The importance of developing a trading strategy
Traders often hear the importance of having a plan when trading the financial markets and it’s one of the best pieces of advice anyone can be offered. Rarely does random trading generate consistent, stable, and long-term profits. It’s akin to gambling and not a characteristic of approaching trading the right way. Trading is a business and looking at it from that perspective can help any trader become consistent over time.
Having a trading strategy means having a defined set of rules and conditions that would help you navigate the financial markets without having to think twice about what to do across all possible scenarios. It’s the difference between being disciplined and organized and being chaotic and unsure.
Just as the market is highly dynamic, a trading strategy will help you make sure you maintain rationality and stability regardless of market conditions.
There are several important considerations to keep in mind when developing your own trading strategy.
Elements of a trading strategy
One of the most important aspects of a trading strategy is defining the timeframe you will be using to trade. This really boils down to a variety of factors starting with your availability to trade throughout the day.
If you are someone with a tight schedule, maybe you should consider a more long-term strategy (Figure 1) or one that is mostly or fully automated.
If you do have a few hours a day, you have much more flexibility in deciding how to trade. You can choose a high-frequency trading approach with multiple trades within a short period of time or you can use a more specific trading methodology that can be enhanced by those extra available hours.
At the same time, some markets are more active during specific hours of the day. For example, the US markets open and trade in the morning which is early or mid-afternoon for European traders. This could prove convenient to trade given that they are at home around that time.
In summary, decide how long you can and are willing to be in front of the screen trading. From there, decide the best approach and what you prefer.
The global markets include thousands of products spread around different asset classes. You can trade Stocks in Cyprus, Forex pairs, Commodities, Indices, and ETFs using a variety of direct or derivative products such as futures and options. Some traders and investors prefer buying something that they understand such as stocks where they can follow the performance of the company and gauge expectations accordingly. Others may look to buy Indices and ETFs (Figure 2) to gain broad market exposure. More sophisticated traders may look for volatile products where they can potentially make bigger returns within a short period of time.
The selection of one or more suitable products for your strategy depends on the first factor which is how much time you can spend in front of the screen trading. For those who are looking at a long-term approach, short-term volatility will not make a difference to their trading. On the other hand, a trader looking to day trade or scalp the market may need a volatile instrument such as Crude Oil or Indices. This is not to say that other instruments are not volatile. In fact, all markets tend to experience volatile conditions occasionally but some are simply bigger movers than others.
Identify the trend
While not all trading methods require an established trend, the easiest way to approach the market and improve your odds is by determining the current direction of a trading product. Some traders may use indicators such as moving averages or MACD (Figure 3) to better understand the direction while others will use price action and look for higher highs and higher lows or lower highs and lower lows.
Whichever method you decide to use, make sure that defining the trend becomes part of your trading strategy as it will help improve the performance of your trades.
Determine your risk
A successful trading strategy includes very defined risk parameters. No matter how correct someone may be when trading the markets, unexpected news or sudden geopolitical tension could change the direction of entire markets in a heartbeat, leaving you stranded in the market. After figuring out the current market trend and having defined your timeframe and product of choice, it’s important to position yourself accordingly.
If you believe you need bigger stop-losses because the instrument you are trading can be volatile, even when you are approaching the market from a long term perspective, then it’s best not to overleverage yourself and potentially using smaller positions as opposed to having more flexibility for instruments that do not whipsaw too much in the short term.
For those who are trading short-term strategies, bigger positions may be acceptable as long as stop losses are in place and the risks are defined.
Now that all the main aspects of a trading strategy have been defined, it’s time to put the focus on when to enter the market for optimal risk to reward positioning.
While long-term trading does not necessarily need extra specific entries, putting some effort into timing could help lower risk and improve the potential reward. For example, if you are trading the daily charts and your strategy is highlighting a potential trade, a smarter approach would be to look at a lower timeframe chart such as 4 hours or 1 hour which could help you find a pullback that could provide a better risk to reward for the upcoming trade.
Some people may go as far as dropping further to 30 minutes or 15 minutes charts for an even more specific entry and while this could make a difference, it might be too nerve-wracking and unnecessary.
On the other hand, short-term traders would need to find optimal entries as it would make a major difference in whether a system is profitable or not. This does not necessarily mean looking at smaller timeframes as some traders are already looking at very fast charts but it could mean using a combination of factors to find the most optimal location for a trade, even if it means missing some in favor of only trading the best.
Applying your system to a timeframe that is smaller than your intended and original timeframe could provide you with a signal that may give a better and more optimal entry.
The final step of any trading system is your exit strategy. Some traders may choose a set number of points or percentages, in line with their risk tolerance without introducing any dynamism to it. This works given the systematic nature but if the characteristics of the market change even the slightest bit, the strategy could fail over the long run.
Others may use a trailing stop which moves as long as the market is moving in the direction of the trade. The downside is that the market may correct, take out the position and continue in the intended direction. This is a good approach when the trend is very strong and with minimal corrections.
Occasionally, traders and investors may choose to have multiple targets which means they can take out some of their position at a predetermined level in order to secure some profits. This is a safer bet but could limit profitability.
There is no right or wrong when it comes to exiting trades. Again, it comes down to how you choose to trade. A rule of thumb entails that short-term traders should have fixed targets to maintain a healthy risk to reward ratio while long-term traders should be slightly more flexible in how they exit trades, depending on long-term volatility and the ongoing trend of a trading product.
Write down steps
Writing down ideas and approaches helps us retain and improve them over time. This is no different for your trading strategy. Write down your daily approach to the market and all the steps needed to help you build your analysis towards your next trade. After doing so, log the trade and its outcome and write down any possible reasons that made the trade profitable or not.
This will help you understand what went wrong and how to avoid it in the future. Also, for the reasons that made your trade profitable or helped move it closer and faster towards your goal, you can focus more on trading when such market characteristics are present.