Do You Know the Difference Between Trading Methods, Systems, and Plans?
There are significant differences between trading methods, trading systems, and trading plans. These variations can be confusing for new traders, but it is important that students of the market understand and develop these areas in order to optimize their chance of success.
A trading method is the overall process and trading style that is used to profit from the markets. A trading method can be defined as principles used to successfully trade in the stock market, options, forex, futures, or bonds. These operating principles are based on the belief of long term profitability and increased value of trading capital. Traders using different systems and different plans can use the same methodology. Methodology is based on the specific style of trading, with some examples being:
- Technical Analysis
- Trend Following
- Value Investing
- Momentum Trading
- Growth Investing
- Swing Trading
A trading system is a set of rules that quantifies buy and sell signals, as demonstrated by successful testing on price history or chart studies. A trading system is the specific kind of data or knowledge used to execute the trading method, based on price action or fundamental valuations. These signals are triggered by measurable technical indicators or key levels on charts. Trading systems have specific parameters relating to position sizing that manage risk and increase the probability of profitability over time. A trading system has at least eight quantifiable elements:
- Entry signal
- Exit signal
- Winning percentage
- Risk to reward ratio
- Position sizing parameters
- Frequency of trading opportunities
- Average expected annual return
- Maximum expected drawdown
A trading plan is a set of rules, consistent with a trader’s chosen methodology and system that govern how trades will be executed in real-time. These rules determine what will happen based on the trading system’s entries and exits, risk management, and psychology. The trading plan is meant to keep the trader disciplined and safe from their own weaknesses, while providing the parameters for consistent profitability.
Understanding the difference between methodology, system, and plan is essential to organizing and implementing trades at the right levels. As traders turn research into beliefs, trading methods will become their religion, trading systems will become their bible, and their trading plan will allow them to walk in faith every day.