A Guide to Trading Systems

Lesson -> The expectation

 Trading System

This is a wonderful day to begin this module! This is the headline that rocked today's stock market - 


Yesterday, i.e. 24 th October 2017, the Finance Minister announced that Rs.210,000 crore would be infused into the Public Sector Banking System. This is basically an attempt to save the PSU banks' non-performing assets (NPAs) from deterioration.

What was the reaction of PSU Banks to this announcement? This is the PSUs' chance to get a new lease of life. They were, of course, jubilant.


You can see that the PSU Bank Index jumped 27.75% in its opening hours.

Some PUS stock options were on steroids. Here is the hero of today -

The Punjab National Bank's 160 call option, which expires on 26 Oct 2017, jumped 20,600% overnight! It would have been 2.02 Cr if you had purchased 1Lac worth option on 24 the Oct. There is plenty of activity on the market today.

My colleague and I had been looking at markets earlier in the day and trying to spot opportunities. Here is an interesting idea:

The Bank Nifty Index also joined the party with an increase of almost 3%. (See the image below for the sectoral indexes). A Bank Nifty move of 3% was not surprising considering that PSU banks only contribute around 10% to the Bank Nifty Index. See the index components and their weights below.


My colleague and I decided to write a brief strangle on Bank Nifty. We would collect a premium of approximately 253 points per lot. This was in the hope that volatility would cease and premiums would decrease.

I don't care to debate the logic of this trade - whether or not it makes money is not the concern. However, I do hope it does

But, I would like you to consider the thought process behind this trade. What I call'systematic deduction' is how the trade idea was born. You need to ask questions about the market to find opportunities and be open to taking contrarian positions. This is what we did.

"Systematic deduction" is one of the most common methods market participants use to trade the market. But not all systematic deductions are correct. You could fall prey to biases or make mistakes while making these deductions. However, systematic deduction is a popular trade technique. Another popular trading technique is -

  • Trade because your gut tells you to
  • My friend tells me to trade
  • Trade because the guy on TV is saying so
  • My broker tells me to trade

None of the methods mentioned above, even the systematic deduction, can be considered a process. These methods are not quantifiable or backtested.

Any trading system that you can't really identify as an approach isn't considered a trading system.

You can, however, define and quantify the trading process in order to trade the market.It is the core of this module.

1.2 - Is Trading system a Holy Grail?

When you mention a trading system, most people tend to view it as a guaranteed way to make money. They expect the profits to start rolling from the first trade. It doesn't work that way.

A trading system takes inputs from you, performs a task and then gives you an output. The system then decides if the trade is worth taking based on the output.

This is how it looks.
(image 5)

Realize that the trading system is a trading system.

  1. The system receives the inputs
  2. The system is yours to design
  3. Trade or not?

The onus of making money is on you. A trading system has the advantage that you only need to create the logic once, and then you can just follow the system you have created.

As you might have guessed, I have slowed down the trading system's journey to a great extent. This is only to give you an idea of what this stage looks like.

1.3 - What can you expect from this module

In the sense that it will include -, the trading systems we will be discussing in this module will be complete.

  1. The core of any trading system is its logic
  2. Input parameters
  3. Interpreting the output
  4. The decision to trade oder not

Here are the 4 trading systems I plan to discuss.

  1. Pair trading
  2. Hedging with Delta volatility
  3. Calendar spreads
  4. Momentum strategy (Portfolio approach)

Two methods can be used to pair trade: one based on correlations, and another based on statistical concepts. We will both explore these approaches. As we move forward, I might add more trading systems.

This module does not include the "backtest" bit. It is up to you to test the system and determine if it works for you. The system's rules will be used to determine if the system has been successful in the past and, if so, which profitability patterns it exhibits.

Backtesting is essential to any trading system. My programming skills are the only reason I am not including backtesting. If you are able to write code, some of these systems can be backtested efficiently. These systems were created by a trader who was proficient in programming. I was able to gain more insight into the systems because of this. These were very competent systems to trade, and I believe they are still so.

Market conditions have changed and therefore a new set of backtesting seems appropriate.

This module's main purpose is to show you different systems and provide insight into how they are created. This module is intended to inspire you to create your own system, and maybe even turn out to be your money-making machine.

Let us now move forward with this hope - to pair trading!

PS. The Bank Nifty short strangle worked quite well