System Development: What Is a Trading System? by Van Tharp

When most people think of a trading system, they think of the conditions that make for a good trade entry. For me, that's only one small piece of a trading system—and not even the most important part. My idea of a trading system is a complete strategy with seven individual parts:


1. Set up conditions

2. An entry signal

3. A worst case stop loss

4. Re-entry when appropriate

5. Profit-taking exits

6. A position sizing TM algorithm

7. Multiple systems for different market conditions (if needed)


1. The set up conditions amount to your screening criteria. For example, if you trade stocks, there are 7,000 plus stocks that you might decide to invest in at any time. That’s a lot of stocks to look at so most people employ a series of screening criteria to reduce that number to 50 stocks or less. For example, you might want to find stocks that are a great “value” or stocks that are making new all time highs or stocks that pay high dividends.


2. The entry signal is a unique signal that you use to determine when you might enter a position—either long or short. There are all sorts of signals you might use for entry, but typically it involves some sort of move in your direction that occurs after a successful set-up.


3. The protective stop is the worst-case loss you would accept before deciding the trade will not work out as planned. Your initial stop might be far enough away from your entry price (say 25%) to keep you in the trade for a long time. On the other hand, for intraday trades, you will probably want a stop very close to the entry price. Either way, protective stops are absolutely essential. Prices don’t go in one direction forever. You need to use stops that protect you and let you stay in the game.


4. A re-entry strategy. When your position hits its protective stop, sometimes the price will then turn in the direction that you originally wanted. Now what? Do you get back in or do you let it go? You need to think about what criteria might make for a good re-entry. What conditions might make you want to get back in to that position again?


5. Your exit strategy could be very simple or it could consist of a series of complex exits. Your exits are the one factor in your trading that you have total control over. Your exits determine whether you make money in the trade. Even though nearly all traders tend to spend most of their time thinking about setups, you should spend a most of your time crafting your exit strategies. This is an important shift in thinking that you will benefit from right now. You don't make money when you enter the market; you make your money upon your exit. Be a top trader and focus on when to sell rather than an average trader who focuses on what to buy.


6. Position sizing is that part of your system that controls how much of your equity you use for each trade. It is absolutely critical to your trading success. Simply put, position sizing determines whether you reach your trading income objectives. I believe that position sizing is the most important part of trading success behind understanding yourself.


7. Finally, depending on how robust your trading system is, you might need more than one trading system for each type of market. Many professional traders have multiple systems that operate in multiple time frames over many markets to help offset the enormous portfolio dependence of a single trend following system. At a minimum, I believe that individual traders need one system for trending markets and another system for flat markets.


Have you ever tried to trade something you read about or something someone you know is trading and not been able to trade it well? Trading a system requires that it reflects your beliefs, and fits with how you believe prices move and who you are as a trader and a person. If a system doesn’t match your beliefs about the markets or your self, you won’t be able to trade it well, or even at all.


So many traders are out there looking for the best predictive indicator, the best set up pattern, or just a system that someone else is trading well. Finding those, however, won’t improve your trading performance—until you build a solid foundation. You have to understand your wants, needs, desires, and lifestyle before you can start working on creating a trading system that fits you. Trading a system that truly fits you will be enjoyable, as well as profitable.