How to Construct a Mechanical Forex Trading System
Updated: April 09, 2013 at 7:42 AM
As forex software becomes more complex and automation becomes more common, many traders now rely on mechanical forex trading systems. These software systems execute trades when certain market conditions are met, with or without the confirmation of the operator. So how do you set up one of these systems?
For starters, you will need software and a broker that supports automated trading orders. Metatrader 4 has the programming language built in and a large number of brokers now use this system. If you are willing to learn the Metatrader programming language, you can set up this part of the system very easily.
The next step is to identify your strategy. Say that you plan to use trend trading based on technical indicators. You would probably use the moving average cross-over system. This method relies on the long-term and short-term moving averages. When the price of the short term average crosses over the long-term, it usually indicates an upward trend.
However, you also need a further step-confirming the trend. Here, you might use technical indicators such as ADX (Average Directional Index) or Moving Average Convergence/Divergence (MACD). These indicators confirm the likelihood that a trend is legitimate and significant. So your order might look like this:
Buy at the market price if the short-term moving average crosses over the long-term moving average from below and if ADX is greater than 25.
Of course, you would then form a sell order with the converse-selling if the short-term crosses from above. Both of these orders are expressible in an objective way and executable by a computer with or without your input. As always, you should also have a stop-loss order in place, in case the trend does not work out. It would be ludicrous to suppose that a system like this will not generate some losses, just like your own, personal trading. But the system is certainly successful if it can generate a net profit.
There are several other things that can be said about mechanical systems. First, you should be sure to manage your risk. This is also easy to build into the trading system. Use traditional risk-management tools and you should generally risk less than 2% of your equity.
Second, you should always test your system. Back testing allows you to see what your orders would have done according to historical data. In other words, had you set up the system five years ago, would you have generated a profit or a loss? Forward testing allows you to test the system against what is happening now. The key here is to use a free demo account, available at most online brokers. Run the system for several months and see how it performs before risking any actual money.
Finally, recognize that there are different kinds of automation. Your system can run entirely by itself, or you can require it to verify every transaction with you before acting. In the same way, you can use this method for long-term trading or limit it to scalping. Whatever strategy you might use personally can also be used for mechanical forex trading systems.
Automation is relatively new in the forex market and it is also fairly controversial. Many people are understandably skeptical about this method, since it eliminates the human element. But there are also significant advantages and benefits to using automation. We will discuss these benefits in the next article.
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Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.