We've been covering a lot of trading psychology lately, so today we'll switch gears and talk about some of the more mechanical aspects of trading. We'll actually be discussing a series of questions we received over the last few days, answering some of them, and hopefully learning something along the way.

Question. Today's comments on controlling loss while keeping self confident hit the target! I trade better when confident and am mope apt to cut losses quickly before ego grasps the steering wheel. Suggestion for future pieces: setting up trading system(s). You might mention the most important ingredients, how to acknowledge trading systems best indicators or combinations thereof, with proper settings, etc.

Answer. This is actually a question in reference to a column from last week. The premise was to let you exits be automated, or to let the market take you 'out' of a trade with an automated trading system that removes your ego from the equation. To take the idea to an even higher level, a trader should also be able to automate a system for trade entries. Again, ego would be removed from the equation.

So the question is a good one - how do you build a good system?  Unfortunately, the barrier to a good answer is the infinite choice you have. Does it mean one index, or is your system designed to find individual stocks among a universe of them? Are you day-trading, or do you intend to hold a trade for weeks (or months)?

Just for the sake of argument, let's say you're looking for an index swing trading system. That is, you're looking for a way to buy and sell an index, and your intended holding period is days, and weeks if the trade goes well. What would a "good" system like that look like? The only thing we'll say is this....keep your system simple - and singular. We discussed this idea a few weeks ago in a column, but we'll recap that idea here. Simply put, running multiple systems can and will create conflicting signals. Find one kind of signal that works over time, and apply it. Period.

Let's pretend we want to be momentum traders on the QQQQ's (which really isn't a stretch for us). We prefer a MACD (moving average convergence divergence) system to spot momentum breakouts. All we have to do is apply our MACD crossover signals (they're included within our software package) to the chart. This is what you see below.

This chart was made with TradeStation, but most charting packages can do the same thing. To keep things simple, this is just a 'long only' system. Entries are marked with blue arrows, and exits are marked with red arrows. Profitable trades are traced with a green line, while losing trades are marked with a red line. This particular system has been 'optimized'. That just means the software has calculated the best possible settings for our MACD lines......and here's where we actually get to answer the reader's question.

The optimized settings for this MACD system is as follows: Fast Length = 18, Slow Length = 37, and MACD Length = 9. The MACD chart at the bottom has been adjusted to reflect those settings. By the way, this system was profitable on eight of its last twelve trades. The average winner was twice as big as the average loser.

Wondering why we just told you that? Shouldn't that be a secret? No, not really. Here's why - there's no holy grail. Those settings were optimal for the last two years, but they may not work the next two years. They may not even work tomorrow. When it comes down to it, systems are a great tool, but they're not all you need. You have to understand so much more with system trading than just a 'buy' and 'sell'.

Feel free to use those settings in your trading, but I promise you they won't guarantee success. We'll look at systems more in the future. For now, we encourage you to build a system that is pertinent to your vehicle and style. Optimize it if you can, but don't have a blind faith in the system.

QQQQ with MACD trading system - Daily

Question. I would like to hear thoughts on taking profits. I understand the goal of a trade is to let profits run, but then how can you set a target to get out?  Once you've achieved some profits, what is the best way to protect them?  Lastly, do you ever get out of positions because even though the stock is doing well, the market is starting to head in the wrong direction? 

Answer. A very relevant question, as we actually applied the answer to our system above. The best way to let profits run, yet protect yourself if the market turns, is to apply what is commonly called a 'trailing stop'. This just means that the stop level would be adjusted slightly every day, as (hopefully) more profits are generated. As long as the trade is moving favorably, the stop is never triggered. But on the first move against you, the stop is triggered and you're out of the trade.

One of the most effective ways of applying such a trailing stop is Wilder's Parabolic Stop-And-Reversal system (or SAR). It wasn't shown above, but we'll re-draw the chart with the SAR markers below. They're the red dots above and below the QQQQ's. We can't get into the details here, but it's clear how these plots provide a nice 'trailing stop'. This tool allows you to let profits run, yet protect them at the same time.......just what the reader was asking for. The step here is 0.02, and the limit is 0.22. Again, we're not losing any proprietary secrets here.

Note that some brokers allow you to apply a trailing stop that changes automatically every day - check and see if yours does.

QQQQ with MACD System and Parabolic SAR Trailing Stop - Daily

And to answer the second question, we don't get out of a good trade just because the market is going in the other direction. The strongest stock trends - the ones we look for - are usually able to overcome any market tide that appears to be working against a stock trade.

Price Headley is the founder and chief analyst of BigTrends.com.