A trading system is a complete set of written rules for one way of trading: which stocks qualify, what setup and trigger start a trade, where the stop goes, how the trade ends and how large it is. Building one means writing each rule precisely enough that two people would take the same trades, then testing the rules before relying on them.
A system is one part of a trading plan. The plan is the wider operating document: it names the systems allowed and sets the account's risk limits, schedule and review routine.
How it works: the six parts
- Market and universe filter: which instruments are eligible, for example US stocks above $10 with enough daily dollar volume to exit at the stop, or only stocks above their 200-day average.
- Setup: the condition that puts a stock on the watchlist, such as a tight base near a high or a pullback within an uptrend.
- Trigger: the exact event that enters the trade, for example a close above the 20-day high. The setup says "watch"; the trigger says "now".
- Initial stop: where the trade is wrong, fixed before entry, such as below the base or a multiple of ATR; see ATR stop.
- Exits: how winners end, by a target, a trailing stop or a time limit, and any rule for leaving early, such as before earnings.
- Position sizing: how many shares, usually a fixed share of equity at risk divided by the distance to the stop, with a cap on position value.
Each rule should be testable: "strong volume" is an opinion; "volume above 1.5 times its 50-day average" is a rule.
How to test it
- Backtest: apply the rules to past prices with realistic fills and costs; see backtesting for the biases that flatter results.
- Forward test: run the unchanged rules on new data, on paper or at small size, and compare the results with the backtest.
- Sample size: a few trades prove nothing. With 30 trades and a 40% win rate, the standard error of the win rate is about 9 percentage points; with 120 trades it is about 4.5. Conclusions from a few dozen trades are tentative.
How to read the result: expectancy in R
Results are measured in R, the initial risk per trade. Expectancy = win rate × average win in R − loss rate × average loss in R. It shows what the system has earned per unit of risk, independent of account size. Check it after costs, alongside the maximum drawdown and the longest losing streak, which decide whether the system can be followed in practice.
Worked example (illustrative numbers)
A breakout system written out in full:
- Universe: US stocks above $10 trading above their 200-day average.
- Setup: within 5% of the 20-day high after a narrowing range.
- Trigger: a daily close above the 20-day high; buy at the next open.
- Stop: 2 × ATR(14) below entry.
- Exit: a close below the 10-day low, or after 30 sessions.
- Size: 1% of equity at risk, no position above 20% of equity.
On a $50,000 account, a stock entered at $80.00 with an ATR of $2.50 gets a stop at $75.00. Risk is $500 and 1R is $5.00, so the size is 100 shares, worth $8,000 (16% of equity).
Suppose a backtest produces 120 trades, wins 40% of them, and averages +2.4R per win and −1.0R per loss. Expectancy is 0.4 × 2.4 − 0.6 × 1.0 = +0.36R per trade, or about +0.31R after costs of 0.05R per trade. The next step is a forward test to see whether new trades behave similarly.
Common mistakes
- Vague rules that leave room for judgment, so the test and the live trades differ.
- Overfitting: adjusting parameters until the past looks perfect. Fewer rules usually hold up better.
- Judging by win rate instead of expectancy and drawdown.
- Changing rules after a few losses, before the sample can say anything.
- No exit rule. Entries get the attention; exits decide most of the result.
Two Academy lessons build and test complete systems: testing and running a trend-following system and building and testing a swing routine.
In Clear Tape
The trading systems page offers preset rule-based systems, such as a 20-day breakout, each with its entry, stop, target and parameters written out, and a builder for your own rules from prices, moving averages, RSI, ATR and volume. Tools and Pro members can screen a watchlist with their systems after each close and backtest them on past daily prices with costs; every backtest states how it was tested, and results are hypothetical. For forward testing, the free trade journal breaks results down by system or setup.
Five of the presets are explained rule by rule on the public strategy pages, from the 20-day breakout to the 21 EMA pullback: entry, stop, exit, filters, who each suits and the common mistakes.
For educational purposes only. Not investment advice.