Here, we’ll shed some light on:
- What a trading strategy is
- Why traders need one
- What to look for when choosing (or developing) a trading strategy
What is a Trading Strategy?
A trading strategy is a set of rules that describes a trader’s investing and trading plan, risk tolerance, entry and exit rules, and trading time horizon. Without a well-defined strategy, trading would pretty much resemble gambling.
In fact, newbie traders who are just getting started with trading, especially if they didn’t have a proper trading education before placing their first trade, are gambling on the markets. They will buy if the price goes up, and they will sell if the price goes down. This is impulsive trading that always triggers an emotional response and inevitably leads to high trading losses.
Having a trading strategy is the complete opposite of impulsive trading. A successful and powerful strategy defines a set of trading rules that the trader has to follow. The rules clearly state what markets to trade, when to enter into a position, when to cut losses, and when to take profits. Rules remove emotions from trading, which paves the road to high-quality trading decisions and long-term capital growth.
Before applying a trading strategy on a real trading account, it should be thoroughly back-tested on a demo account. Only if a strategy returns profitably results on a demo account should you consider applying it on a real account and risking real money.
- Learn more, take our Trading for Beginners course (with Live Trades)
Why do You Need a Strategy?
Trading inevitably involves emotions that can interfere with your trading decisions. How many times did you feel fear or greed after you opened a position?
Many new traders keep their losing trades open, hoping that the market will reverse and provide them an opportunity to exit at breakeven or with a small profit. They also make similar mistakes with winning trades, closing their profits too early, fearing the market will reverse and wipe out their profits.
Following a set of rules outlined by a trading strategy will remove destructive emotions from your trading. It’s much easier to open, manage, and stick to profitable trade if you have a clear set of rules that define how to manage your profits. Also, closing a losing and non-performing trade becomes a normal trading decision if you have a successful strategy.
How to Choose the Right Strategy
Choosing the right trading strategy is one of the most important decisions of new traders. While traders can also successfully combine multiple trading strategies simultaneously, it would be smart to trade with only one strategy until you become consistently profitable. Only then should a trader consider adding another strategy to his trading arsenal in order to catch more trading opportunities and make better profits.
Here are the most important points to consider when choosing a trading strategy.
Make sure it fits your trading style
Your trading strategy should fit your trading style.
A scalper has different needs than a day trader or swing trader, so his trading strategy needs to address these differences. This also applies to other trading styles. Since scalping is a very fast-paced trading style, scalping strategies need to have strict entry and exit rules and risk management rules that allow making a sizeable profit even with small price movements.
Day traders will most likely look into breakout and trend-following strategies to take the most advantage of intraday price movements. This means that day trading strategies need to have wider stops than scalping strategies, as well as attractive reward-to-risk ratios. A survey conducted by a large Forex broker, titled “Traits of successful traders”, showed that day traders who aim for a reward-to-risk ratio of at least 1 are much more profitable than traders who aim for a ratio of below 1.
Finally, swing traders and position traders will need strategies that work best on longer-term timeframes. Those can be trend-following, breakout, and mean-reverting strategies. Since fundamentals play an important part on long-term timeframes, swing trading and position trading strategies also need to take market fundamentals into account.
Keep your strategy simple
Whether you are a scalper, day trader, swing trader, or position trader, it’s important to keep your strategy simple. Forget about exotic indicators, unimportant technical levels, or fundamental reports that no one cares about. Markets are moved by aggregate demand and supply, so you need to be completely focused on those fundamental issues and technical levels that the majority of traders follow.
Here are some examples of powerful yet simple technical levels to base your strategy on:
- Daily highs and lows
- Daily support and resistance levels
- Long-term trendline with at least three retests
- Major Fibonacci levels
- 100-period and 200-period MAs
- Interest rate decisions, etc.
Try to incorporate important technical levels into your trading strategy and keep it simple.
Pay attention to your drawdown
The drawdown of a trading strategy refers to the maximum fall in your equity curve measured from a previous high. As a rule of thumb, the smaller your drawdown the better your trading strategy.
The reason why drawdown is so important in trading is that strategies that have a smaller drawdown usually return higher Sharpe ratios. A Sharpe ratio is a risk-adjusted measure of performance, so it increases when a strategy returns consistent profits. In turn, a consistently profitable strategy with small losing trades allows traders to increase their leverage, which is when the magic happens.
Define your entry and exit rules
Another important point when choosing your trading strategy is your entry and exit rule. The entry rules of a trading strategy define when to enter into a trade, while exit rules define the level where you will close a trade to maximise profits.
Entry and exit rules can make or break a successful trading strategy. Even if your market analysis proves to be right over 50% of the time, you can still end up losing money if your entry and exit rules are not up to the task. Your winning trade can reverse and hit your stop-loss if you don’t define what exit rule maximizes your profits.
Similarly, if you enter too early or too late in a trade, you risk either being on the wrong side of the market or missing a large portion of trading profits.
Scalpers will usually look for entry and exit rules that take advantage of the market momentum. For example, scalpers could stay in a trade as long as the price shows strong momentum in the direction of the trade, such as by forming strong bearish or bullish candles.
Day traders, on the other side, may want to catch a strong intraday trend by having an exit rule that says to close a position when the intraday trend reverses, such as after a trendline breakout in the opposite direction of the trade.
Choose your strategy’s toolbox
When creating a trading strategy, you should also think about what tools you will use in your trading. Will your strategy be based on fundamental analysis, technical analysis, sentiment analysis, or a combination of those?
If you’re creating a trend-following strategy, then trendlines and Fibonacci retracements are likely going to be a major part of your trading process. Trendlines are lines that connect multiple higher lows or lower highs in uptrends and downtrends, respectively, and they tend to act as support or resistance for the price. Fibonacci retracements are used to measure the depth of a market correction, with traders usually focusing on the 38.2%, 50%, and 61.8% levels in trending markets.
- Learn more, take our free course: Fibonacci Fast Track
In a mean-reverting strategy, oscillators may be used to find overbought or oversold market conditions. And in breakout strategies, traders could use horizontal support and resistance levels and candlestick patterns to confirm a breakout setup.
The tools you’ll use depend on the type of your trading strategy and your trading style.
Define your risk management rules
Risk management rules are arguably the most important part of a trading strategy. Successful trading strategies aim for trades that have a reward-to-risk ratio of least 1, which means that on each $1 risk your possible gain is $1 or more. In trend-following setups, your reward-to-risk ratio can easily become 5:1, or even 10:1, if your exit rules state to stay on a trend as long as it lasts.
Besides the reward-to-risk ratio, risk management rules should also define the maximum risk you’re willing to take on any single trade. In order to stay in the game in the long run and protect your trading capital, you should stick to a risk-per-trade of a few percentages of your trading account.
Learn more, take our free courses
Backtest each strategy before applying it on a real account
The final step in choosing and creating a trading strategy is to back-test the strategy using historical price data. A backtest is the closest you can get to the realistic returns of a strategy once applied on a real account.
In most cases, if you’re not developing a quant strategy, you’ll have to back-test your strategy manually. The best way to do so is to scroll your chart to the left and start applying your strategy’s rules on historical data. Write down the results of your trades and look where you could fine-tune your trading rules.
Main Types of Trading Strategies
When developing a trading strategy, it’s important to determine what type of trading are you most comfortable with. Here is a brief description of the three main types of trading strategies.
- Trend-following strategies – A trend-following strategy aims to enter into an early trend and stay on the trend as long as possible. Trend-following strategies have a proven track record and are quite popular among day traders. They can have quite attractive reward-to-risk ratios if the strategy uses powerful exit rules.
- Momentum strategies – Momentum or breakout strategies aim to take advantage of the strong momentum after the price breaks above or below important technical levels. This makes those strategies a popular choice among day traders and scalpers. However, markets tend to form fake breakouts from time to time which can decrease your strategy’s performance.
- Mean-reverting strategies – Finally, mean-reverting strategies are designed to take advantage of the mean-reverting nature of markets. Markets tend to return to their mean or average value over time. However, this often implies taking counter-trend trades, which can be riskier than trading breakouts or trading in the direction of the underlying trend.
Trading strategies are a set of rules that make the life of a trader easier and more profitable. Strict trading rules help remove emotions from your trading decisions by defining rules that help you identify profitable trading opportunities, entry and exit levels, and the maximum risk you’re willing to take on any single trade.
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