if any of these levels cluster together. For example, the price at 127 Fibonacci extension on the weekly time frame may also be the price at a 1.618 extension off of a daily time frame. Such a cluster would add conviction to the support or resistance at that price point. (To learn more, see Advanced Fibonacci Applications.)
Repeat this exercise with different currencies until you find the currency pair that you feel is the most predictable for your methodology.
(C) Remember, passion is key to trading. The repeated testing of your set-ups requires that you love what you are doing. With enough passion you will learn to accurately gauge the market.
(D) Once you have a currency pair that you feel comfortable with, start reading the news and the comments regarding the particular pair you have selected. Try to determine if the fundamentals are supporting what you believe the chart is telling you. For example, if gold is going up, that would probably be good for the Australian dollar, since gold is a commodity that is generally positively correlated to the Australian dollar. If you think gold is going to go down, then wait for the appropriate time on the chart to short the Aussie. Look for a line of resistance to be the appropriate line in the sand to get timing confirmation before you make the trade.
Step 5: Test Your Methodology for Positive Results(A) This step is probably what most traders really think of as the most important part of trading: A system that enters and exits trades that are only profitable. No losses – ever. Such a system, if there were one, would make a trader rich beyond his wildest dreams. But the truth is, there is no such system. There are good methodologies and better ones and even very average methods that can all be used to make money. The performance of a trading system is more about the trader than it is about the system. A good driver can get to his destination in virtually any vehicle, but an untrained driver will probably not make it, no matter how great fast the car is. (Sometimes the best system is a mixture of methods. To learn more, read Blending Technical And Fundamental Analysis.)
(B) Having said the above, it is necessary to pick a methodology and implement it many times in different time frames and markets to measure its success rate. Often a system is a successful predictor of the market direction only 55-60% of the time, but with proper risk management, the trader can still make a lot of money employing such a system.
(C) Personally, I like to use a system that has the highest reward to risk, which means that I tend to look for turning points at support and resistance levels because these are the points where it is easiest to identify and quantify the risk. Support is not always strong enough to stop a falling market, nor is resistance always strong enough to turn back an advance in prices. However, a system can be built around the concept of support and resistance to give a trader the edge required to be profitable.
(D) Once you have designed your system, it is important to measure its expectancy or reliability in various conditions and time frames. If it has a positive expectancy (it produces more profitable trades than losing trades) it can be used as a means to time entry and exit in the markets.
Step 6: Measure Your Risk-to-Reward Ratios and Set Your Limits(A) The first line in the sand to draw is where you would exit your position if the market goes against you. This is where you will place your stop loss.
(B) Calculate the number of pips your stop is away from your entry point. If the stop is 20 pips away from the entry point and you are trading a standard lot, then each pip is worth approximately $10 (if the U.S. dollar is your quote currency). Use a pip calculator if you are trading in cross currencies to make it easy to get the value of a pip.
(C) Calculate the percentage your stop loss would be as a percentage of your trading capital. For example, if you have $1,000 in your trading account, 2% would be $20. Be sure your stop loss is not more than $20 away from your entry point. If 20 pips are equal to $200, then you are too leveraged for your available trading capital. To overcome this, you must reduce your trading size from a standard lot to a mini-lot. One pip in a mini-lot is equal to approximately $1. Therefore, to maintain your 2% risk-to-capital, the maximum loss should be $20, which requires that you trade only one mini-lot. (For more on minis, see Forex Minis Shrink Risk Exposure.)
(D) Now draw a line on your chart where you would want to take profit. Be sure this is at least 40 pips away from your entry point. This will give you a 2:1 profit-to-loss ratio. Since you cannot know for sure if the market will reach this point, be sure to slide your stop to breakeven as soon as the market moves beyond your entry point. At worst, you will scratch your trade and your full capital will be intact.
(E) If you get knocked out on your first attempt, don’t despair. Often it is your second entry that will be correct. It is true that “the second mouse gets the cheese.” Often the market will bounce off your support if you are buying, or retreat from your resistance if you are selling, and you will enter the trade to test that level to see if the market will trade back to your support or resistance. You can then catch profits the second time around.
By fusing psychology, fundamentals, a trading methodology and risk management, you’ll have the tools to select an appropriate currency pair. All that is left to do is repeatedly practice trading until the strategy is ingrained in your psyche. With enough passion and determination, you will become a successful trader. (For more, check out our Forex Trading Guide.)
Why Professional Traders Use Rule Based Trading Systems
A professional trader in my opinion is someone that has been trading successfully for a relatively long time (3+ years) and has maintained account growth through adverse market conditions.
A trader that has made a bucket load of money overnight is not a professional in my opinion, they are a lucky trader…
Professionals make money in favorable market conditions and control risk and exposure in unfavorable conditions.
So how do you know when you’re in favorable market conditions?
Successful Traders Have A Rule Based Trading Method
I’ve been fortunate enough to speak to thousands of Forex traders in various stages of their journey.
Being a part of one of the top Forex Trading Schools has gave me unique insight into key factors that advance traders closer to achieving their goals.
I’ve came to this conclusion for myself and other successful traders I’m surrounded by…
More Rules = More Consistent Success
This is especially true for new traders just getting started in Forex.
Having clear cut rules keeps you on the sidelines when the market is not dancing to your rhythm. At the same time it helps you recognize when there are opportunities to slip in and out of the market grabbing pips and reducing exposure.
What Rules Should You Develop?
Traders that are making money consistently typically have 3 main sets of rules.
- Rules For Entry
- Trade/Money Management Rules
- Rules To Exit The Trade
The more defined your rules are the better you will understand how your system is performing in any given market condition.
Subjective, or discretionary traders often become too emotional and uncertain about trading decisions.
Emotions of uncertainty can ultimately destroy a traders confidence, which then leads hesitation or missing good trades altogether. Most of the negative emotions associated with trading can be avoided by having clear rules in place!
Developing A Rule Based Trading Software
The FxPM software is by no means the holy grail to Forex Trading. There is no holy grail in trading, and if someone says they’ve found it, run the other way.
However, many of the rules mentioned above are built into the FxPM Software to add a level of simplicity to defining trading opportunities.
This allows a new to trader start out on the right foot, and an advanced trader can improve their results by visualizing more data in a simple to view format.
Lets take a look at a few Position Entry rules that the FxPM software helps us clarify.
Price Action Band Shades
The Price Action Band Shades that are built into the FxPM Matrix allow you to see Overbought and Oversold market conditions at a glance. This gives FxPM traders very simple criteria to create rules and help base trading decisions on.
Aggressive or more active traders may take trading positions in the middle “neutral” zone. Typically their position sizing is significantly reduced because win/loss ratios are not as high in the middle zone.
More often traders prefer taking trades in either the Green Buy Zones or the Red Sell Zones. Win ratios are much higher in these areas.
Waiting for trading opportunities in the Buy and Sell zone forces patience and discipline, one of the hardest things to master as a full time trader.
Mastering patience and discipline takes some traders years to develop. This platform helps solve that problem the moment you start trading with the Forex Matrix.
Dynamic Fibonacci Indicators
When it comes to pinpointing high accuracy rule-based entry points, Dynamic Fibonacci clusters like the ones in the image below are the secret sauce to FxPM’s renowned reputation for high accuracy entries.
Creating entry rules around how you enter a 1,2,3,4, or 5 column Fibonacci cluster will greatly increase your success ratio.
Some of our trader increase or decrease position size, manage their stop loss more aggressively, or let profits run longer depending on the strength of the level.
Adding another layer to your entry criteria helps weed out the mediocre setups.
Trade Management Rules
Creating detailed rules around your trade management largely depends on your trading personal trading style.
With that said, here are a couple solid principles that should always be followed no matter what style of trading you adopt.
- NEVER Widen Your Stop-loss
- NEVER Risk More Than Half Of What You Stand To Gain
Those two rules alone will keep you out of trouble.
Another major advantage of the FxPM Software is that it automatically places your predefined Stop-loss and Take-profit for you which eliminates unnecessary mechanical steps.
Creating Trade Exit Rules
Much like money management, these rules will largely depend on your individual trading style.
Some examples our traders use are when the 1 minute trend indicators start to go against our position.
Other examples of fixed trade exit rules are simply taking profit when your 1:2 or 1:3 risk/reward ratio is met.
Trading with a Rule Based Trading System has huge advantages over discretionary trading.
Professional traders will disagree on many things when it comes to Trading strategy and methodology, but one thing we will all agree on is that rule based trading helps ensure long term trading success.
It will allow you to keep emotion curbed to the sidelines and focus on executing your strategy based on your well thought out and planned rules.
What rules do you have in your trading plan? Share in the comment section below!
For over 9 years I have been trading Forex and working closely with Armando Martinez, the Founder and creator of The FxPM Software to develop FxPM. It is our goal to develop a Forex Software that not only simplifies trading decisions but also delivers institutional performance to the retail trader.
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