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A rule-based trading system is crucial for ordinary traders as it ensures consistency by making decisions systematic and repeatable. It helps control emotions, reducing the impact of fear and greed on trading decisions. By following predefined rules, traders can manage risks effectively with defined parameters. This approach leads to more disciplined and objective trading, enhancing the likelihood of long-term success.
What is a Rule-Based Trading System?
The rule-based trading system is an algorithmic system that precisely defines fundamental and technical parameters (trading rules) for the open and close positions and calculates position size. Trading rules exist to help traders avoid overtrading, have an edge and trading plan, and increase the winning rate probability.
The rules must be simple, and all traders must understand their technicality. These rules are generally tough for an outsider to understand. They are specific and not general and help one understand all trading methods properly.
You will use a rule-based forex trading system if you are a discretionary trader. Still, you will have the ability to be flat (sometimes, you will not follow the rules) in correlation to the information that is accessible at present.
Many traders expect trading articles to read secret formulas and secret trading rules that will succeed if they follow them.
Rule-Based Trading System example
An excellent trading system needs to calculate fundamental and technical parameters. Here is an example:
BUY EURUSD if the price is above SMA 200 on the weekly chart AND EU GDP growth>4% AND US GDP growth<1%
SELL EURUSD if the price is below SMA 200 on the weekly chart AND EU GDP growth is <4% AND US GDP growth is>1%
Of course, day traders can not use fundamental indicators for short-time trading, except if they mainly trade the news.
Backtesting is a crucial process in developing a rule-based trading system. It involves applying your trading strategy to historical market data to assess its effectiveness. This allows traders to see how their system would have performed in the past, providing valuable insights into its potential future performance. By using historical data, traders can identify the strengths and weaknesses of their strategy and make necessary adjustments to improve its robustness.
During backtesting, traders can analyze key performance metrics such as the win/loss ratio, maximum drawdown, and overall profitability. This analysis helps them understand the strategy’s risk-reward profile and make informed decisions about its viability. Backtesting also allows traders to identify and eliminate any biases or errors in their system before risking natural capital.
Furthermore, backtesting helps build confidence in the trading strategy, as traders can see how it performs across different market conditions and periods. It is essential to use a comprehensive and representative dataset to ensure that the backtest results are reliable and not just a result of favorable market conditions.
Rule-Based Trading System development steps
Before diving into the specific rules and strategies of forex trading, it’s crucial to understand the psychological and preparatory steps that form the foundation of successful trading.
1. SWOT Analysis
- Strengths: Identify what you excel at in trading. Are you good at technical analysis, or do you know how to interpret economic indicators?
- Weaknesses: Recognize your limitations and areas where you need improvement.
- Opportunities: Look for areas where you can leverage your strengths in the market.
- Threats: Be aware of external factors that could impact your trading negatively.
Knowing your strengths, weaknesses, opportunities, and threats helps you develop trading measures and rules that suit your personality. This ultimately prepares you to be more objective, disciplined, and patient.
2. Goal Setting
Setting realistic goals is essential. Financial goal setting involves:
- Determining the amount of return you aim to achieve.
- Understanding the frequency and size of your investments.
- Preparing for potential losses, acknowledging that all investments carry market risks.
3. Financial Status
Ensure you have enough funds for trading, daily needs, and savings. This financial cushion is crucial to withstand potential losses and market volatility.
4. Selection of Investments
Selecting investments involves:
- Choosing currencies with lower chances of value decline.
- Diversifying your investments across different time frames and markets.
- Keeping abreast of news and trends related to your chosen currency pairs.
- Maintaining charts to track currency movements.
5. Testing Methodology
Before fully committing, test your trading system:
- Start with smaller investments in selected currencies and markets.
- Evaluate if your system aligns with the market conditions.
- Ensure your strategy incorporates support and resistance levels to manage risks.
6. Limit Settings
Setting limits involves:
- Calculating your risk tolerance using the risk-to-reward ratio.
- Establishing stop-loss levels to minimize potential losses.
- Using the 20 pips rule to transition from standard lots to mini-lots.
- Maintaining a 2% risk-to-capital ratio.
Additionally, maintain a market chart to track movements and set investments at 25% of the Daily Average True Range (ATR) from the entry-level, ensuring a 2:1 profit-to-loss ratio.
By following these steps, traders can establish a solid foundation for their trading activities, enabling them to make informed, disciplined, and strategic decisions in the forex market.
7. Dealing with loss: Suppose, even after following every corner of the set rules and system, you tumble down the market slope. Do not give up and be upset. The market is bouncy, and maybe it was not your day, or maybe you made the wrong entry even after being diligent. Keep your patience, monitor the market fluctuations closely, and head back into the market with better support and resistance.
Rule-Based Trading Systems Impacts
Rule-based trading is an automated mechanism that eliminates the influence of emotions and biases while making trading decisions. Decision-making, order placement, and position exit are automated in rule-based trading. A set of rules and circumstances defines the trading setup, and the system executes the deal. By automating your transactions, you eliminate the uncertainties and delays of manual trading and ensure that your trades are completed objectively and without bias.
Rule-based trading can help you watch the markets and find the optimum entry and exit points. With this trading strategy, you may relax knowing that your transactions are being completed based on objective criteria and conditions, free from emotional or psychological biases. So, use a rule-based trading system to simplify your trading experience and reduce biases.
Rule-based trading, which eliminates guesswork and delays, has become popular among investors. Traditional traders must monitor markets and manually execute deals when they see possibilities, which takes time and is error-prone. Rule-based trading executes deals automatically when the investor’s strategy is met. An Options Strategy Builder can help you develop a rule-based trading strategy. A Strategy Builder lets investors enter their trading ideas and rules and test them against historical market data. This helps investors improve their plans before launching them. Rule-based trading and Strategy Builder let investors trade more methodically and profitably, avoiding guessing and delays.
Challenges of Rule-Based Trading Systems
Rule-based trading systems may not react to changing market conditions. They conduct transactions based on established criteria but may not account for unanticipated occurrences or market mood shifts. These systems discover trends and define rules using historical data, which may not reliably forecast market behavior. Over-optimization can sometimes lead to poor performance in new market conditions. Rule-based trading systems must be monitored and managed to work correctly and adjust to market changes. Finally, traders’ rules and parameters determine the effectiveness of rule-based trading systems. Inexperienced traders may need help to choose the right directions and circumstances for their trading methods, which can lead to losses.
Despite these drawbacks, rule-based trading systems can be helpful for traders, especially when supplemented with other analyses and market research.
These basic rules help traders to get an accurate idea of the investments and the net results. Thus, it also helps one to manage money better. If any losses occur, recheck or change the technical indicators used to set the rules or the system. People often think there will be no loss at all by following a definite system. Still, traders would have been more prosperous than their wildest dreams if that had been the actual scenario. So, obtaining and following a sound trading system will only help you follow your passion for trading without facing monetary losses. You can modify some of the forex trading system rules to improve and upgrade your forex trading and tractions skills once you become immensely successful and experienced in this field.
He is an expert in financial niche, long-term trading, and weekly technical levels.
The primary field of Igor's research is the application of machine learning in algorithmic trading.
Education: Computer Engineering and Ph.D. in machine learning.
Igor regularly publishes trading-related videos on the Fxigor Youtube channel.
To contact Igor write on:
igor@forex.in.rs
