Constructing a Systematic Trading Strategy
This lesson sets out the procedure for converting a market observation into a fully specified strategy, including the required conditions, the rule set and the case for simplicity.
Risk note: educational content only. This article is not financial advice, investment advice, or a recommendation to buy or sell any instrument. Trading leveraged products can result in losses greater than expected, and each reader should understand the risks before trading.
A systematic trading strategy is a repeatable set of conditions that produces a defined decision whenever those conditions are met. It differs from a discretionary impression of the market in that its rules are written, its scope is explicit and its results can be attributed to the rules rather than to judgement. This lesson describes the sequence by which such a strategy is constructed: the identification of a market behaviour with a rational explanation, the definition of the conditions under which the strategy applies, the specification of rules for entry, stop, exit and size, and the restriction of the strategy to a small number of well-founded conditions.
The basis of a strategy in observed market behaviour
A durable strategy begins with a behaviour of the market that the trader can observe and explain. Examples include the tendency of price to move through an obvious prior high before reversing, as resting orders above that level are executed; the persistence of trends as large institutions accumulate positions over an extended period; and the tendency of ranges to hold while no new information is being incorporated into the price. In each case there is a mechanism that accounts for the pattern.
A rule that has no explanation behind it is a statistical coincidence that has not yet ceased to occur. Such rules can survive a backtest, particularly where the number of parameters is large, but they have no reason to persist. The requirement for an explanation is therefore not a formality; it is the principal defence against adopting a pattern that describes the past but not the market.
Definition of the conditions of application
The second step is to define the scope of the strategy. This includes the instrument or class of instruments to which it applies, the timeframe on which the setup is identified and the timeframe on which the entry is timed. It also includes the state the market must be in before an entry is sought: for example, a trending market as defined by a specific structural criterion, a ranging market, or the period following the opening of a particular session.
Equally important is the definition of the conditions that invalidate the setup, so that the strategy is not applied outside its intended context. Specifying when a strategy does not apply is as important as specifying when it does, and it is the element most frequently omitted. A strategy designed for trending conditions and applied indiscriminately in ranging conditions will produce results that appear to discredit the strategy when they in fact reflect its misapplication.
Specification of the rule set
The rule set must specify six components. The entry rule states the exact condition that triggers a position. The stop-loss rule states the price or the structural criterion that determines where the position is closed if the thesis fails. The exit rule states how profit is realised, whether by a fixed target, a trailing method or a time-based criterion. The size rule applies the fixed fractional formula from Lesson 14, so that the position size follows from the stop distance and the permitted risk. A limit on the number of positions open simultaneously and a definition of the market and timeframe complete the specification.
The standard for each rule is that a second person, given the same chart and the same written rules, would reach the same decision. If two people applying the rules would take different trades, the rule is not yet complete. Testing the wording on another person is a practical method of verifying this standard.
- Market and timeframe.
- Required market condition and its invalidation.
- Exact entry trigger.
- Stop-loss placement rule.
- Exit rule: target, trailing method or time-based.
- Position size formula and maximum number of open positions.
The case for simplicity
A strategy with three well-founded conditions is generally more robust than one with ten. Each additional filter reduces the number of trades the strategy generates, which reduces the sample available for evaluation, and increases the probability that the strategy has been fitted to the historical data rather than to a persistent behaviour. Complexity also increases the difficulty of execution, since each additional condition must be verified before every entry.
The appropriate discipline is to specify the smallest number of conditions that capture the observed behaviour, to test the resulting strategy according to the procedure in Lesson 22, and to alter one element at a time when the results indicate that a change is warranted. Adding conditions in response to individual losing trades is the most common route by which a simple, sound strategy is converted into a complex, fitted one.
Documentation and review
The completed strategy should be recorded in the written trading plan described in Lesson 16, together with the results of its backtest and forward test and the date on which each version was adopted. Recording versions allows the trader to identify which changes improved results and which did not, and prevents the gradual accumulation of unrecorded modifications.
The strategy is then reviewed at fixed intervals against the evidence in the trading journal. A review considers whether the strategy was executed as written, whether the market conditions for which it was designed were present, and whether its statistics remain within the range established in testing. A strategy that is executed correctly and produces results consistent with its test statistics does not require modification, even during a losing sequence that falls within its expected drawdown.