Designing a Stock Market Trading System
In order to narrow these down to a managable number, most traders use a number of predetermined criteria. In fact, these criteria form the basis of all buy and sell decisions.
Stock market trading systems can grow as mathematically complicated as you're willing to allow. At heart, most rely on analyzing the daily history of a stock's price. Some also take account of the number of shares traded each day - the trading volume.
Building your first Trading System
You need to choose the rules you will use to buy and sell stocks. For example, many stock market trading systems rely on a momentum model of price action. The basis of momentum stock trading is that a stock whose price has been rising is likely to continue rising.
We will write the trading rules for a very basic momentum stock trading model.
Momentum Buy Rule: If today's closing price was greater than the previous day's closing price, buy the stock tomorrow when the market opens.
Momentum Sell Rule: If today's closing price was less than or equal to the previous day's closing price, sell the stock tomorrow when the market opens.
Here's a very basic Excel spreadsheet showing buys and sells of a stock using these rules. In the month the system was used, four trades were made, two of which broke even, one lost and one won.
If each trade was for $2,500 with $12 brokerage to buy and sell, our total brokerage for the four trades would amount to $96. Our single winning trade would have gained us $551. Our single losing trade would have lost us $271. Our total profit would be $185.
Our gain is 7.4 percent in just one month. This is good trading.
Unfortunately our true return may be lowered by slippage. Slippage represents the spread between two prices - the price offered by buyers and the higher price asked by sellers. You might not always manage to trade at the price shown in the spread sheet.
Okay, our basic stock market trading system looks promising.
What we need to do now is backtest it. We need to backtest it on data from different stocks in different years. We need to discover whether the system returns a profit every year. We need to learn whether the system yields a profit on the majority of stocks.
In fact, the basic momentum stock trading system we are using here would not produce a consistent profit.
We will need to design a more advanced stock market trading system.