How to develop a trading system – part 1

There is old adage: “If you give me a fish you will feed me for one day, if you teach me how to catch a fish you will feed me for whole life”. Today I wish to start with series of posts in order to try to teach public how to fish.

As I said many times, trading is marathon run and for every marathon you must have proper shoes to make 42195m long race. In order to make it in trading one must have trading system with positive expectancy. Without having positive expectancy, one could have all the discipline of this world, but money is not going to be made.

I tried to look for articles on the web about this topic, but there are very few and far between. It looks like it is more profitable to sell trading system to people than to teach them how to make one for themselves.

So, what one must consider when developing trading system:

1. Markets to trade

2. Data

3. Software

4. Design of the system: trend following or mean reverting

5. Backtesting

6. Paper trading

7. Real Trading

8. Repeat from step 3

So, let’s start:

First three steps are somehow correlated to each other. First and the most important question is which market one should trade. There are three major groups of markets:

1. Equity market

2. Forex market

3. Futures market

Equity market is probably the most common market traded. Probably everyone in this world has heard about Warren Buffet and the ways he invests. Most common form of trading or call in investing is value investing, but there is place for trading this market. Many institutional investors are doing just that. This should be choice for people who are not enjoying checking prices every hour or so and who would like to make their decisions once a day or even once a week.

Forex market is the biggest and most liquid market in the world. In this market you will often find yourself betting against FED or ECB or JP Morgan. Such market is suited for people who like action of checking prices every few minutes and even waking up at night if positions are left open.

Futures market is similar to Forex, providing high amount of leverage. Futures are issued these days over everything: equities, forex, commodities – name it and it is there. It is, as well, very dynamic market and can move up or down very fast. So, be aware if you want to trade this market.

What is available in South Africa?

Apparently, South African futures market is one of the biggest in the world. There are many single stock futures market makers. Also, there are warrants issued here and together with contract for differences you can use them for trading. Futures market in South Africa is regulated by Safex that is part of JSE and there are several options available: First and the most popular is ALSI contract on financial board, with other options being futures issued over agricultural commodities, to name few: white and yellow maize, wheat, soybeans, etc. Few years back white maize was the most volatile instrument in the world and was traded only in South Africa.

My idea behind this series of posts is to describe process and to develop trading system. So, at this point one must decide which markets to trade. Since we are very familiar with ALSI futures we are going with that one and we are going to develop system for that market.

Stay tuned for next post on how to choose data supplier and software for backtesting.

Trade with trend!