How to develop a systematic trading system

Write your trading idea as a ShowMe study.
- Scroll through several years of data to develop a sense of how your idea performs.
Write a very simple system based on your trading idea.
- For example, you could write a system that enters a position based on your idea and exits the position automatically after n-days. Alternatively, you could write a stop-and-reverse system that uses your idea to enter, exit, and reverse positions.
Design a setup for your trading system idea.
- A setup alerts you that a trading opportunity has developed. Setups don't get you into a trade, but they do tell you that market conditions have become favorable for a trade. An example of a buy setup is a market posting two consecutive closes above a moving average.
- An example of a sell setup is the Relative Strength Index (RSI) crossing from above 70 to below 70.
Design an entry for your systematic trading system.
- An entry is the criterion that must be met after a setup for a trade to be initiated.
- An example of a buy entry is a market rallying one average daily range above yesterday's close. An example of a sell entry is a market's decline below the previous week's low.
Design an exit for your system.
- An exit is the criterion by which a trade is closed out. Trailing stops, profit targets, and exit conditions will account for most of your system's exits.
- A trailing stop is set below the current price for a long position and above the current price for a short position. When you are in a long position, you raise the trailing stop as the market trades higher to lock in profits; while short, you lower the trailing stop as the market trades lower, locking in profits.
- An alternative to exiting on a trailing stop is exiting at a profit target. A profit target closes out a trade when the price reaches a specified objective. One example of a profit-target exit is to close out a position on the second close above the high of the entry day. Another example is to automatically close out a trade when open profits equal three times the initial risk on the trade.
- An exit condition gets you out of a trade when a market no longer justifies an open position. Good traders do not always rely on stops to exit their trades. If the technical condition that got you into a trade (e.g. a rising moving average) is no longer in effect, you should exit the trade immediately rather than waiting for your stop to be hit.
Select the data on which you will test your system.
- For example, you might choose to test your system on continuous, back-adjusted data on U.S. Treasury Bonds from January, 1978 through December, 1997.
Divide the test data into five equal parts.
- Since you are going to test your system on 20 years of data, each part consists of four years. The first four years (01/02/78 - 12/31/81) are reserved for the backward test, and the last four years (01/02/94 - 12/31/97) are reserved for the forward test. The middle 12 years (01/02/82 - 12/31/93) are the data on which you will test and optimize your system.
Test and optimize your system on the large, middle section of data.
- To evaluate the results of testing and optimizing, you should consider several factors including equity curve, net profit, percent profitable, profit factor (dollars won per dollar lost), average trade, and maximum drawdown.
Backward and forward test your system on the out-of-sample data you reserved.
- The test results will probably not be as good as the results on the data for which your system was optimized. However, for your system to be tradable, the backward and forward tests should yield favorable results. Your system is unlikely to perform better in the future than it did on the out-of-sample data. Check your system's performance on the same key factors that you evaluated during your test of the sample data (equity curve, net profit, percent profitable, profit factor, average trade, and maximum drawdown).
Trade your system with consistency, confidence, and courage.

See also these related pages about systematic trading:

Books about systematic trading strategy development:

Book Notes - New Trading Systems And Methods - Encyclopedic in it's coverage
Book Notes - Quantitative Trading Strategies - Good introduction, but the numbers can't be replicated
Book Notes - Money-Making Candlestick Patterns

Sources:

Omega Research System Trading and Development Club - volume 6