Tuesday, June 29, 2010

Looking at the Future Through the Past : The Key to Successful Entry Logic Design

When you first attempt to design your own mechanical trading systems you often start with big questions about the way in which this is supposed to be done. The building of the entry logic - which marks the potential of a trading strategy (not its profitability !) - is quite commonly the first obstacle new traders find when attempting to develop a strategy. Generally people who aren't familiar with system development will start to develop entry logic based on visual observations - without a true grasp of the underlying market- something which is bound to create significant problems and eventually lead the trading strategy to failure. On today's post I will be writing about how you should address entry development and how you should focus on the understanding of the currency pair and the building of causality chains so that you can truly build entry logic criteria that have a good potential for the development of a long term profitable trading strategy.

When you sit down and start to build the entry logic for your next strategy you have to think mainly about two very important factors. First, you need to think about the underlying market characteristic you want to exploit and second, you need to think about the chain of causality that is bound to bring your trades to exploit this desired characteristic. To do any of these two things, you require an understanding about the underlying price action characteristics of the instrument you are trying to trade. Aiming to do this without a proper understanding of the behavior of the instrument you are trying to trade will bring nothing but failure.

How do you start then ? The first thing you need to do is to ask yourself about the inherent characteristic of the market you want to tackle. For example, let us suppose you want to exploit hourly trends in the GBP/USD. After deciding you want to do this you then need to look for the "ideal trades" you would have wanted your system to get into, when you would have ideally wanted to get in. Once you know your ideal entry you now need to look into the past and see if there were any changes that pointed out that this would happen. This leads us to the second part, developing a sense of causality.

Everything that happens in our world has a cause and so do market movements. When a given market movement develops there is bound to be a cause behind it. By looking into the past and finding certain market behavior that signals that a certain event is likely going to happen we find ourselves with the goal of entry development, a market inefficiency. The idea here is to look at the past and see what particular price behavior has led to our intended ideal entry setup. Once you have pinpointed this past cause that leads to your ideal entry setup you can code the logic and do a mathematical expectancy analysis. As you see here, the key is to find a particular market behavior in the past which leads to a given outcome in the future with a high probability.

The thing you need to understand here is that a given cause is not always bound to give the same effect because market behavior is almost never bound to repeat itself in precisely the same ways. What you are doing is building a "general case" from a very specific setup. Sometimes this general case assumption will not work since your logic "misinterprets" the current behavior as its "general case" while in other instances it will match and you will enter your ideal setup. This is what leads to market exposure and - when potential for profitability exists -to positive mathematical expectancy values.
Generally your general case will only determine the system's potential but money management (lot sizing plus exit logic) will finally determine profitability. Trying to modify an entry logic to achieve profitability is a wrong approach which usually leads to poorly built systems with very complex entry logic criteria that do not achieve long term profitability. Knowing the mathematical expectancy of your entry logic is vital for success since these data will tell you if there is potential or if your "general case" assumption simply does not work in the long term.

If you would like to learn more about automated trading systems and how you can build systems based on sound trading logic with realistic profit and draw down targets please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

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