What is a trading system?

For some traders, building a trading system means that they focus on finding the best indicators they could get their hands on or the one trading setup that is backtested to work 99% of the time. All I can say is, to each his own. For me, the keyword of a trading system lies not with trading, but with system. Remember, it is a system. First of all, it is a system for trading. Not a system to trade. What do I mean by that? Consider this saying, "traders don't go broke by missing opportunities, they go broke by taking too many." A trading system needs to be selective. It needs prudent risk management. Secondly, you need to generate your own market view to trade. Rather it be technical, fundamental, sentimental, or just following some joe, you trade based on your view. Trading is a test of your market hypothesis using money. If you think the market will rise, you buy. If you think the market will fall, you short. Lastly, a trading system needs to execute trades. Otherwise you'd be an anlayst. It needs to time entries and exits. Again, this could be as simple as on a whim or as complicated as some n-th order algorithm. Thus we have the three pillars of a trading system.

  1. Risk Management
  2. Market Analysis
  3. Trade Execution

What's more, if we combine some of these pillars we get some well known concepts. For example, market analysis + trade execution = trading signals, wherein you derive signals based on market conditions to execute trades. Or risk management + trade execution = position management, wherein you manage your holdings by manipulating your trades based on your risk profile. All these relationships and composition of a trading system can be summarized with a Venn diagram. So, this is my view of a trading system:

[caption id="" align="aligncenter" width="414" caption="Trading system Venn diagram"][/caption]