Developing a Mechanical Trading System

As a trader, having a good trading system is very important. A system allows a trader to save time on a daily basis when trading. It also allows a trader to be only make decisions based on a platform that has been backtested using various parameters. Broadly, there are two main types of trading systems. One, there is a manual system where one uses excel analysis. Secondly, there is the automated or mechanical system. A simple Google search will produce thousands of trading systems which have been developed by traders. Some are good while some are not appropriate at all. In this article, I will write on how you can develop your own trading system. When developing a mechanical trading system, your aim should never to make a billion dollars. The two most important goals you should aim to achieve are: to identify a trend as early as possible and to avoid whipsaws. On paper, these are simple strategies which you can come up with. In reality, it is more complicated than this because the strategies contradict one another.

Set the timeframe

Every trader has specific timeframes that they trade with. Some are perfect trading with hourly charts while others are perfect when trading 30 minutes charts. To select the timeframe, you need to assess yourself to understand the type of trader you are. If you are a day trader, I suggest you use hourly and 30 minutes charts. If you are a swing trader, you should use daily charts.

Select indicators

After setting the timeframe, the next step is to select the indicators to use. As a day trader, to accomplish the first goal mentioned above, I suggest that you use moving averages. You should use two moving averages, one fast and another one slow and wait until the fast one crosses the slow one. This is a concept known as moving average crossover.

Find indicators to confirm the trend

In this stage, you simply want to fulfil the second goal we mentioned above. You want to avoid being in a false trend, thus the need to confirm the trend. To achieve this goal, I suggest that you use MACD, Relative Strength Index, and Stochastic.

Risk assessment

No system is accurate. Therefore, it is important to define the risk that you intend to use. Some trades will go against the system. It is thus important to define the amount of risk you are willing to take on every trade you enter.

Entry and exit points

After following the above steps, the final step is to define the entry and exit points. There are many theories on how to make this happen. However, most people believe in entering the trades when all the indicators match up even before the candle closes. Other people prefer seeing all the traders match up and wait until the candle closes up. In my experience, I believe in waiting for the candle to close. This is because at times the indicators might match and change before the candle closes. Once you are in a trade, the next challenge is on when to exit. The best way to do this is to trail your stop. This means that if your trade turns positive by X, you move your stop by X. You can also set the stop loss by using the support and resistance levels.

An example of a trading system

In this part, we will create a simple trading system that you can reciprocate.

 Entry positions

Place a buy position if: the 5 day moving average is above the 10 day simple moving average and when the stochastic lines are moving up. Finally, enter when the RSI is greater than 50.

Exit positions

Place a sell order when the 5 day simple moving average moves below the 10 day simple moving average. The stochastic lines should be moving down. This will prevent you from entering when the stochastic lines are in overbought sections. The relative strength index should be less than 50.

Rules of exits

The trade should exit when the 5 day simple moving average crosses the 10 day simple moving average in the opposite direction. Also, the RSI should cross back to zero. Finally, you should exit when the trade hits the stop loss of 100 pips. The charts below shows some examples of this system in action.

A short trade develop1 A long trade

develop2