Mechanical Trading System a Full Overview and Strategy

It is very common that forex traders need to work round the clock most of the time as this market operates 24 hours. Working that long is not feasible for health and may lead to severe health issues including back pain and other health complications. So, trading without continuously sitting in front of computers will help you out. So, the automated or mechanical trading system comes in handy in such cases.

The good thing is you can create your own mechanical trading system. Let’s see how can you do that.

What is a Mechanical Trading System

A mechanical trading system is a set of predefined rules and criteria for making trading decisions in forex markets. However, it can be any financial market. The machinal trading system removes human emotions and subjectivity from the decision-making process, aiming to provide consistent and objective trading signals. These systems are typically based on technical analysis, which involves the study of historical price and volume data to identify patterns and trends that may suggest future price movements.

Components of Mechanical Trading System

A mechanical trading system typically consists of the following components:

1. Entry Rules: These trading mechanical rules determine when to enter a trade, either by buying or selling a financial instrument. Entry rules are often based on specific technical indicators, chart patterns, or price levels.
2. Entry Stop: You can consider this as stop-loss. It has a logic to stop the entry position of the market movers against the entry signals. Traders usually use the ATR indicator for entry stops. Forex traders normally place the entry outside of the regular fluctuation of price movement.
3. In Trade Stop: It helps to take a little extra profit from the forex market. You can choose from different trade stops ranging from break-even to trailing take profit.
4. Filters: There are times you may trap by false signals. Filters can help you with that and ensure that your entries match the favorable market condition. If you can set the filter properly you can surely increase the profit.
5. Exit rules: These trading mechanical rules determine when to exit a trade, either by taking profit or cutting losses. Exit mechanical trading rules can be based on fixed profit targets, trailing stop-loss orders, or specific technical indicators.
6. Pyramiding: It is a sort of forex trading strategy to stack up orders if a mechanical system generates more than one buy or sell condition. A pyramid is great for making money on strong forex trends. However, this component may also work as a catalyst for system risk as it may give you more options to open a position in the market.
7. Risk Management: This component defines how much capital to allocate to each trade and how to manage the risk associated with each position. Risk management techniques include position sizing, stop-loss orders, and diversification.
8. Circuit Breaker: It temporarily measures to halt a trade to save your equity from going to zero during the market crisis.
9. Alerts: It is one of the most attractive components of a mechanical trading system. You can automate the system by sending buy and sell signals to the exchanges.
10. Money management: This aspect focuses on managing the overall trading capital and ensuring that the system remains profitable over time. Money management techniques include adjusting position sizes based on account equity, using a fixed percentage of capital per trade, or employing a risk-based approach.

How to Build A Mechanical Trading System?

Mechanical trading systems can be developed and tested using historical data to evaluate their performance before being implemented in live trading. They can be executed manually by the trader or automated using trading software or platforms.

The main advantage of mechanical trading systems is that they help traders maintain discipline and consistency in their decision-making process, reducing the impact of emotions and biases.

However, it’s essential to keep in mind that past performance is not always indicative of future results, and mechanical trading systems may need to be adjusted or optimized over time to adapt to changing market conditions.

Building the Trading System

After learning the technical analysis basics, you should now put all that information into developing a trading system. That should offer you a view of what you are after when building a forex trading system.

The trading is a moving average crossover system that applies moving averages in the determination of whether to go short or long. Before entering a trade, more technical indicators are used for confirmation. The technical indicators come in handy when establishing entry and exit levels.

There are four steps you can use to develop a trading system

• Defining the time frame
• Determining entry triggers
• Determining exit triggers
• Back testing

Trading setup

• Swing trading that is trading on a daily chart
• Application of 5 SMA to the close
• Application of 10 SMA to the close
• Stochastic (14,3,3)
• RSI (9)

Entry Mechanical Trading Rules

When entering a trade enter long if the 5 SMA crosses over the 10 SMA and when all stochastic lines are destined to the top, and the RSI is more than 50. Avoid entering when stochastic lines are in the overbought region.

Consider entering short if the 5 SMA crosses under the 10SMA and when all the stochastic lines are on a downward trend, and the RSI is lower than 50. You should avoid entering if you see that the stochastic lines are in the oversold region.

Exit Mechanical Trading Rules

Consider exiting when the 5 SMA crosses the 10 SMA in the reverse direction to your trade or when the RSA crosses 50. You can as well exit the trade once it reaches stop loss of 100 pips.

Back Testing

Try different time frames when your daily chats seem to be slow. Always remember that the quicker the time frame, the higher the probability of false-positive trades. Usually these are trades that seem to meet entry rules, but in the end, you will get stopped out. You should note that a trading system will only work if it is followed to the latter. You should be disciplined and play by the rules.

3 Benefits of Algorithmic Forex Trading

Automated trading is quite ubiquitous in the forex industry. Every day, traders sit for long hours to create a mechanical trading system with the primary objective of getting more time off the trading desk. These systems are linked directly to preferred brokers through the trading software available in the industry.

The fact that many traders opt for this automated system of trading implies that there are benefits worth consideration. Here are a few of them.

It takes emotions out of the trading

A good number of traders who crash out of the market lack a forex mechanical trading strategy. On the contrary, the reason is quite distinct from the effectiveness, or lack of, of the trading plan. Usually, the traders get overtaken with emotions, and they end up destroying potentially profitable positions.

Once you have created your mechanical trading system, the only remaining thing is to take the output and use it to make decisions. Preferably, you can design the system in such a way that it operates autonomously and you have to do is check if there is any loss made or return earned.

It achieves consistency

Trading as a human is full of many challenges. This is especially significant in this age of Facebook, Twitter, and YouTube. The challenge is to remain alert for all the trading sessions without succumbing to the distractions brought by social media and even gaming.

Such distractions can lead to one missing important trading opportunities, or even lead to one blowing up an account for not paying attention to drawdown limits.

On the contrary, an automated trading system strictly follows the trading plans without any deviation. This system cannot alter rules unless commanded to do so. Therefore, one should expect a 100% consistency from the algorithm.

Diversified trades

Unlike humans, algorithms can handle as many accounts as possible. As such, one can employ various strategies or even open multiple trades with a view on spreading the risk and creating a comfortable hedge. Normally, the systems can execute trades in milliseconds, and hence, one cannot miss any trading opportunity.

Mechanical Trading Indicators

Mechanical trading indicators help traders to identify trends, reversals, and potential entry and exit points. Here are some popular mechanical trading indicators:

Moving Averages (MA)

Moving averages find outs the price data to identify trends. There are several types of moving averages, including Simple Moving Average (SMA), Exponential Moving Average (EMA), and Weighted Moving Average (WMA).

Relative Strength Index (RSI)

RSI is typically a momentum oscillator that measures change of price movements as well as the speeds. Further, RSI ranges from 0 to 100. If the value is more than 70 it is  considered as overbought and if the value is less than 30 considered oversold.

Stochastic Oscillator

The Stochastic Oscillator is a momentum indicator that compares a currency pair’s closing price to its price range over a certain time period. It ranges from 0 to 100. If the value is more than 80, it is considered as overbought. On the other hand, if the value is less than 20, it is considered as oversold.

Bollinger Bands

Bollinger Bands are volatility bands placed above and below a moving average. They help traders identify periods of high and low volatility and potential price reversals.

Average True Range (ATR)

ATR is a volatility indicator that measures the average range between the high and low prices over a specified period. It helps traders assess the market’s volatility and set appropriate stop-loss levels.

Moving Average Convergence Divergence (MACD)

MACD is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. It helps traders identify trend direction, momentum, and potential reversals.

Parabolic SAR (Stop and Reverse)

Parabolic SAR is a trend-following indicator that helps traders identify potential entry and exit points in trending markets. It provides stop-loss levels that move with the price, adjusting for volatility.

Ichimoku Cloud

It is a comprehensive indicator providing information on trend direction, momentum, and support and resistance levels. It helps traders identify potential trading opportunities in various market conditions.

These are just a few examples of mechanical trading indicators. Traders often combine multiple indicators to create a comprehensive trading system. It’s essential to back test and optimize any trading system using historical data before applying it to live trading. Additionally, consider risk management and position sizing to improve the overall performance of your trading system.