How to Build the Best Trading System

Nov 20, 2020

Vijay Bhambwani, Editor, Fast Profits Daily

Over the last few days, I have been recording videos for you based on your feedback. I love to hear from you. Keep your comments coming.

I think this was one of the best and most important videos I've made.

In this video, I've explained the way to build a trading system in detail. This was to fulfil a request made by many of you.

I'm uploading it again today for the benefit of all those who may have missed watching this video.

I'll have a new video for you on Monday.

Hi, this is Vijay Bhambwani and I welcome you in this video of the Fast Profits Daily. I hope you're enjoying the markets and trading the markets even though the volatility, of course, has been a big challenge, as I have been mentioning on Equitymaster's Telegram channel, which you hopefully would have joined by now and if you haven't, I strongly urge you to do so.

It has the Equitymaster official as the handle, which you can search on telegram and join. I put up a lot of stuff there and post market late evenings based on my statistical data model, which helps you become a better trader and I assure you will be better off for it.

Now, this video and why am I recording this video? What's it all about? This is about, a subject that is very close to my heart. It touches me. It excites me. It keeps me alive at night and it's something that I am very, very passionate about.

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It's about trading, creating trading systems, training other people to trade and becoming a better trader in the bargain through this given take of ideas, learning from each other, and teaching others. It is said that if you want to learn something, well, start by teaching it to somebody else.

The psychological consciousness that you are being benchmarked, you're being watched, and people will basically try and evaluate you, keeps you on your toes, keeps you on the edge, and in the bargain, you yourself become a better trader. That works for me, and I get very excited when I get opportunities to go and talk to young college students, universities are brokerage firms, mutual funds, or even individual traders.

There's so much to learn, there is much to teach and so many ideas to exchange and in the bargain, I've made a lot of very good traders as personal friends who I keep in touch since many years. One of the questions that has been a put forth in my social media accounts in the comments section here and in a couple of videos in which I have talked about trading systems is, why don't you record videos on how to create better trading systems, how to segregate stocks out of finalise stocks, what are your blueprints for trading success? So this video, my dear friends, is all about how to create a good trading system.

Now there are two aspects to it, the quantitative and qualitative. By now you know that I believe in the 360 degree worldview approach, which means a very well rounded, holistic approach towards anything in the financial markets. So I'm gonna tell you a holistic method of creating a good trading system.

Now the quantitative or the material and the broad aspects of the trading system. It should be well rounded. It should work both in a bull and bear market. You know, unlike a fair weather friend whose only with you during of good times, a trading system cannot be a bull market centric or a bear market centric trading system.

You should be able to put food on your table for your family through bullish and bearish time. So it must cater to both markets. It should be simple to understand. It should be simple to program, and it should be simple to teach.

Now, when I was writing articles for many newspapers, at one point in time between 2000 to 2012, I used to run regular columns in various pink papers, one of my editors told me that the trick to being a good writer is if you go back home and give the newspaper to your domestic help and if they read it and understand what you're trying to convey through it, you have succeeded as a writer because you must write very simply, yet you must not sacrifice the accuracy and the point that you are trying to meet.

Trading system is intending to do only these three things. Earn the most amount of money in the shortest possible time and with the least amount of risk. And if you can make that simply, nothing like it. So it must be simple.

It must be scalable by scalable, meaning it should not work only on one lot or 200 or 500 shares. It must work equally well with 50,500, 5,000 lots because each trade of has his or her unique pocket size, risk appetite, and quantum of trading.

There are some traders who, if are told to do only one lot of nifty trade per transaction, they would simply lose interest and say look, I am not here to pick pennies. This is not me. There are others who, if I tell to trade more than five lots at the time, would simply lose their mind and say, look, this is the kind of stress that I can't take. So the trading system must be scalable.

It must focus on very liquid counters. For example, in the F&O space, the nifty 50 futures are the most liquid counters on the period. You can get in and get out with 500 lots in a few seconds without damaging the price too much.

The risk reward ratio must be high. So for every rupee that you are willing to lose in a drawdown or trade, which gives you losses, you must make at least Rs 2.5 as potential profits in winning trade. Which means your gross losses should not exceed more than 40% of your gross profits. By gross, I mean before brokerage taxes and other execution costs.

The trade efficiency ratio must be at least 3x, if not higher. Now the trade efficiency ratio is a phrase I have coined myself. Basically it means that your net profit, after all, execution costs, commissions, and taxes, vis-a-vis all the execution costs, commissions, and taxes. So what I mean is, if you're paying Rs 1000 per day in brokerage, STT, GST, etc, your profit must be 3,000 bucks.

Which means your trade efficiency ratio is three times more than the cost, that you are incurring and therefore your trade efficiency ratio is termed as 3x. So try to make a trading system which will identify or allow you to trade only those trades where the trade efficiency ratio is at least 3x.

Focus on trading system that gives you consistent profits rather than big numbers. Big numbers would mean you make Rs 1 lakh on one day and lose 90,000 on the other. You make 120,000 on day three lose one 110,000 on day four. You know what? In all these four days of trading, you've taken home only Rs 20,000.

You were better off in a trading system, which gave you Rs 5,000 hypothetically. I know you can't make money each day to like clockwork, but hypothetically speaking, in an example, a trading system that allows you to make Rs 5,000 per day peacefully over four days, giving you Rs 20,000 is better than making 100,000, losing 90,000, making 120,000, losing 110,000. That kind of stress will make you old, give you back aches, neck aches, heart attacks, high blood pressure, and cut down your staying power in the markets. Believe me, I know. This is my 35th year of trading in the markets.

Now I come to the qualitative aspect. Now, this is actually the heart of the trading system. Now your training system must throw or yield all kinds of solutions for all types of trading sessions. There are some trading sessions where the markets open in one direction and continue to trade in that direction. There are the others where the market opens in one direction, trades there for maybe first 10, 15, 20 minutes and reverses direction and there you see it. After a bearish opening, completely bull closing or vice versa.

Does it mean that your trading system should only yield money in one type of trading session? No, because your family will demand food on the table three or four times a day, irrespective of the kind of market that you are encountering. So the trading system should be an all-weather friend.

These are the critical components or the moving parts of a good trading system, 10 of them, which all trading systems worth their money should have without fail. It should have momentum following technology, which means if your following and trend and the trend is up, it gets you in the trade reasonably well early and allows you to ride a major part of the move. That means you're going with the flow.

It should also have contrarian technology or what we traders all fade plays when you're fading a move you actually going in the opposite direction of the present move because you're betting that the price will reverse. If the market as upwards, it will go down and in the market is downwards it will reverse and go up because you need to make money both in reversing as well as trending markets.

Your number three requirement is that trading system should also have mean reversion techniques built in. By mean reversion I mean if prices are running away in one direction, they can come back to the mean or the statistical average price.

Take, for example, again, a hypothetical example. You have a 25 day moving average and the price which is trending above and below the 25 day moving average. Now the price shoots up. Where do you think the price will reverse from and revert back towards the moving average?

Believe me, whenever the markets reverse, people who have mean reversion techniques in their trading system and to make a lot of money, a huge amount of money. So this tool must definitely be a part of a of your armoury.

Number four. It should have cycle time measuring techniques. Markets tend to move in cycles. Your derivative series are valid for four weeks. Mutual funds tend to prop up their NAVs at the end of every quarter. FIIs tend to want the markets to go up towards December because the fund manager goes to his respective parent country to collect his performance bonus through that calendar year for when he is invested in India.

There are cycles in the market and I have recorded ample videos. If you go back in time in the same playlist, I have broken down the market into a decade of the century, year of the decade, month of the year, week of the month, day of the week, and hour of the day. It is possible to do this. So you're trading system must be able to break down the session into cycle times. So that point number four.

Point number five, You must, without fail, have incorporated something that allows you to quantify or put in numbers, screen reading techniques. If you can't read the screen in front of you, which basically tells you that the flow of money is going upwards or downwards, believe me, you're trying to swim with your hands tied behind your back using only your legs. You are going to be half the trader you can be at peak performance potential if you do not know how to read the screen.

Number six. It must have technical analysis and especially anchoring techniques. Anchoring would mean a very simple thing. If you were to drive a nail in the wall and take a piece of string and a pencil attached to it, you can draw a circle by allowing the pencil to go as far away from the nail as the string allows you and draw a perfect circle.

So that nail is the anchor and the pencil is basically going as far away as the string allows it. So you must have technical analysis with anchoring in the price, which tells you where the support where the resistance is, where the price can go. The furthest away in the uppermost and lowermost direction before it reverts back to mean.

Point number seven. You must have trading techniques for two types of markets. Hi beta, high impetus markets, where in the markets really move very large price points and even if you were to buy 200 to 500 shares of the stock, you're made and there are some days when the market refuses to budge. To make Rs 5,000 for that particular training session, you might have to trade 1,000, 2,000 shares. Maybe five, maybe eight, maybe 10 times during the day.

So high beta, high impetus. High impetus means large price moves. You must have trading techniques for high beta, high impetus days. You must trading techniques for low beta low impetus days. So high beta wants 500 shares. Wait for Rs 10 moves. Low beta, low impetus means buy 5,000 shares, waiting for a smaller Re 1 price move to make the same Rs 5,000 bucks. Believe me, these are not the same. The risk reward ratio, the effort, the stress involved is completely different and unless you know the difference, you're not even been going to get there.

Point number eight. It must have at least one chaotic attractor built in. Now, if you observe any smoker, smoking in a closed room without the fan on, he will realise that the minute he takes the cigarette off his lips, the cigarette is actually giving out a plume of smoke and that smoke tends to generally go in a wavery fashion but accumulate at the ceiling at roughly, I am saying roughly, at the same point.

Why?

That point in the ceiling where the smoke is going in hitting it is called the chaotic attractor as per quantum physics studies. Take for example, your lightning rods or lightning conductors. Why have tall buildings and historical monuments built lightning conductors?

It's because a bolt of lightning tends to concentrate and hit very sharp objects which are metallic and grounded to the earth so that electricity can reach the earth. Now that point on the lightning conductor is the chaotic contractor. If you google search, there is enough material out there to know how to program chaotic attractor codes into your trading system. You must have at least one chaotic attractor if not two.

It must have a bionic component. This is point number nine. By bionic, I don't mean as a child I used to watch a series on television called colonel Steve Austin 6 Million Dollar Man, 7 Million Dollar Man, which was a sequence. A space astronaut loses his arm in an accident and is fitted with a bionic arm, how he has superhuman strength. I am not talking about a metal arm here.

I am talking about a statistical model. Why should your trading system have a statistical component to it? It's because it takes away the emotions from the trading system, the subjectivity from the trading system, and relies purely on objectivity or rationale and logic. So this is point number nine, which every trading system must have.

The last point. It must have techniques for computing time versus price and price versus time. You know, if I was to tell you that a stock XYZ, trading and Rs 10 is going to go to a point in price at say Rs 15. You would think that I have given you a secret or a tip of making 50% return. I have actually told do nothing.

You know why? It's because I have not told you the time frame. If you're going to go in this stock from 10 bucks to 15 bucks over the next 10 years, you're better off keeping your money in a fixed deposit. So what I forgot or deliberately omitted was the marriage between time and price. This is called the time and price continuum.

If your trading system forgets how to compute profits in hours, in days, in weeks, months, and years, it's told you nothing. It's given you nothing at all. Remember anchoring and the three things that trading system is supposed to do? Maximum amount of profits, minimum amount of time, and with the least amount of risk.

So I hope I have covered all the aspects that you need to create a fantastic trading system and this answers your queries those specific viewers of my videos who are looking out to become better traders. I assure you I'll be recording more on this in my future videos.

On this reassuring note, I bid goodbye to you in this video not before requesting you to click like on this video if you liked what you saw and subscribe to my YouTube channel. Click on the bell icon to receive alerts for fresh videos. In the comments section do let me know what you think about this video and what you want me to record next. I'll try and accommodate as many requests as responsible.

Help me reach up to fellow like-minded traders were looking for a 360 degree approach, behavioural finance, and knowledge based investments and trading systems, by referring my video to your family and friends.

Goodbye for now. Take very good care of yourself, your health, your family, your friends, investments, and trades. Have a very, very profitable day ahead. Vijay Bhambwani signing on for now.

Thank you for watching.

Stay safe!

Warm regards,

Vijay L Bhambwani
Vijay L Bhambwani
Editor, Fast Profits Daily
Equitymaster Agora Research Private Limited (Research Analyst)

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1 Responses to "How to Build the Best Trading System"

Dinesh Tiwari

Nov 21, 2020

Hi

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