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Define your trading style
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2
Select your technical tools
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3
Establish your entry and exit rules
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4
Backtest your technical trading system
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Optimize your technical trading system
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Forward test your technical trading system
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Here’s what else to consider
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Technical trading systems are rules-based methods of entering and exiting trades based on technical indicators, patterns, and signals. They can help traders to identify trends, reduce emotions, and improve consistency. However, creating and testing a technical trading system is not a simple task. It requires careful planning, analysis, and evaluation. In this article, we will explain how you can create and test a technical trading system in six steps.
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- Sebastian Lehner Portfolio Management Associate | Invesco Quantitative Strategies
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1 Define your trading style
Before you start designing your technical trading system, you need to define your trading style. Your trading style depends on your goals, risk tolerance, time horizon, and personality. For example, if you want to capture short-term price movements, you might be a day trader or a scalper. If you prefer to follow long-term trends, you might be a swing trader or a position trader. Your trading style will influence your choice of markets, time frames, indicators, and strategies.
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2 Select your technical tools
Once you have defined your trading style, you need to select your technical tools. Technical tools are the indicators, patterns, and signals that you will use to generate trading signals. There are many types of technical tools, such as moving averages, trend lines, support and resistance levels, oscillators, chart patterns, and candlestick patterns. You should choose the technical tools that suit your trading style, market conditions, and personal preferences. You should also avoid using too many or too few technical tools, as this can lead to confusion or missed opportunities.
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3 Establish your entry and exit rules
After you have selected your technical tools, you need to establish your entry and exit rules. Entry and exit rules are the specific conditions that trigger your buy and sell orders. For example, you might enter a long trade when a moving average crossover occurs and exit when a reversal pattern forms. You should also define your stop-loss and take-profit levels, which are the prices that limit your losses and lock in your profits. Your entry and exit rules should be clear, objective, and consistent.
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4 Backtest your technical trading system
Before you apply your technical trading system to real markets, you need to backtest it. Backtesting is the process of testing your technical trading system on historical data to evaluate its performance and reliability. You can use software programs, online platforms, or manual calculations to backtest your technical trading system. You should backtest your technical trading system on different markets, time frames, and periods to see how it performs under various scenarios. You should also measure your technical trading system's profitability, risk, and accuracy using metrics such as return, drawdown, win rate, and reward-to-risk ratio.
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- Sebastian Lehner Portfolio Management Associate | Invesco Quantitative Strategies
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Address common mistakes traders make when backtesting. Highlighting issues like lookahead bias, overfitting (mentioned but could be expanded upon), and data snooping will help readers avoid them. Include realistic costs like slippage and commission. Otherwise the backtest is not meaningful.
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5 Optimize your technical trading system
After you have backtested your technical trading system, you need to optimize it. Optimizing is the process of fine-tuning your technical trading system's parameters and settings to improve its performance and reduce its drawbacks. You can use optimization techniques such as sensitivity analysis, curve fitting, or walk-forward testing to optimize your technical trading system. However, you should be careful not to over-optimize your technical trading system, as this can lead to overfitting or curve fitting, which means that your technical trading system works well on historical data but fails on new data.
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6 Forward test your technical trading system
The final step in creating and testing a technical trading system is forward testing it. Forward testing is the process of testing your technical trading system on live or simulated data to verify its validity and robustness. You can use demo accounts, paper trading, or small positions to forward test your technical trading system. You should forward test your technical trading system for a sufficient period of time and with realistic conditions to see how it handles market fluctuations, slippage, commissions, and emotions. You should also monitor and review your technical trading system's performance and make adjustments as needed.
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7 Here’s what else to consider
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