Steps to Design a Likely Long Term Profitable Trading System

To tell the truth, making a likely long term profitable trading system is a very difficult thing to do. When you search online for people who attempt to design profitable trading systems you will find that most of them don't have a mechanical, well-thought approach to system design and the final achievements are usually based on an initial "thought" based on repetitive and almost constant modifications to eliminate short term draw down periods which are natural to long term profitable systems. In the end, the result is a set of dangerous systems - sometimes without even accurate simulations abilities - that will put account equity at a very important risk of long term total loss. On today's post I want to write a little bit about my steps in system design and the main characteristics of my mechanical approach to sound trading system development.

So where do we start ? You will see that most traders who have never coded a likely long term profitable system will start by coding a given entry logic found on a forum or studied briefly through limited demo trading or visual backtesting. What they do then is assign a fixed lot size to trading and some given - almost always arbitrary - stoploss and profit target values with no particular extensive study. What you get then is a system that has no possibilities of success and which is flawed from the beginning since it has no adaptation, no real sound studies behind it and simply not enough focus on money management (which is lot sizing plus exit logic). This is revealed when traders start to put these systems to the test but instead of looking at the development process as a source of the problem they usually end up adding unsound tactics - such as martingales - over optimizing their exit values, adding complexity to the entries and other things which in the end lead to the generation of a system - which is simply - very bad.

First of all, there are probably many ways in which successful system design can be approached. I am going to discuss mine because it has worked for me and has led to the generation of many long term profitable systems but you should use my approach only as a guide to develop your own way of tackling the system design problem, as something different may work better for you.

What are the necessary steps to successful system development ? I have prepared a practical diagram (click to enlarge) showing you graphically the process I take in order to develop trading systems - including all those within the Watukushay Project - and all other experts. You will see that the first step I take is a design of an entry logic followed by a mathematical expectancy analysis which defines the trading system's potential. If the mathematical expectancy analysis is not positive, then I modify the entry logic or the evaluated number of periods and time frame until I am able to achieve a positive value. Most people would be surprised to know how little importance the entry logic actually has as most entry mechanisms have some degree of positive mathematical expectancy on different time frames or periods. The problem with the usual system development tactic used by most new traders is that they don't do a mathematical expectancy analysis at all, therefore, they truly don't know the potential of their system or if it is being used on the adequate time frame or if they are targetting adequate profit and loss values per trade.
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After doing this analysis - and having positive results - I continue to develop the system's money management which will be the KEY to the system's long term profitability. Using the previous mathematical expectancy analysis I figure out what exits (as adaptive TP and SL) and what time frame will be the most beneficial to my system, always taking care to use time frames and profit targets to preserve the reliability of the simulations being done. Defining an adaptive lot sizing technique which modifies positions against both balance and volatility is also vital to ANY trading system's long term success. Many people underestimate the HUGE importance lot sizing has, having a fixed lot size or adapting lot sizes against a fixed percentage of account balance is a death sentence for most trading systems.

The next steps are probably the most important and the ones new traders and most designers never do. You need to do a 10 year backtest and then a TRADE BY TRADE analysis of the results to design adequate internal exit logic mechanisms to increase the profitability of the systems. After you introduce a new trading logic you need to check if the expected payoff (which measures the relationship between profit and draw down) is increased. If it is not, then you need to go back to a TRADE BY TRADE analysis until you come up with a logic that works.

After you find a closing logic that increases the expected payoff you need to optimize variables in an uncorrelated way - one by one - with large steps to prevent any significant curve fitting that may happen (some variables however, like the SL and TP adaptive criteria, may be optimized in a correlated fashion). After this is done you need to evaluate your results and ask yourself if you are satisfied with the draw down and profit targets of your system. If you are, then you are done. If you are not, then you need to go back and analyze TRADE BY TRADE a 10 year backtest to come up with other closing mechanisms to increase profitability.

I believe that this approach, which attempts to increase system profitability through analysis and sound development is incredibly powerful at generating long term profitable systems. Usually people focus way too much on the potential of the trading strategy - the development of entries - when in reality very simple entries have very good potential and only the development of adequate exit mechanisms really guarantees that large profitability levels are achieved. If you see the graph, most of my efforts are around the development of profitability as only the initial mathematical expectancy analysis is devoted to potential.

In the end, profitable system development is NOT easy and requires many hours of hard work and development. Each analysis of a 10 year backtesting result can take me hours - sometimes even days - of work but in the end this analysis is absolutely necessary as it gives me the understanding necessary to implement good exit criteria that will bring my systems to new profitability levels. All this effort that goes into development also allows me to deeply understand my systems and trade them with confidence under very varied market conditions.

The above way of developing systems has allowed me to develop several expert advisors which show success on 10 year backtests and also on live trading accounts, adapting to changes in market conditions and tackling true market inefficiencies. If you would like to learn more about system development and how you too can develop your own long term profitable systems to achieve success in forex trading 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 !