What does a Trading Strategy consist of?
Now that we know what a trading strategy is based on, we need to know what it consists of. A typical trading strategy or system is based on three key decisions of any given trade: (1) the precise entry point into the market, i.e. at what point the trader decides to open a position. (2) The precise level or levels to take profit, in other words when you close a profitable position. And (3), the precise level or levels to exit, or close, a losing position. Traders base their strategies around these three key decisions, but many fail to formulate a “blueprint” in order to follow them.
Here is a suggested list of five points to follow when designing your own trading system:
- Decide on the trading style you are comfortable with
Are you a trend-follower? A contrarian (someone who goes against prevailing trends), an intraday trader (someone who opens and closes position within a single day) or a long-term trader?
- Formulate the rules of the systems
Set rules based around the three key decisions. What are the conditions to enter a buy? What are the conditions to sell? What happens when the market moves in the expected direction, and when it moves against you?
Write all of these rules down.
- Test the system
The first step in testing your system is through visual inspection. Scroll back and forth on the price chart to check whether the system is profitable. If so, then you can test more thoroughly with larger amounts of data and on various financial instruments.
- Backtest the system
For those with programming knowledge, backtesting the system using trading bots can be very handy. The reports that can be generated can reveal information about profit factors, average losses, wins and so forth.
- Forward test the system
Once you have a clear system with its own set of rules in place, forward test it before investing your money. See how it behaves in a real trading environment by testing with live prices.
One more video remains in our Trading Basics series, and it’s an extremely important lesson for every trader: Risk Management! Until then.