This type of trading system is very appealing to some traders because it can take a lot of the emotion out of trading. If you find that you are too emotional when you are trading, then this type of trading might be for you.
A rule-based trading system has strictly defined rules for all components of a trade. A trader is not allowed to deviate from the rules. The basic rules cover: entry criteria, lot sizing, maximum trade risk, trade management, maximum portfolio risk and exit criteria.
There are basically three types of rule-based systems:
- 100% automated strategies
- Manual trade management strategies
- A mixture of both automated and manual elements (Incremental Automation)
Regardless of which one you choose to use, this guide will show you how to create a system that works for you.
Step 1: Understand What Works With Your Personality
This is a really important step, so don't overlook it.
Many new traders think that they don't have to worry about system/personality fit because they just have to follow the rules of a system and they will make money.
Nothing could be further from the truth.
Even if you have black and white rules, you still have to consider how you will react to the results.
You could have a very profitable system, but if you cannot tolerate certain aspects of the system, you will give up on it.
Let's take a look at the primary elements that you should be aware of.
What Are Your Goals?
The first thing you should consider are your goals for the trading system.
Do you want to multiply a small account? Or do you want to make a steady income on a larger account?
These are very important questions to ask yourself when you are getting started.
Your answer to this question will determine the type of system you will create.
It helps to write down a yearly goal that you will be shooting for.
Some traders want to make 10,000% in a year (yes, they are serious). But in reality, 30% a year, with a decent sized account would be more than enough to meet their desires…with a lot less stress.
So take a realistic look at what you really want to get out of your trading system.
Write down your goals in your trading plan.
A lot of traders want to make the big bucks. But big profits usually also means big drawdowns.
Can you handle that?
Some traders can.
However, in my experience, most traders can't.
So pay attention to your drawdown numbers. A 40% drawdown might not be a big deal when you are demo trading. But the psychology can change dramatically when real money is on the line.
If you have a hard time feeling the emotional impact of a drawdown in a demo account, open a small real money account and use nano lots.
You may find that you are willing to tolerate a higher or lower drawdown than you expected. That's why it's important to test different types of trading systems to find out what works best for you.
Next, it's important to understand how frequently your strategy trades and how you feel about that frequency.
For example, let's say that your strategy only executes a few trades a month. But when it does trade, there's a high probability of success and you usually have a few big winners because you trail your stop loss.
That sounds great right?
Well, that actually sounds terrible to some traders. These traders get bored easily and want to be trading more frequently.
The opposite can also be true.
If a system executes too many trades, some traders get stressed out about having to trade all the time, or having too many trades open at once.
So take some time to consider your optimal trading frequency.
It's not the same for everyone.
Are you the type of trader who likes to see a high win rate? Or do you prefer to win less often, but have higher risk multiple returns per trade?
One trader I know of likes to go for 100R trades. But he only wins about 20% of the time. Could you handle 8 losing trades in a row (or more), before you get a winner?
Or would you rather only make 1R, but win 75% of the time?
Both methods are profitable.
There are no right or wrong answers here.
It's all about what you are most comfortable with.
Again, experiment with both to see what you prefer.
Fully Automated, Manual or Both?
The mechanics of how you enter and exit trades can make a big difference in your trading results.
For example, if your trading system has to be automated in order to be profitable, but you don't know how to program an automated trading strategy, then that strategy won't work for you.
But you can always learn. Take our Beginning MT4 Programming Course by master developer Adam Hartley.
Of course, you can also look for programmer to code it for you. Here's a list of programmers and a guide on how to find the right one.
On the other hand, maybe you don't trust an automated system and would prefer to manage trades yourself. If that's the case, then be sure that you will be able to trade at the times when your trades usually set up.
If your system usually has its best trades at 3:00 am local time, then that probably won't work as a manual system.
This is why backtesting and beta testing are so important. You want to figure out the blind spots in your system so you can compensate accordingly.
Step 2: Create a Written Trading Plan
The next step is to write down your trading rules.
This ensures that you have a solid reference point from which to make all of your trading decisions.
Use any recording method that works for you, but I've found that good ol' pen and paper works best for me. It's just easier to take notes and change things during the development process.
If you want a template for your trading plan, you can download a free PDF worksheet here. I find it very useful to print out a bunch of these and leave them near my desk.
When I get an idea, I jot it down so I don't forget. Then I can come back to it later to develop the idea.
A good trading plan should have the following elements:
- Trading system name
- Version number
- Indicators used, with settings
- Entry criteria
- Trade management rules
- Risk rules
- Re-entry rules
- Rules for portfolio risk
- Will this be traded manual, fully automated, or a little of both?
There may be other elements that you want to add later, but that list is a good start.
You can get a trading plan from many sources on the internet. There's no shortage of them, you can get them from courses, forums and blog posts.
See the strategies that we've shared here.
I would also recommend checking out the MQL5 Codebase and TradingView trading strategy communities. They are a big mish-mosh of strategies, with varying levels of quality, but they can give you some good ideas.
You can also look at the code and copy/paste ideas you like. If you find a strategy that actually works, that can be a great starting point for your strategy.
But how do you know if a trading strategy will give you an advantage in the markets?
That's what backtesting is for…
Step 3: Backtest Your Trading Plan Rules
Next, it's time to test your plan so you are confident that it will work in real-world trading. If you are new to backtesting, read our free guide here.
There are different ways to backtest and the best method for you will depend on the type of strategy you have.
Your backtesting will give you some key pieces of information:
- Win rate
- Longest win streak
- Longest losing streak
- Best/worst days to trade
- Best/worst times to trade
- And more!
If a backtesting platform doesn't give you some of this data, you can always export it to a spreadsheet to figure it out.
Don't expect to hit the jackpot on the first try. A successful backtesting result is almost always the result of many, many experiments.
Successful traders make small tweaks to a strategy and test the results. Remember to only change one thing at a time and test that change.
Otherwise, you won't know which changes worked and which ones didn't.
Once you have a strategy that hits your goals, you are ready to move on.
Step 4: Beta Test Your Rules
After you have tested your strategies and are confident in the results, don't jump into live trading just yet. There's one more step to do before you start risking real moola.
This is called beta testing or forward testing.
You don't want to jump directly into live trading because there are still a few things that you may need to work out.
For example, if you have a fully automated trading strategy that runs on MT5, you should definitely test it in a demo account with the broker that you intend to trade live with.
The broker's spread or server lag may affect how your strategy trades in live conditions. Sometimes the results can be significantly different.
So run this beta test for a few months to be sure that there aren't any other hidden issues with your trading system. Once you are confident it will work as you expect, now it's time to go live!
Step 5: Go Live
Now it's time to put your system into action. I would recommend starting out with a small account or using a smaller amount of risk in the beginning.
There may still be a few unforeseen differences between your broker's live server and the demo server.
But if it's all good, then let your strategy loose!
Remember to track your trades in a trading journal, so you can review the results every week.
Don't change anything about the system until you have at least 100 trades in the books. It can be tempting to start to mess with the system if it isn't winning right away.
Resist the urge because you may just be in a normal drawdown. You need to give the system time to apply your edge.
Final Thoughts on Rule-Based Trading Systems
A rule-based trading strategy will not take all of the emotion out of trading. For some traders, a very strict trading system can actually lead to more losses because they are not free to take all opportunities that come along.
But for traders who can be indecisive about trading decisions, or prefer to minimize the effect of their emotions, strict rules can be a great way to trade.
The added benefit of a rule based strategy is you can change specific elements of the strategy and see exactly how those changes affect the results.
If you want help testing a rules-based system or a discretionary trading strategy, join the TraderEvo Program. We take you step-by-step through the process of testing, verifying and reviewing trading strategies.