How to Create a Trading Strategy

Wed May 25, 2022, 03:07 pm | by Dan Schmidt | No comments

“I love it when a plan comes together” was the weekly catchphrase of John “Hannibal” Smith, who fought criminals and corrupt politicians with his mercenary team on the hit 80s show The A-Team. If you’re familiar, the ‘plan’ usually involved excessive violence and over-the-top stunts (that miraculously left no one injured). Even so, the A-Team never took on a challenge without a plan, and they pitied the fool who came at them unprepared.

If you want to have success trading in the market, you’ll need to have a plan come together as well. Your plan won’t require any rifles and explosives, but there are some rules and guidelines to keep your trades from veering off course. Trading requires commitment and it’s difficult to stay disciplined if you don’t have an overarching strategy or plan. Before jumping headfirst into the markets, you’ll need to develop a trading strategy. Here’s how to get started.

What to Look for in a Strategy 

What type of trader do you want to be? This is the first question you’ll need to ask yourself when devising your trading strategy. Are you trading for long-term gains or short-term profits? What types of markets will you attempt your strategies in? Not every type of trading strategy will fit your goals and mindset. What is your specific risk tolerance? If you have a full-time job and family, day trading is probably not something you’ll be able to dedicate the necessary time.

Whether you’re using technical analysis to day trade or gauging future earnings growth for a decade-long investment, you’ll need to understand the pros and cons of your strategy. The best investors in history have a track record littered with mistakes, so it’s unrealistic to think you’ll never encounter a losing streak or a run of bad luck. Choose a strategy you can stick with through the good and bad times because if you do it right, you’ll experience both (just hopefully more of the former).

Pick Your Market 

Some trading strategies will work in all markets, but if you’re just developing your plan, you’re probably better off sticking to the securities you know best. Each market has its pros and cons, so choose one that fits in with your trading techniques.

  • Stocks – If you’re reading this article, there’s a good chance stocks are the security you’re looking to trade. Stocks can be traded using many different strategies and while the markets are unpredictable, you can pencil in a few certainties like trading hours and quarterly earnings reports. 
  • Options – Trading stock derivatives like options can be more rewarding than traditional investing, but it also carries far more leverage and risk. Options markets aren’t for the faint-hearted. It’s not uncommon to see an options trade lose 50% in a single session, only to jump back up 100% the following session. Trading options take a certain level of risk tolerance (and experience since options permission must be granted by a broker).
  • Forex – Trading currencies can be a profitable venture, but the markets are quite different from stock and options markets. Trading is done 24/5, and traders use amped-up leverage to profit off incremental moves. Currency markets can still be volatile though and traders must understand the risks involved that aren’t present in other markets (ie. exchange rate risk)
  • Commodities – Investing in commodities like oil and gold can provide some diversification to your portfolio and exposure to assets that don’t move in lockstep with stocks. However, commodities must be traded with futures contracts and assets like oil are much more beholden to geopolitical influences than stocks or options.

Choose Your Timing 

Time horizon is one of the most important factors when it comes to investing. Your time frame molds your strategy because the length of time you hold your securities holds a ton of sway over your profits. Are you investing for the long haul through index funds or looking to swing trade for more immediate profits? Here are three different styles of trading and the time frame involved with each.

  1. Day trading – Opening and closing positions in a matter of hours (or even minutes) is the mantra of the day trader, who never holds positions overnight. Day traders can have varying levels of risk tolerance and profit goals, but all day traders must utilize technical analysis to identify trends and ideal entry and exit points. Every penny matters when day trading so these entries and exits must be precise. 
  2. Swing trading – Swing traders utilize many of the same strategies as day traders, but they’re willing to expand time frames to days, weeks, or even months at times. Contrary to popular belief, swing trading involves more risk than day trading since you must hold positions overnight when volatile moves can occur with no chance to liquidate. Swing traders aim for bigger profits than day traders, but also occasionally take major losses.
  3. Buy-and-hold investing – If you want to save for retirement or build wealth slowly over a period of years or decades, buy-and-hold investing is probably for you. You don’t need to use advanced technical analysis to predict abrupt price changes, just some fundamental research and basic trend analysis. Or you can buy index funds and just check on your investment once a year.

Choose Your Indicators 

Searching for good trades is a bit like being a detective. You don’t know in advance which stocks or commodities will rise in price, but you can look for clues, gather evidence, and make educated guesses. Trading analysis generally falls into two camps: fundamental analysis and technical analysis. 

Technical analysis can be used in many disciplines to measure patterns and formulate predictions based on seemingly random data (like stock price points). Day and swing traders rely on technical analysis to buy or sell securities before the price moves in their predicted direction. Some of the bread-and-butter technical tools are moving averages, which help smooth price data so trends can be more easily identified. Technical traders often use moving averages to locate areas of resistance and support. Once identified, resistance and support levels offer great entry and exit points for trades.

Fundamental analysis is used by traders with longer time horizons. Fundamental investors care about the nuts and bolts of the business, not the gyrations if its stock price. Earnings growth, debt levels, regulation, gross margins, and market share are important fundamental factors used to project the long-term profitability of public companies.

Paper Trading 

Practice might not make perfect (especially if you ask Allen Iverson), but practice does allow us to learn from mistakes in a risk-free environment. If you’re developing a new trading strategy and want to test it out before putting any real money at risk, utilize the paper trading service offered by most brokers or find a place to create a paper trading account and practice with fake cash.

Paper trading is no substitute for the real thing. You know the money is fake, so big wins and losses won’t affect you the same way psychologically. However, just because the paper trading doesn’t have the same impact, doesn’t mean it’s useless. You can still use it to implement new ideas, reinforce your strategies, and see how your plan might play out in the real markets.

Final Thoughts 

Tackling a challenge without a plan is a fool’s errand and trading securities is a challenge that has kept the world’s smartest minds off balance. You can’t trade every security in the market and you won’t find easy riches following the picks of Twitter gurus or CNBC talking heads. You’ll need to find your niche as a trader – that means devising a plan, sticking to the securities you know, and keeping your emotions at bay if a trade turns against you. Keep track of your trades and tweak your strategy if needed, but know that discipline and dedication are required for success in the markets. Stick to the plan.

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