Yesterday I looked at what a mechanical trading system is and how to create one. Today I’m going to look at adjustments you could make to your system, an example of a system that I use and the benefits of system trading.

Adjustments To A Mechanical System
Many traders like to have a little bit of manual control over their mechanical system. This normally works fine but remember not to make to many adjustments. You don’t want to violate the main principles and elements of the system’s structure. Finding a balance that works for you is the key.

Adjustments could include closing a position before your system says so. For example you may want to do that if a big interest rate decision is coming up and you don’t want to risk keeping a trade open going into it.

For me, the biggest adjustment that I make is not trading every signal that my system says to. I often screen them and choose only the best signals (in my opinion). When my system’s signals and fundamental views align, I make the trade.

An Example Of A Mechanical Trading System
The Relative Strength Index (RSI) is one of the best known indicators. It compares upward movements in price to downward movements over a selected time, usually 14 periods. It is seen as a leading indicator i.e. price will eventually follow the RSI’s lead.

So, my system looks for RSI and price divergence signals. It’s a popular signal, used by many traders. Following my guidelines that I described in Part I, I’ll run through how I trade this system.

Step 1: Select timeframe
I’m not a professional spread bettor and I don’t have the time to be looking at the trading screens throughout the day. So I set my charts to ‘daily’.

Step 2: Define entry rules
What I’m looking for is a divergence between the price trend and the trend in the RSI. Or, as shown in the chart, I’m trying to find a situation a line between two relatively close extreme price points slope one way and the corresponding RSI line slopes the other way. So, in Example 1, the two high price points are sloping up and the RSI is sloping down. When this happens, as RSI is a leading indicator, the theory says the price will tend to follow the direction of the RSI slope, so it’s a ‘time to go short’ signal.

Example 2 shows the opposite situation which of course generates a long signal.

Step 3: Define exit rules
Here’s my exit rules:

• I set my stop loss order at 5% of my available trading funds. If my trading capital were €10,000 then I would be willing to lose €500 on each trade. If I wanted to set my stop loss order to be 100 points away from where the current price level is, then I would trade €5 per point.
• I set my limit profit order at 1.5 times my stop loss order level. In this example, this would mean that I would set my limit profit order level 150 points away.
• I feel that after five trading days my RSI divergence signal is gone. So if neither order is hit by then I close the trade.

That is all there is to my favourite mechanical trading system. It’s simple really, and there’s the beauty. Mechanical systems don’t have to be complicated to be profitable.

Benefits Of A Mechanical Trading System

1. They are simple to use. No need for complicated interpretation or judgment – it’s all done for you.
2. Many traders don’t have that much time to monitor and digest all the information out there. A pure ‘mechanical system’ approach removes the need to do that.
3. Emotions hinder the performance of most traders, including me and (probably) you. No trader has been able to conquer the market without first controlling their emotions. A mechanical system takes most of the emotions away.
4. They allow you to trade with more conviction. If you have backtested your system comprehensively, you can be confident that your trading will be profitable and sustainable in the long run. So fewer sleepless nights worrying about a position left open.

Why Not Just Buy A Profitable System?
At this stage, you may be thinking about just buying a profitable one on the internet. Caveat emptor! There are lots of systems for sale on the internet that claim to be wildly profitable. Buying one is an option, but it’s not one that I recommend – at least not before extensive research into the system’s rules and logic.

You see, most mechanical systems on the internet have been subjected to ‘curve fitting’. Curve fitting is the tweaking and fitting of data to give systems seemingly extraordinary profits. One trader describes it as shooting holes in a barn door, and then drawing circles around every hole to make each shot a bull’s eye! Needless to say, going forward, these systems are unlikely to repeat their previous extraordinary performance.

For a look at thousands of legitimate internet mechanical systems check out Collective2. But beware, they can be expensive.

Conclusion
I think that the real key to sustainable profits through systems trading is to learn computerised research to build your own customised robust system. There’s a lot of initial homework and education that goes into finding a system that works. But the potential profits and satisfaction at the end is quite a motivator.

Mechanical trading suits some people very well, especially those who don’t have time to read all the information and / or feel like they get overloaded. But they may be no good for someone like FlashRabbit though, who seems to love pitting his wits against the market

Even if you don’t use mechanical trading, there are some aspects that you can take away, like defining you entry and exit points and giving yourself a set time to be proved right.