What is a forex system? A forex system is a set of rules that tells you when to enter and when to exit the market. A good forex system will tell you precisely when to enter and when to exit the currency market. A good forex system should be mechanical and rule based meaning you simply have to follow the rules when trading with that system. A mechanical rule based system eliminates the greatest enemy of any trader, his or her emotions.
These emotions are fear and greed. Greed compels a trader to take on risky trades in the hope of hitting a big home run. Taking unnecessary risk is always dangerous and can results in a huge drawdown to your account. In the same manner, when a trader is trading with fear of losing, he or she will often avoid making trades that have a high probability of winning. Using a proven and tested forex system can help a lot in reducing these two emotions while trading.
Developing a forex system needs a lot of trading experience. Any new forex system needs to be tested thoroughly in live trading. This takes time. Testing a forex system means making hundreds of trades with that system and then evaluating the performance of that system on statistical basis. There are a number of parameters that are considered to be very important in evaluating a trading system.
Profit Factor
Profit factor is just gross profit/gross loss. So if the system made a gross profit of $4K in one month while it made a gross loss of $4K as well the profit factor will be 1 only. If on the other hand the gross loss was $2K, the profit factor would be 2 and in case the gross loss was only $1K, the profit factor would be 4. A profit factor of less than 1 means the system is not profitable while a profit factor higher than 1 means the system is profitable.
Expectancy of a Trading System
In order to compare two or more trading systems, you need to calculate the expectancy of each trading system. Expectancy tells you how much you expect to make for each $1 that you risk with that system.
Expectancy=(Average Win Size)(%age of Winning Trades)-(Average Loss Size)(%age of Losing Trades)
Expectancy of a trading system tells the chances of that system being profitable over a large number of trades like 100 or more. Suppose, you have a trading system that has win rate of 90% meaning it makes 9 winning trades out of a total of 10 trades. Suppose, it’s makes on average $1 per winning trade on average and loses $10 on a losing trade on average. So in a series of 10 trades, it will make $9 and lose $10 meaning you will be losing $1 even though you had won 9 trades out of ten.
Now, suppose a trading system has got 40% win rate meaning out of every 10 trades, it loses 6 trades and wins only 4 trades. You must be thinking this trading system is going to be awful. Let’s see. Suppose, it makes $10 on average on a winning trade and loses $2 on a losing trade on average. Now in a series of 10 trades, it is going to make $40 and lose $12 meaning it will make a net profit of $28. You can see what is more important is the size of the win as compared to the size of the loss instead of the win rate. Turtle Trading System is a famous system that made many millionaires. What was it’s win rate? Only 44% but it still made millionaires. How? It’s winning trades were far bigger than the losing trades.
So a forex system can have a high win rate but still lose while another forex system can have a low win rate but still be profitable as it makes large winning trades as compared to it’s losing trades. Always look at the detailed performance stats of any forex system compiled after making hundreds of live trades before making your decision whether it is a good system or not. Go for those trading systems that have a high profit factor and are simple and easy to trade.
A forex system is very important to a forex trader. Just like you choose a friend with lot of care, in the same manner always choose a forex system with a lot of care. Choosing a forex system requires a lot of testing. Don’t hesitate to test your forex system thoroughly on the demo account before you trade live with it. When you trade live with it, in the start trade with the lowest risk settings. Once you have developed the confidence that you can depend on the system, only then think about trading seriously with it.