After you`ve set your initial stop loss, chosen your method for calculating your trailing stop loss, and implemented all your money management rules, there is one last thing you should do; you should begin back testing your system.

With out back testing you will be headed in the right direction, but you won`t know what to expect from your system. Back testing will also give you the confidence to keep going when you begin to experience the doubt that every trader faces at some time.

Back test your system by applying the rules and conditions of the system to the stock`s historical market data. However, this is only possible if you`re trading a system that is entirely mechanical and does not require any human input to place the trades. How do you know whether or not your system is completely mechanical for back testing? Can you take down your trading plan, the set of rules and guidelines that you follow, and hand that over to someone else, who could then trade the same system and receive the same results as you would if they followed the system carefully?

If you can do this, you have a mechanical system that is ready for back testing. If you can`t, you should look at implementing a completely mechanical system. Perhaps one of the hardest parts in trading any system is to have the confidence to stick with your system. In fact, a mechanical system almost forces you to make decisions that are in direct conflict with what your gut feeling might tell you to do.

Remember, our gut feeling tells us we should hold on to losing stocks until they get to the break even point, and our gut feeling would tell us to sell shares as soon as we`re a little bit in profit. Obviously, a mechanical system goes against these human tendencies, and that is one of the reasons why it`s psychologically difficult to trade. However, back testing a mechanical system, will tell if you it your plan will work or not.

While back testing will not tell you with 100% accuracy what the profitability of your system will be once you start trading it, it will give you a very good sense of what you can expect. All prices are driven by the same two factors, supply and demand, in the present and in the past. So, even though price movements are never going to be exactly the same, in your back testing you will see the patterns, and similar movements that show up over time. With back testing you can discover the how profitable you system is likely to be, and how often you are likely to have a loss rather than a profit.

Back testing your system over different market conditions, it can be reasonable to draw parallels as to the performance of your system historically to its performance trading it in real time. Knowing this, because of back testing, will make it much easier to stick with your system, and the profits you can realistically skyrocket.

If you’re looking for a good piece of technical analysis software to do the back testing for you you should have a look at MetaStock End-of-Day or MetaStock Professional (for day traders).

-=-=-==-=-=-=-==-=-=-=-=-=-=-=-=-=-=-=- David Jenyns is recognized as the leading expert when it comes to MetaStock and designing profitable trading systems. His MetaStock website offers a huge free collection of trading related tips and tricks. Gain free access now. Click Here ==> http://www.meta-formula.com/subscribe -=-=-==-=-=-=-==-=-=-=-=-=-=-=-=-=-=-=- Article Source: http://EzineArticles.com/?expert=David_Jenyns

]]> http://www.financialmarketplace.com/the-idiots-guide-to-back-testing-trading-systems/feed/ 4 http://www.financialmarketplace.com/designing-a-trading-system-in-metastock-part-1/ http://www.financialmarketplace.com/designing-a-trading-system-in-metastock-part-1/#comments Tue, 02 Sep 2008 19:40:08 +0000 admin http://www.financialmarketplace.com/?p=64

By David Jenyns

In this three article series, I`m going to guide you through the process I use to design a trading system using MetaStock. I’ll cover the four major components that every successful trading system has in common, and then I’ll show you how to code these components into the MetaStock program. Please note that this is by no means investment advice and any information I cover is purely for illustrative purposes.

I am a technical analyst by trade. It is my belief that all fundamental and economic influences on a stock price are taken into consideration by the market. Therefore, I focus my attention on price action. All my trading systems are based on this understanding of the market, and the rules of my systems are built to respond to price actions. In this article, I’ll cover the basic rules of trading:

• Entry rules (when you get into a position)

• Exit rules (when you get out of one)

• Money Management rules (how much do you put in a trade?)

• Back-Testing (does the system work historically?)

These four components make up a proven formula for designing profitable trading systems in MetaStock. Let’s start with the first part.

A stock passing through a precise set of conditions creates entry signals before you will enter a trade on that security. I believe the rules set to signal an entry into a position should leave no room for individual judgment. I follow the KISS principal – that is they should Keep It Simple Simon.

Remember, there is no Holy Grail of entry systems. There is no MetaStock formula that will get you in at exactly the right time, everytime. With this in mind, it’s your goal to construct a simple, yet robust entry system.

Even though I always say that the entry is the least important component of any trading system, you still must have some way to enter a trade. Here are the points that I think are important to consider when identifying possible entry points.

PRICE: It is important to set price maximums/minimums because a stock’s price can determine its attributes. For example, speculative stocks tend to be cheaper, and blue chip shares tend to be more expensive.

LIDUIDITY: This is a measure of how much money the stock trades at. You need to set minimum levels of liquidity to keep you out of stocks that simply don’t trade enough. You can risk being trapped in stocks where the market is moving against you if they have a low liquidity.

VOLATILITY: This measurement tells you how much a stock moves. It is important to trade stocks that move enough for you to make a profit, yet aren’t so erratic that you can’t sleep at night.

TREND: This is the cornerstone of technical analysis. Remember that “the trend is your friend” and that you always want to trade with it, not against it. You will need a way to measure trend in your system.

TRIGGER: This is the point that will indicate it is time to enter a trade. The trigger condition occurs only at one point in time and doesn’t hold “true” over extended periods of time, such as with a moving average cross over.

When combined, these components are going to make up your entry rules. But, before we even begin coding this into MetaStock, you need to determine one of the most critical elements of any system. What time frame are you going to trade?

+ Short-term, such as a reversal trader

or

+ Long-term, such as a trend follower

There are distinct differences between these two types of systems and your choice here will have a marked effect on every other decision you make about your system.

Short-term systems tend to require a greater time commitment, and more money. However, the benefit of trading more often is that usually your profits are more consistent, and are realised more frequently.

Conversely, longer-term systems tend to require less time, and less money. However, since you are keeping your positions open longer, you need to wait until positions are closed out before you can collect any profits.

Generally, I steer my clients, particularly those who are just starting out, to a longer-term trend following system. It takes less time, less money, there is less risk and it is easier to do than short-term trading. In addition, trend following systems tend to have a higher win to loss ratios and are psychologically easier to follow because of this.

For the sake of this example, let us construct a trend following system. In the next two articles, I’ll explain how to code the four entry components of a trend following system into MetaStock.

David Jenyns is recognized as the leading expert when it comes to MetaStock and designing profitable trading systems.

His MetaStock website offers a huge free collection of trading related tips and tricks. Gain free access now.
Click Here ==> http://www.meta-formula.com/subscribe

Article Source: http://EzineArticles.com/?expert=David_Jenyns

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