Trading Strategies

Trading Strategies fo Forex, DSC 0200

Forex, DSC 0200—matsubokkuri (Flickr.com)

Trading Strategies used by professionals vary in make up, application, and complexity. Whether you are going to learn an existing strategy and tweak it to your unique circumstances or invent an entirely new trading strategy from scratch you will still need to follow some fundamental concepts if you want to make money.

Below you will find a list of common denominators found in almost all profitable trading strategies used by professionals in both long term and high frequency trading. If you come across a trading plan that does not encompass most (if not all) the factors below, you can be assured that it was not designed by a professional trader and is most likely an unprofitable strategy.

So what is the make up of a profitable Trading Strategy?

1. Trading Strategies – The Trading Plan

Something you will not see when going over someone’s trading strategy is how they trade the plan itself through its development.

Here are some quick guidelines

  • Beginner traders should adhere strictly to the plan without breaking any rules
  • Intermediate traders – Rules broken for purposes of testing and recording new data as the plan begins to become dynamic
  • Professional traders due not break any rules, but do supersede them when circumstances change

As you develop your trading plan you will notice that you are moving from one level to the next. Even if a trader has been trading for years at the professional level, they do not skip these steps when creating a new strategy, they merely go through them faster.

So now that we understand a little bit about the developmental process of a professional trading strategy we can look at its fundamental make up.

2. Trading Strategies – The 3 Elements of Every Trade

Every trade within all profitable trading strategies has:

  • An Entry,
  • An Exits and
  • A Catalyst.

Without each of these things, there can be no trade.

The Entry and Exits are chosen based upon a risk reward analysis that takes into account potential profit of the move to the potential loss and then weighs that ratio against the frequency win loss of the move.

For example:

If the trader sees a 2-1 profit to loss ratio on a move that has a 50-50 percent chance either way, the trade is considered to be a profitable one and will be entered. It does not mater if the trade makes money or not because the professional trader knows that over the course of 100 trades 50 will pay out $2 and the other 50 will cost $1 leaving resulting in a profit of $50 overall for each dollar risked.

3. Trading Strategies – Risk Management

A profitable trading strategy will encompass the trader’s own risk tolerance and risk management. This may include an assessment of:

Position size in relation to account size
The style of entry and exit (does the entire trade get entered or exited at one price at one time or gradually over a pricing zone through averaging?)
Commission risk. Does the trade profitability analysis take into account the price of commission for entering the trade?
Outside Risk. If one out of 100 trades the software or trading computer crashes, how will this affect profitability?

The risk tolerance is not just a mathematical assessment, but more importantly a psychological assessment as well. If your position size is too big, you will be more likely to succumb to the sway of greed and fear. If your position size is too small, you may succumb to boredom and place a trade outside of your trading strategy. That being said, it must be mathematically profitable for a trader to incorporate a set up into their trading strategy, and there are many outside unprofitable risk factors that you may not see until you actually trade the set up.

This is why you need to be familiar with step one where a beginner sticks to the plan. If you don’t, then your data could become corrupt leading you to think that you have bad luck, when in fact, you just have a bad analysis.

4. Trading Strategies – Market Risk

Market risk refers to a trading strategies exposure to market risk factors like:

A rise in fall of interest rates and/or their implied volatility
A rise or fall in the stock market or indexes that the strategy trades
A change in the currency that the underlying is priced in
Commodity Risk – A change in the price or volatility of commodity prices

To create a professional trading strategy, the trader must be aware of how market risk will affect their overall trading plan.
For example, during an FOMC meeting, bank stocks may become extremely volatile due to anticipation of a change in interest rates. When interest rates go down, banks make more money due partly to the fact that the money they have already lent out now costs them less. Likewise, during the weekly natural gas and oil inventory reports, oil stocks may see a spike in volatility. If the trader is unaware that these announcements are coming out, their entire strategy will become feckless due to the fact that it is based entirely on a separate volatility analysis.

If you lose your entire account, you may think it was bad luck, when in fact, it was bad timing and improper risk analysis.

There are many factors both micro and macro that will affect your design of a profitable trading strategy, but the most fundamental factors will always be:

  1. How you trade the plan
  2. How you choose the 3 factors of every trade
  3. Your Risk Management skills including your mathematical and psychological risk assessments, and
  4. our market risk analysis that determines just how well you know what you trade.

Day Trading Strategies can be simple or extremely complex, but they are always deemed simple by the people who trade them. If you are creating a strategy that confuses you, stop. You should be the master of the strategy, not the other way around. Once you master a strategy at its fundamental level you can begin to add complexity. Just make sure its mathematically sound and its risk exposure will keep you psychologically balanced.

If you follow these fundamentals, the sky is the limit. You will be well on your path to creating many professional and profitable trading strategies.