Strategies for developing a mechanical trading system
As a trader, it is very important to have a good trading system, as it allows you to save time on a daily basis when operating in the markets. It also allows a trader to make decisions only based on a platform that has been backtested using various parameters. Broadly speaking, there are two main types of trading systems: – A manual system where one uses excel analysis – An automated or mechanical trading system A simple Google search will produce thousands of trading systems that have been developed by traders. Some are good while others are not suitable at all. In this article, we will write about how you can develop your own trading system. When developing a mechanical trading system, your goal should never be making a billion dollars. The two main goals you should aim to achieve are to identify a trend as early as possible and to avoid whipsaws. On paper, these are simple strategies that you can come up with. In reality, it’s more complicated than that because the strategies contradict each other.
What you need to know about trading systems
A mechanical trading system is also known as robot or expert advisor. It is a highly technical tool that can execute a trade or send a signal when a certain combination is reached. For example, suppose you are a trader who uses the Relative Strength Index (RSI) indicator to trade. Suppose also that you always open a buy trade when the RSI moves to an extremely oversold level of 10. Now you can stay in front of your computer and wait for these conditions to be reached. Alternatively, you can create a software that automatically opens a trade when the RSI moves to that level. Then you can create a program that sends you a notification when the RSI moves to that level. This system is known as a robot or a mechanical system. As you can see, creating such a system is not an easy process. Firstly, you need to have a routine that works well. You also need to have some experience in software development because a robot is a computer program.
How a mechanical system works
A mechanical system works in a relatively simple way. Firstly, a trader can build or buy an already built system. The system is usually built using several programming languages like Python and CSS. After this, the software is incorporated into the trading system. This is important because not all systems accept these robots. For instance, it is almost essential to incorporate a mechanical system into Robinhood or Schwab. Once all the settings are made, the system will do what it is supposed to do. For instance, it can open trades when the parameters match. It can even stop trades when conditions change.
Key settings
Set the time frame
Every trader has specific time frames that they trade with. Some are perfect trading hourly charts while others are perfect when trading 30 minute charts. To choose the time frame, you need to assess yourself to understand what type of trader you are. If you are a day trader, we suggest using hourly and 30-minute charts. If you are a swing trader instead, you should use daily charts.
Select indicators
After setting the time frame, the next step is to choose which indicators to use. As a daytrader, to achieve the first objective above, we suggest using moving averages. You should use two moving averages, one fast and one slow and wait until the fast one passes the slow one. This is a concept called moving average.
Find indicators to confirm the trend
At this stage, you simply want to fulfill the second objective we mentioned above (avoid whipsaws). You want to avoid being in a false trend, and thus the need to confirm the trend. To achieve this goal, we suggest using the MACD, Relative Strength Index and Stochastic.
Risk assessment
No system is correct. Therefore, it is important to define the risk that you intend to use. Some trades will go against the system. It is therefore important to define how much risk you are willing to take on each trade you make. You don’t want to ruin your account and incur huge losses for neglecting risk management, right?
Entry and exit points
After following the steps above, the last step is to define the entry and exit points. There are many theories on how to make this happen, but most people believe in entering the trades when all indicators match even before the candle closes. Other people instead prefer to see all traders match and wait until the candle closes. In our experience, we believe in waiting for the candle to close. This is because the indicators can sometimes match and change before the candle closes. Once you are in a trade, the next challenge is when to exit. The best way to do this is to follow your stop. This means that if your trade turns positive by X, you move your stop by X. You can also set the stop loss by using the support and resistance levels.
Here is a practical example.
Entry Positions – Place a buy position if: the 5-day moving average is above the 10-day simple moving average and when the stochastic lines are moving upwards. Finally, indicate when the RSI is greater than 50. Exit Positions – Place a sell order when the 5-day simple moving average goes below the 10-day simple moving average. The stochastic lines should be moving downwards. This will prevent you from entering when the stochastic lines are in overbought sections. The relative strength index should be less than 50. Exit rules – The trade should be exited when the 5-day simple moving average crosses the 10-day simple moving average in the opposite direction. Additionally, the RSI should go back to zero. Finally, you should exit when the trade reaches the stop loss of 100 pips. The charts below show some examples of this system in action.
Backtesting of the mechanical system
The next key step when building a mechanical system is called backtesting. It’s simply the process where you use historical data to see how the software would have performed in a real market situation. Fortunately, many trading platforms such as TradingView and MetaTrader have features that allow you to test a robot.
Pros and cons of mechanical robots
There are several advantages to using a mechanical robot. The first advantage is that the bot will always do what you have programmed it to do. Second, the bot can scan multiple assets simultaneously to identify trading opportunities. Third, the mechanical system does not sleep. It can work even when you are not around. There are several drawbacks to using these systems. First, building a mechanical system requires significant skills that most people do not have. For example, it is rare to find someone who knows how to code and trade. Second, sometimes a mechanical system can lead to significant losses. Thirdly, it is often difficult to test the mechanical system in advance.
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