By Richard K.
Introduction on How to Build a Strategy
Most traders will inevitably come to the point where they want to develop their own trading strategy or trading system, probably because the strategies or systems they have spent their hard-earned money on before turned out to be garbage and a complete waste of time.
Developing a trading strategy is probably one of the most important steps any trader can take in becoming more successful and consistently profitable but at first, it can also seem to be a very daunting task.
The purpose of this article is to provide you with some important factors to consider and a process you can follow on how to build a strategy. This process can be challenging but is a vital step in the right direction, not only from a profitability point of view but also from a psychological standpoint. Without trading discipline, even the most well-developed trading system will eventually fall apart. Developing a winning strategy and putting it down on paper is what people do that strive to become a professional trader but those who can actually follow their strategy without breaking its rules are what sets apart wannabe professionals from actual professionals.
Factors to Consider Before You Start Developing a Trading Strategy
In order to start developing a trading strategy, you would need to know and identify a few things about yourself first. They include in no particular order:
- Your realistic goals.
- Time constraints.
- Financial capital requirements.
- Risk appetite.
Setting Realistic Goals
Traders often start out in the trading world with dollar signs flashing in their eyes. The truth is that there is no quick fix in trading and that most traders will quit before they even come close to tasting real money. Trading like any other profession takes time and commitment and keeping your monetary goals small with the intent of gradually building them as you become more experienced is a realistic goal.
Every person is different though and one person’s goal may differ greatly from the next, but you should at the very least set yourself a goal and aim to achieve it. The SMART Goal system provides an excellent framework for creating goals, both in trading and other ventures.
So here is an idea: Start with small realistic goals and gradually build up from there, while at the same time rewarding yourself for good progress.
What Are Your Time Constraints?
How much time will you have to dedicate to a) developing your strategy and b) actually trade it? Do you have a full-time or part-time job and which time frame will you base your strategy on to suit your time constraints?
Before you can devise a comprehensive trading strategy, you need to narrow your chart options and define your trading style. Ask yourself whether you’re a day trader, swing trader, or investor. If you trade on minute time frames, you will need to use different techniques and tools than traders who trade on a weekly or monthly basis.
Financial Capital Requirements
When the majority of traders think about this topic they only consider how much money they can open a trading account with when in fact they should also consider the financial requirement necessary in developing a trading strategy the right way.
Before you ever trade your strategy with real money, the actual development and diligent testing of your strategy can cost money and time. Properly investing in this process should be of high priority and only once you have a proven and reliable strategy should you think about how much money you are willing to trade live with.
Always keep in mind that you should never trade with money you cannot afford to lose and I think it is just as important to not even start trading with real money until you have a good idea of whether your strategy will be profitable at all.
What is Your Risk Appetite?
Some traders prefer to trade conservatively while others like the fast-paced action that day trading provides. The question you should ask yourself is how well you can handle losing money on any given trade and how loss affects your emotions.
Only once you have properly tested your strategy to see how it performed in the past will you have a clearer picture of what sort of losses you can expect in the future, so before you get to the strategy development phase you should have a good idea of what size of losses you are comfortable with.
Strategy Development Process
Assessing your risk appetite gives you thorough insight on how to develop your trading strategy so you can withstand ever-changing market conditions and the stress that accompanies them.
However, developing a trading strategy takes time and errors. Traders must continuously evaluate indicators such as candlestick patterns, chart patterns, mini-cycles, and volume. Once you find a strategy that achieves success, the work isn’t over. You should retrace your steps and see how to recreate that success.
After you determine rules that allow you to enter the market to make a profit, you should also look to see what your risk would have been if you hadn’t adhered to those rules. Examine your stop prices, and analyze the price movement after entry.
If you’re a day trader, you should frequently check exits, use your exit indicators, candlestick patterns, chart patterns, percentage retracements, trailing stops, Fibonacci levels, and other tools to capture profits.
When developing a strategy, you will encounter anomalies. That’s a part of any trading strategy. Your strategy shouldn’t place too much importance on the anomalies. Rather, you should evaluate it over time. Don’t become a prisoner of the moment, but don’t ignore obvious trends, either.
Additional Trading Tips to Consider
Using historical data to develop a trading strategy doesn’t guarantee profits. Because of this, many traders fail to backtest their trading strategies against historical indicators. Instead of incorporating more data, they make spontaneous decisions. This type of trading strategy represents a lack of strategy and will eventually damage the trader’s finance, no matter how much fortune favors the bold.
Analyzing historical data lets you know whether a strategy has ever worked. It forces you to ask the question, “If it hasn’t worked in the past, why would it work now?” Visual backtesting- perusing charts and applying new methods to the data over time- will help.
However, most trading strategies don’t last forever. They are profitable for a while and then they fall out of vogue. Traders need to be malleable with their trading strategy so they can profit off the strategies that make the most sense at that time. Without analyzing the past success of a particular strategy, you blind yourself from potential opportunities. Feeling comfortable with your analysis means you can gain confidence in your trades. You learn that you’re not looking for infallible strategies. You’re looking for sustainable strategies.
Step 1: Strategy Operation Parameters
What do you want your strategy to achieve?
This is a very broad question that needs serious consideration from your side to answer, taking into account the personal factors we discussed before. Here is an example of how I answered this question:
I want to trade with the major trend as defined by my larger time frame chart, but to do so I want to enter at the end of any correction, that went opposite the major trend so that I can join the path of least resistance with the least risk possible. The trend is your friend and I do not want to trade against it!
Above is a chart of the EUR/USD that shows a clear uptrend and the opportune areas where I would have liked to enter in order to join the major trend at the end of corrections. Simple concept but in practice, this is easier said than done! So how would I hope to achieve this you may ask? Let’s move on to the next step.
Choose Which Markets you Want to Trade
Considering what it is I want to achieve, I would next need to know which markets I want to apply it to. I like trading Forex, Commodities, and Stocks and to be able to trade all of them I would need to have a strategy that can be applied and work on all of them.
Traders that are a little less experienced may want to consider trading one market first in order to avoid overcomplicating things or losing focus by staring at too many markets.
Choosing a Trading Time Frame
The time frame you trade on will decide how often you want to trade and what style of trading you want to become involved in e.g. scalping, day trading, swing trading, position trading, etc.
To achieve my goal, I decided on 3-time frames that each have a very specific function as I want to hold positions anywhere from a day or more, probably putting me into the intermediate position trading category.
My time frames and their functions are:
- The 4-hour chart identifies my trend, when a trend may have ended and where a correction may occur.
- The 30-minute chart defines the internal market structure, identification of corrective patterns, and the use of market geometry to pinpoint the end of corrections.
- The 5-minute chart is used to spot momentum slowing down, reversal candlestick patterns, and defining my entries to limit my risk.
So judging by my timeframes and their very specific functions I aim to achieve my strategic goals in a very methodological fashion. Later on, I will show you chart examples to illustrate the process I use to find the end of corrections but let’s move on to our next step first.
Choosing Your Trading Tools: How Will You Define Your Entry, Risk, and Profit Target Parameters?
Professional traders are masters at managing their risks while maximizing their profits. This is again easier said than done, so for me to achieve similar results to that of a professional trader, I would want a way to limit my risk while at the same time maximize my profit potential.
Although my multiple timeframe approaches are all part of my larger strategic goal, I use my 5-minute chart to identify very specific entry conditions that allow me to enter trades knowing exactly where I want to place my entry, stop loss, and profit targets.
Step 2: Put Your Strategy on Paper and Define Your Rules
During step 1, I have shown you the basic foundation of what it is I want to do and how I hope to achieve it. Step 2 is a very important part of the process and it involves that you write out your entire strategy from how you start your analysis to how you actually enter a trade with very strict and specific rules to keep you in check.
This step was one of the best things I have ever done as it built confidence in my strategy but it was also one of the most difficult parts of the process as I ended up with nearly 100 pages in total!
It is not my intent to show you all 100 pages in this article but instead, I will quickly show you a great example of how I use multiple time frames to attain my goal.
4 Hour Chart
I identified on my 4-hour chart that the AUD/USD has broken out of its previous downtrend when the price broke through the downward sloping blue tend line and over the red horizontal line which indicated the previous market structure.
I then simply used my Fibonacci extension lines to indicate where the price is most likely to find resistance on the way up, as they will generally gift me some sort of correction. From my second 4 hour chart, you can see that both the 1.618 and 1.786 Fib extensions acted as resistance and caused a correction to form.
Now that I know a correction was underway, I looked at my 30-minute chart next.
30 Minute Chart
I follow 4 corrective patterns when I trade and they, in turn, have different variations to them as well, but what was clear after a while was that AUD/USD was forming what is called a Symmetrical Triangle correction, and since my bias was bullish I wanted to trade the end of the correction to the upside.
These triangular corrections are always labeled A-B-C-D-E and each of these 5 “waves” sub-divide into 3 smaller waves each labeled a-b-c in turn. Knowing which corrective pattern I was dealing with and knowing how these patterns behave allowed me to pinpoint an area where the E wave was most likely to end (blue rectangular box) which would allow me to enter a trade in the direction of the intermediate trend as identified by my 4-hour chart.
My knowledge of corrective patterns allowed me to pinpoint the most likely area for a reversal ahead of time, giving me enough time to prepare and plan for my entry.
5 Minute Chart
Using my smallest time frame to confirm entries that satisfy my own rules, I was able to spot momentum divergence (green lines) and 3 different reversal candlestick patterns in a row (red ovals). They all signaled to me that I could make a trade after the price entered the entry zone that I earlier identified on the 30-minute chart.
Where I place my entry order and my stop loss is all known ahead of time and after my entry conditions were met I placed them and eventually got filled.
This trade worked out beautifully and reached my target which is always set at an area where the correction started from on the 4-hour chart. Sometimes that target can be very far away which often results in much larger profits than this example.
The profit vs risk ratio on this particular trade was 5.6: 1 which shows exactly why I use the 5-minute chart to enter with.
The charts above show an actual trade that I took and offers a glimpse of how I achieve my strategic goal but for you to develop your own strategy you would need to have an idea of how you are going to achieve your own goal, which we covered before and then proceed to step 3 which involves testing your strategy.
Step 3: Testing Your Strategy
You might have heard about backtesting before which simply means that you need to test your strategy’s performance as if it was traded historically. This will allow you to measure different metrics that are very important to know, which include: win vs loss ratio, average drawdowns, how long a trade lasts on average, etc.
There are software programs out there that can backtest mechanical systems for you, but if you had a strategy like mine then you are left with the task of manually backtesting each and every trade historically over a set period of time, following your very specific rules as outlined by your strategy.
This can be a very painstaking task, but it is well worth the effort as this exercise accomplishes one very important goal: Building confidence in your strategies performance and capabilities.
If you were to manually backtest your own strategy then make sure that you keep honest with yourself and that you do not bend your own rules that you set for yourself. This is the one part of building your strategy that requires complete precision devoid of any human emotion.
Once you have all the important metrics you need, taken from at least a year of historical data will you know whether your strategy is profitable or not and whether you can handle some of the drawdowns that you are inevitably going to experience. If you do backtest manually then make sure you keep a proper spreadsheet of every metric you can think of.
In the case where you do not come up with the results you were expecting then it’s time to go back to step 1 and 2 and start over. You do not want to trade with real money until you know for sure that your strategy has an edge in the marketplace.
Step 4: Trade in Simulation Account
One of my trading mentors, that I have a lot of respect for once said: “If you cannot make money on a simulated account and treat it as if it was real money, then you better the hell does not get close to real money trading”.
Those words are very true, trading is not a game and it should be treated as a business. You should see the opportunity of trading in a simulated account as an employment trial period before you land your dream job and your performance will show to your employers that you are the right person for the job.
Logging all your trades in a trading journal and sticking to your trading rules should be a sort of a ledger that holds you accountable for your own actions. As soon as you break your rules you will start skewing your strategies results. Step 4 requires that you trust your strategy and you will only trust your strategy if you trust your backtesting results!
Step 5: Trade Real Money
It is said that you should only trade real money after a minimum of 20 trades. I personally think that number should be higher and more like 100 trades because trading with real money brings a whole lot of different emotions with it that you would not have experienced trading with paper/simulation money.
Going through a proper simulation phase would definitely ease you into things but it’s a fact that real money trading can amplify emotions like fear, greed, anger, etc. If you manage to get to step 5 and you followed all the processes properly then you should be at the stage where you trust your system and trust yourself to follow your own rules.
If you can do that then trading real money will become second nature and lead you on the path to making consistent profits.
Trading Strategies to Consider
The following examples are a few strategies to familiarize yourself with, and gain a better understanding of your trading strategy. The news trading strategy, end-of-day, swing trading, day trading, and trend trading, are all common strategies that might work with your personal preferences.
News Trading Strategy
News traders trade based on the news and market expectations. They can make their trades both before and after news releases and they include a substantial amount of speculation. These traders have to pay close attention to the media- especially in the age of the internet- since news travels fast and investment opportunities appear and disappear in the blink of an eye.
End-of-day traders trade most often near the market closing times. They activate their trades when it becomes clear the price will settle. End-of-day traders should study price action compared to the previous day and speculate how the price will move based on indicators they use in their system. These traders often create a risk management system using limit-orders, stop-loss orders, and take profit order to reduce overnight risk.
Swing traders trade both sides of price movements in Fibonacci markets. They buy securities when they suspect the market to rise and they sell assets when they expect the market to fall. Swing traders essentially take advantage of the market’s fluctuations as prices swing back and forth. Swing traders are purely technical and use charts and technical indicators to make their trades.
Day traders trade during the daytime, typically as a full-time profession. Day traders take advantage of price fluctuations in between the market open and close. Day traders typically hold multiple positions throughout the day but they let go of their positions open overnight to minimise risk.
Trend Trading Strategy
Trend trading incorporates technical analysis to define trades. It only enters the trades in the direction of the pre-determined trend. Trend traders don’t have a fixed-view of where the market should go. They employ an accurate system to determine and follow their trends. These traders have to stay alert to potential market reversals, which they can mitigate by utilizing stop-loss orders.
This article only touched on the important processes or steps on how to build a strategy. It is not a quick process and if you do it properly it could take many months for you to come up with a fully functional and profitable strategy that has an edge.
Do not rush this process as it is crucial to your long-term success as a trader and treat it as if you are writing a business plan. Then go prove this business plan to yourself in real-world situations so that you know you have a decent shot at extracting money from the markets on a consistent basis.
If you ever wondered how I trade my strategy and to see how to develop a trading strategy that has an edge then be sure to check out my course info here.
I wish you a successful and profitable trading journey ahead!
All the best,
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