Constituents of a Trading System
A trading system is simply a set of rules which decides three things:
- When to enter the trade. For a stock, when do you buy it.
- When to exit the trade. When do you sell it.
- How much money to put in the trade.
When do we enter a trade?
There are many ways people decide to buy a stock. A tip from a friend. A politician bought it. Strong conviction in the business. Some of these reasons are better than others, and later in this course we will turn "reasons to buy" into rules you can actually check.
When do we exit?
The exit is really two decisions in one, and you need both defined before you enter:
- When do we book profit, if the trade goes our way. That is the target.
- When do we book a loss, if it does not. That is the stop loss.
Yes, you need to define beforehand when you will book a loss. Booking a loss is part of trading, and you should learn to book a loss and accept your defeat in the stock market. This is not real life where you can argue with your partner and decide a win for yourself. This is the market and the market will crush you if you do not accept your defeat early enough.
How much money do we put in?
We will be coming up with a simple, well diversified, systematic approach for this in the later part of this course.
Decisions 1 and 2, the entry and the exit, are defined by the trading strategy the trader has in mind. Decision 3 is part of the risk management style the trader follows. There are many frameworks of risk management, and we will talk more about them in the coming lessons.
These terms will not make a lot of sense today. But we will be using them again and again in this short course, and you will learn them quickly. We talk about the trading strategy in the next lesson, and things will get clear from there.