Unpredictability is a feature of trading. But this does not mean that you can act solely according to the situation when making deals. On the contrary: your success depends on discipline, which in turn is based on your trading strategy.

How to create a trading strategy and what does it consist of? Find out in this ParadTrade material.

What is a trading strategy?

A trading strategy is a pre-developed plan of action on the financial market aimed at systematically obtaining profit. It is based on strict adherence to certain rules and principles, which eliminates the influence of emotional factors and accidents. The strategy is developed taking into account the fundamental or technical characteristics of financial instruments, which reduces the likelihood of losses.

The main element of any trading strategy is a clearly formulated goal that determines the direction of investment activity.

How is a trading strategy formed?

A trading strategy defines a trader’s investment goals, their attitude to risk, and the specific steps that will be taken to achieve these goals. The strategy takes into account both the investor’s long-term and short-term financial needs, the tax implications of investment decisions, and the investment time horizon.

Before deciding to make a trade, an investor must conduct a thorough market analysis, studying current trends and identifying potentially profitable opportunities.

A trading plan is an integral part of a strategy and describes in detail the investor’s algorithm of actions on the financial market. It includes:

  • rules for entering trades;
  • stop-loss and take-profit levels;
  • criteria for closing positions.

When developing a trading plan, the investor usually cooperates with a broker, who assists in choosing the most suitable financial instruments and managing trading operations.

After the trading strategy is developed and implemented, the investor constantly monitors the market situation and adjusts their positions in accordance with the initially set goals. Regular analysis allows you to evaluate the effectiveness of the strategy, promptly identify emerging risks and optimize the structure of the investment portfolio.

Key components of a trading strategy

Risk tolerance. This is the ability of a specific trader to withstand fluctuations in market prices and potential financial losses. This indicator directly affects the formation of an investment strategy and the choice of financial instruments. The level of risk tolerance isn’t a static value and can change over time under the influence of both external factors (for example, economic crises) and internal ones (changes in financial situation, life goals, etc.). Therefore, regular assessment of risk tolerance is an integral part of effective investment management.

Trading products. Creating a balanced investment strategy involves a thorough analysis of the potential profitability of each financial instrument and its contribution to the overall portfolio. Various assets – stocks, currencies, commodities, cryptocurrency – differ from each other in their degree of volatility, liquidity and trading complexity.

For example, options, while highly flexible and requiring relatively small initial investments, are at the same time a more complex instrument compared to stocks. Thus, choosing the optimal combination of financial assets is a key factor in successful investing.

Use technical analysis. Technical analysis is a method of studying market dynamics based on the study of historical price and volume data. Its main goal is to identify patterns and trends that can predict future market movements and thus help investors make informed trading decisions.

Technical analysis uses various indicators, each of which reflects certain aspects of market dynamics. Stochastic oscillator, on-balance volume, and relative strength index are just some of the most popular technical analysis tools. These indicators allow you to assess the strength of the current trend, determine whether the market is overbought or oversold, and identify potential reversal points.

Developing a trading strategy

Technical and fundamental analysis form the basis of most trading strategies, providing investors with quantifiable and verifiable data to make decisions.

Technical trading strategies focus on studying historical price data and trading volumes to identify recurring patterns and trends. They use various technical indicators, such as moving averages, relative strength index (RSI), and others, to predict future price movements. For example, a strategy based on moving average crossovers would involve entering a buy position when the short-term moving average crosses the long-term moving average from below to above, and vice versa.

The number of indicators used in the trading system should be optimal. On the one hand, an excessive number of indicators can lead to over-optimization of the system and a decrease in its efficiency in the real market. On the other hand, too few indicators may not provide sufficient reliability of signals. The optimal number is considered to be 3-5 indicators that complement each other and allow you to get a more complete picture of the market situation.

Fundamental analysis, unlike technical analysis, focuses on studying economic, financial and other factors that affect the value of an asset. Fundamental strategies are based on the assumption that the asset price will tend to its fair value in the long term, determined by these factors. For example, a strategy based on fundamental analysis may include selecting companies with high profitability, low debt and promising industries.

In addition, sharp price movements in financial markets are a reaction to significant economic events and publications. Even if a trader is planning a short-term deal, he should be prepared for the fact that the release of important macroeconomic data can significantly affect the market.

4 main elements of a trading strategy

The world of investment offers a huge variety of trading strategies, each of which is based on fundamental or technical principles of financial market analysis. Despite the apparent diversity of approaches, all trading strategies have a common structure, combining unique combinations of tools and techniques.

An effective trading strategy is a carefully thought-out plan of action that includes clearly defined components.

The first component is the choice of trading instruments. The investor must determine in advance a specific set of assets that he will operate. For example, for a forex trader, these may be specific currency pairs, and for a stock trader, specific stocks or indices.

The second component is the conditions for entering a trade. Each strategy must contain clear criteria that determine under what market conditions a position will be opened. These can be various technical signals, fundamental factors, or a combination of both. For example, a strategy based on a breakout of a resistance level involves opening a buy position after the price breaks through this level.

The third component is position sizing. Any trading strategy involves determining the optimal position size for each trade. The position size should be calculated in such a way as to minimize potential losses and maximize profits. Usually, various risk management methods are used for this, for example, a fixed percentage of the deposit.

The fourth component is trade management rules. This component determines under what conditions the position will be closed – when the target profit is reached, when the stop loss level is reached, or when other predetermined conditions occur. Trade management rules allow you to minimize losses and lock in profits.

The closing process: why is it important?

A successful exit from a trade often outweighs a successful entry. The key difference between these two moments is the degree of risk. Waiting for the perfect moment to enter the market does not involve significant losses. A missed opportunity can always be compensated by another. However, the situation changes dramatically when it comes to exiting a position.

Remember: choosing the wrong moment to take profit or close a losing trade can lead to significant financial losses.

The exit strategy has two main goals. Firstly, it is aimed at tight control over potential losses, which is an integral part of any trading activity. Since there is no 100% guarantee that you will be able to avoid losses, the task is to develop mechanisms for timely closing of losing positions, minimizing their negative impact on the trading account. This aspect of the strategy is often called money management and is implemented by setting stop orders.

The second goal is to extract maximum profit from successful trades. It is necessary to avoid premature closing of positions, limiting yourself to only a small profit. On the contrary, you should strive to hold on to profitable trades for as long as possible to get the maximum return. To achieve this goal, such tools as trailing stops and limit orders are used.

How to choose the right timeframes?

Choosing a time frame (time interval) for market analysis is one of the key decisions made by a trader. A time frame is the period of time during which one candle or bar is formed on a chart, and can vary from several minutes to several months. The most common in trading are hourly and daily intervals.

The size of the trading account has a significant impact on the choice of time frame. When working with hourly bars, tighter stop losses are usually used (30-70 points), which requires a relatively small deposit. Daily bars imply wider stop losses (100-250 points or more), which requires a significantly larger amount of funds in the account. This is due to the fact that most trading systems allow a certain number of losing trades in a row, and when working with daily bars, the potential drawdown can be significant for small deposits.

The frequency of market access is also an important factor. If a trader has the ability to constantly monitor the market, he can work with hourly bars. However, if access to the market is limited, it would be more rational to use daily bars, which require less frequent monitoring.

Thus, the optimal choice of time frame depends on two main factors: the size of the trading account and the frequency of market access. It should be remembered that too short intervals (less than one hour) can make it difficult to apply classical methods of technical analysis, and too long ones (weekly and monthly) are more typical for long-term investors.

Why is it important to take breaks from trading?

Traders often overlook one extremely important aspect – the need for regular breaks in trading. It would seem that this issue is obvious, but in practice many traders ignore it, continuing to make trades day after day, regardless of the results obtained.

Practice shows that continuous participation in the trading process can lead to emotional exhaustion, decreased concentration and, as a result, to making biased decisions. In order to avoid such situations, it’s necessary to introduce a mechanism of regular breaks into your trading system.

Breaks allow the trader to rest, analyze their actions and adjust the trading plan if necessary. Of course, you can use other criteria to determine the moment for a break, for example, calendar dates or achieving certain financial goals.

It is important to understand that the market will always be present, but it is not always necessary to react to its every move. Regular breaks allow the trader to maintain clarity of thought, avoid impulsive decisions and increase the effectiveness of their trading activities.