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Forex Education

Create Your Own Trading System

Create Your Own Forex Trading System

After learning how to develop your own trading plan and discovering what type of trader you are, it’s now time to create your very own trading system!

How To Create A Mechanical Trading System

So far, we’ve taught you how to develop your trading plan. We’ve also discussed how important it is for you to discover which type of forex trader you are.

Now it’s time to teach you how to add some meat to your thin trading plan by showing you how to create a forex trading system. More specifically, we’re gonna teach you all about forex mechanical trading systems.

Forex Mechanical Trading Systems

Mechanical trading systems are systems that generate trade signals for a trader to take.

They are called mechanical because a trader will take the trade regardless of what is happening in the markets. In theory, this should eliminate all biases and emotions in your trading, because you are supposed to follow the rules of your system NO MATTER WHAT.

If you do a simple search in Google for “forex trading systems” you’ll find many many many people out there who claim to have the “Holy Grail” system that you can purchase for “only” a few thousand dollars.

These systems supposedly make thousands of pips a week and never lose.

They will show you supposed “results” of their perfect systems and it will make your eyeballs turn into dollar signs as you sit there and say to yourself, “Wow I can make all this money if I just give this guy $3,000. Besides, if his system making thousands of pips a week, I’ll be able to make my money back in no time.”

Slowww down cowboy. There are some things you should know before you give them your credit card number and make that impulse buy.

The truth is that many of these systems DO in fact work. The problem is that forex traders lack the discipline to follow the rules that go along with the system.

The second truth (Is there such thing as a second truth?) is that instead of paying thousands of dollars on a system, you can actually spend your time developing your own mechanical trading system for free, and use that money you were going to spend as capital for your forex trading account.

The third truth is that creating mechanical trading systems isn’t that difficult. What is difficult is following the rules that you set when you do develop your system. There are many articles that sell systems, but we haven’t seen any that teach you how to create your own system.

This lesson will guide you through the steps you need to take to develop a forex mechanical trading system that is right for you.

At the end of the lesson, we will give you an example of a system that one of the FX-Men use just so we can show you how awesome we are! (Insert evil laugh here.)

Goals of your mechanical trading system

We know you’re saying, “DUH, the goal of my trading system is to make a billion dollars!”

While that is a wonderful goal, it’s not exactly the kind of goal that will make you a successful forex trader.

When developing your mechanical trading system, you want to achieve two very important goals:

  1. Your system should be able to identify trends as early as possible.
  2. Your system should be able to avoid you from getting whipsawed.

If you can accomplish those two goals with your trading system, you have a much better chance of being successful.

The hard part about those goals is that they contradict each other.

If you have a system who’s primary goals is to catch trends early, then you will probably get faked out many times.

On the other hand, if you have a mechanical trading system that focuses on avoiding whipsaws, then you will be late on many trades and will also probably miss out on a lot of trades. Your task, when developing your mechanical trading system, is to find a compromise between the two goals.

Find a way to identify trends early, but also find ways that will help you distinguish the fake signals from the real ones.

Tons of forex traders post their ideas for trading systems, so you may find one or two that you can use when you build your own mechanical trading system.

Design Your Trading System in 6 Steps

The main focus of this article is to guide you through the process of designing your own forex trading system.

While it doesn’t take long to come up with a system, it does take some time to extensively test it. So be patient; in the long run, a good forex trading system can potentially make you a lot of money.

Create Your Forex Trading System in Six Steps

Step 1: Time Frame

The first thing you need to decide when creating your system is what kind of forex trader you are.

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Are you a day trader or a swing trader? Do you like looking at charts every day, every week, every month, or even every year? How long do you want to hold on to your positions?

This will help determine which time frame you will use to trade. Even though you will still look at multiple time frames, this will be the main time frame you will use when looking for a trade signal.

Step 2: Find indicators that help identify a new trend.

Since one of our goals is to identify trends as early as possible, we should use indicators that can accomplish this.

Moving averages are one of the most popular indicators that traders use to help them identify a trend.

Specifically, they will use two moving averages (one slow and one fast) and wait until the fast one crosses over or under the slow one.

This is the basis for what’s known as a “moving average crossover” system.

Moving Average Crossover

In its simplest form, moving average crossovers are the fastest ways to identify new trends. It is also the easiest way to spot a new trend.

Of course, there are many other ways forex traders spot trends, but moving averages are one of the easiest to use.

Step 3: Find indicators that help CONFIRM the trend.

Our second goal for our system is to have the ability to avoid whipsaws, meaning that we don’t want to be caught in a “false” trend.

The way we do this is by making sure that when we see a signal for a new trend, we can confirm it by using other indicators.

There are many good indicators for confirming trends like MACD, Stochastic, and RSI.

Indicators

As you become more familiar with various indicators, you will find ones that you prefer over others and can incorporate those into your system.

Step 4: Define Your Risk

When developing your forex trading system, it is very important that you define how much you are willing to lose on each trade.

Not many people like to talk about losing, but in actuality, a good trader thinks about what he or she could potentially lose BEFORE thinking about how much he or she can win. The amount you are willing to lose will be different than everyone else.

You have to decide how much room is enough to give your trade some breathing space, but at the same time, not risk too much on one trade.

You’ll learn more about money management in a later lesson. Money management plays a big role in how much you should risk in a single trade.

A trader should aways think about the potential loss BEFORE thinking about potential gain.

Step 5: Define Entries & Exits

Once you define how much you are willing to lose on a trade, your next step is to find out where you will enter and exit a trade in order to get the most profit.

Entries

Some people like to enter as soon as all of their indicators match up and give a good signal, even if the candle hasn’t closed. Others like to wait until the close of the candle. Others like to wait until the close of the candle.

One of the forex traders here in BabyPips.com, Pip Surfer, believes that it is best to wait until a candle closes before entering.

He has been in many situations where he will be in the middle of a candle and all of the indicators match up, only to find that by the close of the candle, the trade has totally reversed on him!

It’s all really just a matter of trading style. Some people are more aggressive than others and you will eventually find out what kind of trader you are.

For example, in the chart below, this trader’s entry was when the candle closed below the support line.

System Entry

Exits

For exits, you have a few different options.

One way is to trail your stop, meaning that if the price moves in your favor by ‘X’ amount, you move your stop by ‘X’ amount.

Another way to exit is to have a set target, and exit when the price hits that target. How you calculate your target is up to you. For example, some traders choose support and resistance levels as their targets.

In the chart below, the exit is set at a specific price which is near the bottom of the descending channel.

System Exit

Others just choose to go for the same amount of pips (fixed risk) on every trade.

However you decide to calculate your target, just make sure you stick with it. Never exit early no matter what happens.

Stick to your trading system!

After all, YOU developed it!

One more way you can exit is to have a set of criteria that, when met, would signal you to exit.

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For example, you could make it a rule that if your indicators happen to reverse to a certain level, you would then exit out of the trade.

Step 6: Write down your system rules and FOLLOW IT!

Write Down Trading System Rules

This is the most important step of creating your trading system. You MUST write your trading system rules down and ALWAYS follow it.

Discipline is one of the most important characteristics a trader must have, so you must always remember to stick to your system!

No system will ever work for you if you don’t stick to the rules, so remember to be disciplined.

Oh yeah, did we mention you should ALWAYS stick to your rules?

How to Test Your Forex Trading System

Initial Trading System Testing

The fastest way to test your system is to find a charting software package where you can go back in time and move the chart forward one candle at a time.

When you move your chart forward one candle at a time, you can follow your trading system rules and take your trades accordingly.

Record your trading record, and BE HONEST with yourself!

Record your wins, losses, average win, and average loss. If you are happy with your results then you can go on to the next stage of testing: trading live on a demo account.

Trade your new system live on a demo account for at least two months. This will give you a feel for how you can trade your system when the market is moving. Trust us, it is very different trading live than when you’re backtesting.

After two months of trading live on a demo account, you will see if your system can truly stand its ground in the market.

If you are still getting good results, then you can choose to trade your system live on a REAL account.

At this point, you should feel very confident with your forex trading system and feel comfortable taking trades with no hesitation.

Build Your Trading System in 3 Steps

Now that you’ve learned the basics of technical analysis. Let’s now combine all this information and build a simple trading system.

This should give you an idea of what you should be looking for when you develop your own forex trading system. This system is moving average crossover system, which uses moving averages to determine whether to go long or short.

Additional technical indicators are also used for confirmation before entering a trade.

You’ll learn to use these various technical indicators to establish specific “crystal clear” entry and exit levels. The trading system can be built in 3 simple steps:

  1. Define your time frame
  2. Determine your entry trigger(s)
  3. Determine your exit trigger(s)

Trading Setup

  • Trade on daily chart (swing trading)
  • 5 SMA applied to the close
  • 10 SMA applied to the close
  • Stochastic (14,3,3)
  • RSI (9)

Trading Rules

Entry Rules

Enter LONG if:

  • The 5 SMA crosses above the 10 SMA and both Stochastic lines are heading up (do not enter if the Stochastic lines are already in the overbought territory)
  • RSI is greater than 50

Enter SHORT if:

  • The 5 SMA crosses below the 10 SMA and both Stochastic lines are heading down AND (do not enter if the Stochastic lines are already in oversold territory)
  • RSI is less than 50

Exit Rules

  • Exit when the 5 SMA crosses the 10 SMA in the opposite direction of your trade OR if RSI crosses back to 50
  • Exit when trade hits stop loss of 100 pips

If the daily chart is too slow fo you, you can try experimenting with different time frames. Keep in mind though that the faster the time frame, the higher likelihood for “false positive” trades. These are trades that meet the rules for entry but where you end up getting stopped out.

Remember: A trading system is only effective if it is followed!

You need to have the discipline to stick to the rules!

Okay, let’s take a look at some charts and see this baby in action…

Build Your Forex Trading System

The “So Easy It’s Ridiculous” Trading System

As you can see, we have all the components of a good forex trading system.

First, we’ve decided that this is a swing trading system, and that we will trade on a daily chart.

Next, we use simple moving averages to help us identify a new trend as early as possible. The Stochastic help us determine if it’s still ok for us to enter a trade after a moving average crossover, and it also helps us avoid oversold and overbought areas.

The RSI is an extra confirmation tool that helps us determine the strength of our trend.

After figuring out our trade setup, we then determined our risk for each trade. For this system, we are willing to risk 100 pips on each trade.

Usually, the higher the time frame, the more pips you should be willing to risk because your gains will typically be larger than if you were to trade on a smaller time frame.

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Next, we clearly defined our entry and exit rules. At this point, we would begin the testing phase by starting with manual back tests.

Trade Example: Buy EUR/USD

Here’s an example of a long trade setup:

Long Entry Signal

If we went back in time and looked at this chart, we would see that according to our system rules, this would be a good time to go long.

To backtest, you would write down at what price you would’ve entered, your stop loss, and your exit strategy.

Then you would move the chart one candle at a time to see how the trade unfolds.

Long Exit Signal

In this particular case, you would’ve made some decent pips! You could’ve bought yourself something nice after this trade! You can see that when the moving averages cross in the opposite direction, it was a good time for us to exit.

Of course, not all your trades will look this sexy. Some will look like ugly heifers, but you should always remember to stay disciplined and stick to your trading system rules.

Here’s an example of a short entry order for the “So Easy It’s Ridiculous” system.

So Easy It's Ridiculous System Short Entry Signal

We can see that our criteria is met, as there was a moving average crossover, the Stochastic was showing downward momentum and not yet in oversold territory, and RSI was less than 50.

At this point, we would enter short.

Now we would record our entry price, our stop loss and exit strategy, and then move the chart forward one candle at a time to see what happens.

So Easy It's Ridiculous Forex System Short Exit Signal

Boo yeah baby! As it turns out, the trend was pretty strong and pair dropped almost 800 pips before another crossover was made!

Now isn’t that ridiculously easy?

The "So Easy It’s Ridiculous" Forex Trading System

We know you’re probably thinking that this system is too simple to be profitable. Well, the truth is that it is simple. You shouldn’t be scared of something that’s simple.

In fact, there is an acronym that you will often see in the trading world called KISS.

It stands for Keep It Simple Stupid!

It basically means that forex trading systems don’t have to be complicated.

You don’t have to have a zillion indicators on your chart. In fact, keeping it simple will give you less of a headache.

The most important thing is discipline. We can’t stress it enough. Well, yes we can.

YOU MUST ALWAYS STICK TO YOUR TRADING SYSTEM RULES!

If you have tested your forex system thoroughly through back testing and by trading it live on a DEMO account for at least 2 months

Then you should feel confident enough to know that as long as you follow your rules, you will end up profitable in the long run.

Trust your system and trust yourself!

Summary: Creating Your Own Mechanical Trading System

There are many systems out there that work, but many forex traders lack the discipline to follow the rules and as a result, still end up losing money.

Your mechanical trading system should attempt to accomplish two goals:

  1. Be able to identify a trend as early as possible.
  2. Be able to find ways to avoid whipsaws (confirm your trend).

If it is profitable, then you trade your forex system live on a demo account for at least 2 months.

This will help you get an idea of how you would trade your system when the market is moving. It is a lot different trading live than manually backtesting.

Once you’ve demo traded your system for at least 2 months and you are still profitable, you are then ready to trade your system live with real money.

However, you must always remember to stick to your rules no matter what!

There are 6 steps to developing your mechanical forex trading system:

  1. Find your time frame.
  2. Find indicators to help you identify trends early.
  3. Find indicators to help you avoid whipsaws and confirm your trend.
  4. Define your risk.
  5. Define your entry and exit.
  6. Write your forex trading system rules down and ALWAYS stick to those rules!

There are 3 phases to testing your system:

First Phase: Go back and time and move your chart forward one candle at a time.

Trade your system according to its rules and record your trades to see if it ends up being profitable. This is called backtesting.

Second Phase: If it is profitable, then you trade your system live on a demo account for at least 2 months.

This will help you get an idea of how you would trade your system when the market is moving. It is a lot different trading live than manually backtesting.

Third Phase: Once you’ve demo traded your system for at least 2 months and you are still profitable, you are then ready to trade your system live with real money.

However, you must always remember to stick to your rules no matter what!

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