How to Create a Profitable Trading System

In this guide, you’ll learn how to create a trading system that helps you achieve more consistency and success in the markets.

We’ll be covering the following topics:

How to categorise the main aspects of your trading
Understanding the objective / purpose of your trading system
The main phases and steps of a successful trading system

Before you go through this guide, there are some important things you need to understand:

Watch our FREE Masterclass to understand what makes a great trading opportunity
Watch this video to understand how estimating trade probabilities will improve your trading psychology
Watch this video to understand how probabilities impact your trading performance
Read our detailed guide on how to estimate probabilities in the markets

By starting with those topics, you’ll better understand the reasons for having a trading system set up the way I explain in this guide. You’ll also understand the critical mistakes most traders make that limit their chance of success.

Introduction

In my early trading years, I was confused about what a trading system was and what it was meant to do. In particular, I didn’t understand the difference between a trading system, strategy, and plan. Everyone seemed to use these words interchangeably when referring to the same thing, but that didn’t make practical sense to me.

I’ve now been obsessed with the markets for over 20 years and that’s given me plenty of time to question everything, and understand the role each aspect of my trading is meant to play.

With this in mind, we're going to start by clarifying what each aspect of our trading is meant to do. This will help you understand the important part your trading system plays in this. If you’ve gone through our FREE Masterclass and read my follow-up emails, you’ll already be familiar with some of these concepts.

The important thing I want you to notice is how everything slots together as an overall blueprint for successful trading. If you follow this blueprint, you’ll have everything you need to be a long-term profitable, successful trader.

Note: What you'll learn in this article is very different to what you'll see most traders doing and what you'll learn elsewhere. Don't be alarmed by this... The majority of traders just follow what everyone else is doing, and 95% of them lose!

Why you need to define the main aspects of your trading

I think it's important to define the purpose of each aspect of your trading. That means, understanding the role each part plays and the clear objective they're intended to achieve.

Most traders don't have this sort of clarity. Instead, their entire process is blurred into one overall process that's broadly defined as, "finding profitable trades".

But imagine inspecting a system from another industry that successfully forecasts future events and capitalises on them. You'd expect that each component is there for a reason and they each have individual objectives that come together to achieve the overall goal.

If you're clear about the purpose and objective of each aspect of your trading, it means you can make sure they're focused on achieving that in the most effective way. You can cut out any unnecessary parts, figure out what needs to be improved, and be better placed to achieve great results.

So let's start by defining some of the main aspects of our trading. By doing this, it will become obvious what role your system itself is meant to play, and how to develop it correctly for that.

Defining our trades

Let's start with the end in mind. Ultimately, everything we do is focused on finding and executing trades that will lead to profits over time.

It might sound counter-intuitive, but one of the biggest mistakes that stops traders succeeding is the incorrect belief that you're meant to look for profitable trades. In other words, trades that likely to close in a profit.

In reality, if you're taking trades with asymmetric risk-returns (meaning, the amount at risk is lower than the potential profit) each trade is usually more likely to result in a loss. Therefore, you're actually taking trades expecting to lose money because that's the more likely outcome.

If that's the case, why would you open a trade you're expecting to lose money on? And how can you become a profitable trader by doing that?

If you’ve gone through our FREE Masterclass you’ll already know the answer to this.

When we open a trade, it’s not because the outcome is likely to be a profit. Instead, it’s because the opportunity has an overall positive expectancy.

We don’t know what the outcome of an individual trade will be, it could be a profit or a loss, either way it shouldn't matter to us. Instead, when we open a trade we're making a statement that we believe if the same situation played out over and over again, we would end up being in profit overall. So when you add up all the times it was a loss, and all the times it was a profit, the total is positive.

So how do we figure out if an opportunity has a positive or negative expectancy?

We have to estimate the following:

The size of the potential positive outcome(s)
The size of the potential negative outcome(s)
The probability of each outcome happening.

The first two points give us the potential risk-reward of the opportunity. You may have been told that this is the main thing you need to consider when analysing an opportunity; as long as it meets your entry criteria and has a positive risk-reward ratio, you can take the trade. But this is not the right thing to do!

If we don’t know the probability of each outcome happening, we won't know whether the opportunity actually has a positive expectancy or not.

Here’s a simple calculation to figure out the trade expectancy:

(profitable outcome x probability) - (negative outcome x probability) = Trade expectancy

So you might have a trade that matches your entry criteria, with a potential profit of 30 pips and a potential loss of 10 pips (1:3 risk reward, or 3R). You might think that's a great trade.

But once you estimate the probabilities, it may paint a different picture:

(30 pips x 0.25) - (10 pips x 0.75) = 0

If you took that trade over and over again, you’d expect to be break-even overall, or lose money due to the transaction costs.

Not such a great opportunity!

On the other hand, the same situation might have different probabilities:

(30 pips x 0.35) - (10 pips x 0.65) = 4

That would be a better opportunity to trade. The outcome of that individual trade could still be a loss, but as long as we continue to take trades like that with a positive expectancy, our long-term results are likely to be profitable.

It's by estimating the probabilities that we can determine whether a situation is a viable trading opportunity or not.

With this in mind, we can now define the purpose of our trades:

To trade opportunities that have a positive expectancy.

And to achieve that, there are two objectives we need to achieve. We need to:

Identify the potential outcomes
Estimated the probabilities of those outcomes

I won't explain these in detail for now, as they're beyond the scope of this guide. However, here are some points to consider and resources to help you understand them better:

To estimate probabilities, the potential outcomes must be well-defined. You can't just say "the price may go up" or "the price may go down". Instead, you need to know how far and by when.
To have well-defined potential outcomes, they must be based on something meaningful. For technical analysis, this is likely to be based on where we may see a change in activity.
To identify a change in activity, the trading method you're using must be related to how the markets actually work.
To estimate probabilities, you need to gather information on the context of the market.

To understand the above points, check out the following guides:

We now know the purpose of our trades and the two objectives we need to achieve that. This means, we are now able to define the purpose and objectives of our analysis.

Defining our analysis

As I mentioned earlier, most traders would define the role of their analysis as “to find profitable trade opportunities”. They’re basically scanning the markets indiscriminately looking for situations that match their trade entry criteria.

But now that we’ve defined the purpose of our trades, we have a clear understanding of what our analysis needs to provide for us.

We should be analysing the market in order to identify meaningful potential outcomes and estimate the probabilities of them.

Once our analysis has helped us achieve that, we can assess the situation to see whether there is an opportunity with a positive outcome or not. This becomes our criteria for entering a trade.

So how do we assess the potential outcomes and estimate the probabilities?

You may remember from my guide on estimating probabilities that it’s all about gathering information on the market context.

This means, our analysis is a process of gathering relevant contextual information and using it to make forecasts about future price movements.

We can summarise this as being a sequence of steps:

Understand what’s happened that's led to the current situation (the past)
Use that information to interpret the current situation (the present)
Use the information from steps 1 and 2 to anticipate the potential outcomes (the future)
Use the contextual information from steps 1-3 to estimate the probabilities of each outcome (the future)

Here's the great thing... If you can achieve these four steps, you'll be able to be a consistently profitable trader. That is, assuming your probability estimates are accurate (which is something that can be measured and improved through a calibration process).

If you can achieve these four steps and find positive expectancy opportunities, you technically don't need a system or strategy. You could find opportunities in any market across any time horizon.

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But, hold on! This is a guide about creating a trading system...

So, if your analysis provides everything to find great opportunities, do you need a system at all?

The answer is, yes! But the purpose of your system is not what most traders think. It's not there to identify trade opportunities or dictate how you execute them, instead it has its own specific purposes.

Defining our trading system

There are two main purposes for your trading system:

To make the process of finding a trade opportunity more efficient.
To keep you consistent with your conclusions from a situation (e.g. how you identify the outcomes, and the way you estimate probabilities).

There is also a third point that could be added to that list, which is that a trading system allows you to identify problem areas and improve them. But that's something for a separate guide on optimising your trading.

Purpose 1: Being more efficient

Let's start by discussing how the system makes you more efficient.

Many traders will analyse the markets aimlessly and indiscriminately, hoping they'll stumble upon an opportunity sooner or later. Doing things this way wastes a lot of time and mental energy, and can lead to you missing great opportunities elsewhere.

After all, every action we take has an opportunity cost - we want to use our time and effort wisely.

We should consider the 80/20 rule with our trading. Most traders will find that only a small percentage of their actions are leading to the most valuable outcomes. So how can we change that to cut out the wasteful actions, and ensure our time is spent on the things that have valuable outcomes?

Since we know what we're trying to achieve with our trades and analysis, our actions should be in line with that. Each action should be moving us closer to the desired end result.

This is what your trading system can help you do. It provides a systematic process that keeps your actions focused on what's necessary. It's acts as a filter for unneeded actions, and stops you spending any more time and effort on markets that aren't in line with what you need.

Purpose 2: Being more consistent

Many studies have looked at the effectiveness of expert judgement, this began with groundbreaking work by Peter Meehl in the 1980s and has been contributed to by great minds including Gary Klein and Daniel Kahneman.

It’s been found that experts often perform worse than if you simply followed a formula to make a judgement. A big part of this comes down to how inconsistent people are at making judgements based on complex information. In fact, when we’re asked to evaluate the same information on two separate occasions, we’ll often give different conclusions.

The same is true for traders too. If you give a trader a situation to analyse in the markets, they’ll come to a conclusion about it. But if you gave them the exact same situation at a later point in time, their conclusion would likely be different. This is particularly true for probability estimates; a critical part of assessing the viability of a trade.

There are many reasons why this happens. A major reason is how we mentally process information and analyse it - we don't tend to do it in a consistent way and we're influenced by cognitive biases. For example, even just the order in which we receive information can change how we perceive it.

So by having a system that dictates how we analyse information, in what order we process it, and what we give priority to, we can increase the likelihood of us coming to a consistent judgement about things. This is essential if we want to be consistent overall and able to depend on our Trader’s Equation.

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The Main Phases of a System

Over the years, I’ve found a formula that's most effective for the broad phases that need to be included in a system. In each phase, there will be individual steps that will depend on the method of analysis and trading you're using, but this is the overall structure they should follow:

Market Selection
Primary Analysis
Secondary Analysis
Trade Entry
Trade Management

Market Selection

The first phase is market selection. This is your process for efficiently and effectively identifying the right market to focus on.

Great trades start with great market selection. A lot of traders waste time and effort trying to find opportunities in inappropriate markets.

Instead, by having a process to filter out and find the right markets, you dramatically increase your chance of having a great trade.

Most importantly, the market should be one you that you believe you can identify potential outcomes and estimate probabilities in, without too many guesses or blind assumptions. Therefore, the context should be clear and the price should be near a meaningful level that makes it easier to anticipate what activity may happen next.

In addition to that, the market should be in an area that is more likely to provide the types of opportunities you look for. The factors you might consider for this will depend on the specific method of trading you use.

Primary Analysis

The next phase is your primary analysis. In this stage, you’re trying to understand what’s happened in the market so far, and using that to help interpret the current situation. This analysis is all about looking backwards.

I have a set order I follow for identifying core information about the context of the market. I start by identifying the structure of the market, including the characteristics of the price moves within each wave. My main focus is on identifying what this meant for things like volume and liquidity.

Based on that, I’ll then find where there are significant levels that are likely to cause changes in market activity in future. These will help me identify potential outcomes.

Finally I’ll look at the micro-structure and order flow to understand how the price is currently behaving and where we are in relation to critical points on the chart.

These factors give me the context of the market that I can use to forecast potential outcomes and estimate the probabilities of them happening. Which is what I use in the next phase.

Secondary Analysis

The secondary analysis is about anticipating what may happen next. You’re using your primary analysis to now identify potential outcomes.

You start by assessing first-order outcomes (what may happen immediately) and then second-order outcomes (if a first order outcome happens, what may happen after that?) and beyond.

You will then use the contextual information from your primary analysis to estimate the probabilities of these outcomes, following the process I explained in the guide to estimating probabilities.

Trade Entry

Once you’ve assessed all potential outcomes, you can now determine which situation (or multiple situations) have a positive expectancy.

It may be that the current situation doesn’t provide any opportunities, but specific future outcomes could lead to a favourable opportunity. In these situations, you can set an alert and revisit the market once the outcomes unfold.

This phase also involves deciding how to structure the trade to limit downside while maximising the upside. On a basic level, you'll be choosing a percentage at risk based on how positive the expectancy is. But on a more advanced level, you can strategise how to structure the trade and initial trade management decisions to tilt the odds more in your favour. If you do this correctly, you can take a positive expectancy trade and enhance it even further, so the overall result is greater.

Trade Management

The trade management phase is done once the trade is open. You continue analysing the market as price movements develop and assess what the next potential outcomes and probabilities may be.

Based on this, you can take strategic risk management actions (e.g. scaling in, scaling out, or moving your stop loss) to align with your assessment of the potential outcomes.

For example, if a particular price move will mean the probability of positive outcomes is reduced significantly, you may want to place your stop loss based on that occurring. As outcomes take place, you can reassess the expectancy of the next moves and scale in or out of the trade in proportion to that.

Conclusion

What I’ve described to you is a logical way to structure your trading approach overall, including your system.

This might seem complex at first, but as I explained in the guide to estimating probabilities, you're already doing many of these things subconsciously without realising it. The benefit of turning these into conscious processes is that they become more deliberate and measurable, which means they can be more effective and easier to improve.

In reality, the processes I've outlined are much more simple than they seem on face value. The key is that every aspect has a purpose and an objective, so you have absolute clarity about what you're doing and why.

Members of the Duomo Trader Development Program learn this in a logical way using the Duomo Method, and don't usually struggle to put it into practice. They're able to understand it and apply it without too much confusion or difficulty. I know you can do so too!

How to Create a Profitable Trading System | Ultimate Guide