Build your own trading system

Financial trading obeys the Pareto Principle. In fact, financial trading is hyper-pareto. Instead of 20 per cent of stocks generating 80 per cent of volume as in a normal Pareto system, less than two per cent of stocks generate 80 per cent of volume.

A day-trader with a trend-following system can mechanically focus upon the set of 20 stocks generating the highest volume, and ignore all others. The top 20 will usually come from the upper echelons of large-caps. Most will feature repeatedly. The bulk of volumes is in the single stock futures segment. Of course, the membership of this set changes daily. But it takes extraordinary news flow to push a counter that’s small and available only in the cash segment into such a high-volume category and mostly, they’ll be from the derivatives segment.

The advantage of focusing upon such a small set is that a trader can know the technical characteristics of each very well. He can go short or long on high leverage and if necessary, hold overnight positions. It’s possible to track average daily volumes, different price-volatility indicators, correlations to the index and to other assets, etc. That helps the trader manage money better and also have a more realistic assessment of potential returns and risks.

One of the simplest day-trading systems I’ve heard of is on the following lines. Focus on the 20 highest-volume stocks round about 30 minutes into every session. If there’s something in there from the cash segment, Google for the specific news driving it. This is unusual. You will have to make a contingency decision as and when it occurs, whether to trade such a “cash-only” stock or not.

Otherwise, compare the current session’s list of top 20 to the top 20 list of the previous session. If there are new entrants, Google for news on those. Pick the five stocks where you are confident of trends. This last involves filtering via the usual technical parameters (moving averages, stochastics, relative strength, etc) as well as news. Ideally, the technical variables should be automated. Set stop-losses and trade those five stocks in the direction of the trend diagnosis.

According to a friend of mine, who uses a modified and more sophisticated version of this system, the strike rate of winning trades is better than 60 per cent. That is a huge number for a day-trader.

Suppose you have a slightly favourable risk to reward ratio – say you make 1.25 per winning trade for every 1 unit you lose when stop losses are triggered. In that case, the return is 7.5 units of potential profit for around 4 units of loss with a 60 per cent strike rate.

The author is a technical and equity analyst