Preliminary Steps for Building a Successful Trading System

The First Steps for the Successful Development of any Trading System

This article outlines some essential preliminary steps for developing a successful trading system, along with key biases to avoid. The content is primarily based on Van Tharp's book Trade Your Way to Financial Freedom.

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Step 1: Finding a Concept That Works

Finding a concept that works should be considered the first step in building any trading system. An effective concept should include detailed setups for entries and exits, along with clear money management rules. This means defining entry conditions, exit strategies, and position sizing. However, most traders focus primarily on high-probability entries without considering proper position sizing or exit planning. This approach often results in a negative expectancy.

• Less than 20% of all traders have a defined system.
• Of those, only a small proportion truly understand the concept behind their system.
• The key to a successful concept lies in accepting trades with a high reward-to-risk ratio and letting profits run.
• Traders who understand position sizing and the importance of exits can be profitable even with an entry system that yields only 40% winners and 60% losers.

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Step 2: Determining Your Strengths and Weaknesses

The second crucial step in developing a trading system is to assess your strengths and weaknesses. Without this self-evaluation, creating a methodology that suits you will be nearly impossible. Consider the following key factors:

• How much capital can you allocate?
• What is your risk tolerance, and how much loss can you withstand?
• What time constraints do you face?
• Do you possess strong computer or mathematical skills?

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Step 3: Setting Objectives

Setting objectives is the most critical step. Before building a system, you must clearly define what you want to achieve. Without knowing your destination, you can never reach it.

• Establishing the right objectives accounts for about 50% of the work required before developing any trading system.
• Objectives will differ among traders, investors, and money managers.
• The methodology you adopt should be a low-risk one, as outlined below.

A low-risk methodology refers to an approach that limits drawdowns while still offering a long-term positive expectancy. It protects you from the worst short-term conditions while allowing you to reach your long-term goals.

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Step 4: Mental Planning for the Worst Possible Scenarios

It’s essential to evaluate how your system will perform under various market conditions. Without assessing its behavior in different scenarios, you won’t know what to expect from your trading system.

• How will your system handle extreme volatility?
• How does it react to major news events?
• Is it effective in both trending and ranging markets?
• Can it adapt to thin, low-liquidity markets?
• What happens during a liquidity crisis or a black-swan event?

Compile a list of adverse market conditions and develop contingency plans for each.

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Step 5: Avoid Biases Affecting the Successful Development of Your Trading System

These are key biases to recognize and avoid when developing your trading system.

□ Trade Size Bias

Traders often risk too much capital on a single trade.

• Most retail traders overlook the importance of position sizing.
• Professional traders typically risk no more than 1–2% of their capital per trade.

□ Cutting Profits Bias

Traders tend to be conservative with profits and aggressive with losses, creating a false sense of being right.

• Many are quick to take profits but allow losses to grow.
• The correct approach is the opposite: cut losses quickly and let profits run.

□ Pattern Recognition Bias

Traders may fixate on ineffective patterns and become convinced of their validity.

• A few selective examples can falsely reinforce belief in a pattern.
• Always use volume to confirm pattern formations, especially with breakout patterns.

□ Randomness Bias

Traders often try to impose order on inherently random markets.

• They see what they expect, not what is truly happening.
• Market price distributions often exhibit infinite variance, with “long tails” at the ends of the bell curve.
• Random markets can still display long streaks, making top and bottom fishing one of the hardest trading strategies.

□ Gambler’s Fallacy Bias

This bias arises from the randomness bias and reflects the mistaken belief that a trend will reverse simply because it has persisted.

• For instance, after four up days, traders may expect a down day and act on that belief.
• It leads to flawed position sizing—betting more after losses and less after wins.
• The rational strategy is to increase position size during a winning streak and reduce it during a losing streak.
• One of the most important rules is to let profits run and cut losses, yet fear often drives traders to close profitable trades too soon.

□ Degrees of Freedom Bias

This bias results from excessive backtesting and data manipulation to fit historical outcomes.

• Traders would benefit more from understanding their concepts through minimal testing.
• A degree of freedom refers to a system parameter—like the length of a moving average—that alters system behavior.
• The more degrees of freedom used, the more likely the system is over-optimized to past data, reducing future profitability.
• Limit your system to 4–5 degrees of freedom. For example, two indicators and two filters would already reach this limit.

□ Reliability Bias

This relates to trusting data that appears accurate but may contain errors.

• Backtesting with flawed market data can lead to poor trading decisions.
• Always assume your data may have inaccuracies, and account for potential errors in system development.

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Step-6: Calculating The Expectancy of your Trading System after Developing it

Once you have developed a trading system, you need to calculate its expectancy by considering several key factors.

a. Calculating the Overall Expectancy of Your System

You can calculate the expectancy of your trading system by dividing the total profit by the number of executed trades:

Expectancy = Total Profit / Number of Trades

Alternatively, use this formula:

Expectancy = (PW × Average Profit) – (PL × Average Loss)

Where:

• PW = Probability of Winning
• PL = Probability of Losing

b. Categorizing Your Trades

By categorizing your trades across different markets and conditions, you can make more accurate estimations of your system’s expectancy.

• Group your trades by market type, conditions, and as general winners or losers.

c. Eliminating the Effects of Position Sizing

To isolate system performance, consider only single-unit trades, removing the impact of position sizing.

d. Converting Your Trade Groupings into a Probability Matrix

Use your smallest loss as a unit to build a probability matrix. This allows you to calculate expectancy per dollar risked.

e. Evaluating the Results

If your system includes at least 100 trades and shows an expectancy above 50 cents per dollar risked, it can be considered a good system.

f. Improving Your Expectancy

Analyze the size of winners and losers in your probability matrix and reflect on the following:

• What do the winners and losers reveal about your system?
• Is there a pattern in the sequence of winning and losing trades?
• How can you adjust your system to increase the number of winners?
• How can you reduce the frequency or size of large losses?

Key Notes

• Expectancy and probability of winning are not the same.
• Always align your risk with the system’s expectancy.
• Even with a system that has a high positive expectancy, it is still possible to lose money.

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□ Preliminary Steps for Building a Successful Trading System

G.P. for ForexAutomatic.com (c)

December 11th, 2024

Main Source: “Van Tharp - Trade Your Way to Financial Freedom”