NOVICE TRADER

Know Your System, Use It Wisely
Trading Systems Defined
by Martha Stokes

What is your trading style? Here's an overview of different types of trading systems that can be applied to different markets.

To succeed as a trader, you must understand how the market works. This begins with a foundation of core market knowledge, as can be seen in Figure 1. The next level is trading styles, followed by trading systems, and then, at the top, the implementation of trading strategies.

Figure 1: trading pyramid. Here you see the various levels of a trading pyramid. Trading systems sit at the third level. Only after overcoming this level can you implement your strategies.

One of the least-understood aspects of this formation is the trading systems level, second from the top. Without a thorough understanding of trading systems and the strategies designed for each kind of system, your trading efforts may yield disappointing results. (See Figure 2.)

No matter how you trade the market, you are using a trading system. A trading system is not a strategy, a software program, or an entry signal. It is a set of rules and parameters developed around a formula of indicators and price action for a specific type of market condition.

Often a trader will complain that a strategy doesn't work. They struggle with meager results that entice them to continue trying but seldom pay the bills. These traders go from seminar to seminar hoping to find the “perfect” strategy. But it's not the strategy that's the problem. It's the market condition under which the strategy is being applied that is not right. You must find the right strategy for the right market.

Strategies work best when applied to the market conditions for which they were designed. But before you can choose a strategy for the current conditions, you must understand what a trading system is and which system works under what condition.

Trading systems have been around for more than a century in many versions and variations, but all trading systems used today fall under six categories. Since the sixth is fundamental systems, we will not discuss it here.

TRADING SYSTEM TYPES

For technical analysis traders, there are five primary types of trading systems (Figure 3). These systems are:

Trending market?based systems are the most popular and most prevalent of all trading system types. The first trending systems were developed in the early 20th century. The first trending systems used moving averages as the basis for buying, holding, and selling stocks. Obviously, today's trending systems are more sophisticated while many are computer-generated entry and exit signals. No matter how modern, trending systems fail during certain market conditions because of the parameters of those systems.

A trending system assumes the stock market or certain sectors are moving in a strong uptrend or downtrend. A strong uptrend or downtrend is defined as one that has at least a 35-degree angle of ascent or descent with brief retracements or bounces and/or weak consolidation patterns that form as the stock or market moves. Short in duration, these periods are shallow adjustments to price due to profit-taking or resting phases of the uptrend.
...Continued in the March issue of Technical Analysis of STOCKS & COMMODITIES

Excerpted from an article originally published in the January 2007 issue of Technical Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2006, Technical Analysis, Inc.


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