What is a Trading Strategy?
A trading strategy is a fixed plan for buying and selling securities designed to generate a profitable return on the investments. It should be objective, consistent, quantifiable, and verifiable. The strategy is founded on fundamental analysis or technical analysis so that the inevitable systemic risks cannot lead to catastrophic effects on financial instruments. When building a trading strategy, traders should formulate clear goals that they aim to achieve.
- A trading strategy is a fixed plan for executing orders in the markets to achieve a profitable return.
- A good trading strategy should be consistent, objective, quantifiable, and verifiable.
- The trading strategy should outline the specific assets to trade, the investor’s risk tolerance, time horizon, and overall goals.
Trading Strategy Explained
A trading strategy outlines the investor’s financial goals, including risk tolerance level, long-term and short-term financial needs, tax implications, and time horizon. Before executing a trade, an investor needs to perform solid market research on the current market trends and patterns.
A trading plan sets out the strategies of buying and selling assets, ranging from bonds, stocks, futures, options, FTEs, among other securities. When creating a trading strategy, an investor works alongside a broker-dealer to choose profitable trading products and manage trading activities.
Once a trading strategy is created and executed, the trader monitors the markets and manages the trading positions to ensure they align with the initial strategy. The trading strategy keeps track of the risks, returns, and impact of current trades on the investor’s portfolio.
Key Components of a Trading Strategy
1. Risk tolerance
Risk tolerance refers to the degree of risk that an investor is willing to withstand in their trading activities. It determines the trading strategy that an investor will adopt. Throughout the trading period, risk tolerance is bound to change. For this reason, it should be assessed regularly, especially in the face of financial or lifestyle changes.
For short-term investments, traders should consider time-based risk tolerance to craft an optimal trading strategy. Long-term investment can accommodate higher risk levels, and investors can identify trading opportunities when the market is volatile.
On the other hand, a short-term investment may tolerate lower-risk asset classes that help escape losses and secure gains by diversifying the portfolio. Limiting risk exposure to the lowest possible level can help investors secure their capital and cap the extent of losses.
2. Trading products
Developing a well-balanced trading strategy requires investors to determine the potential added value to the portfolio. Financial instruments are diverse in terms of trading complexity, risks, and the liquidity they offer.
For example, trading options are complex, come with some level of risk, require a comparatively lower upfront investment, and offer more flexibility than trading stock. Thus, selecting a viable combination of financial instruments is a prerequisite for an optimal portfolio. Frequent adjustment of investor’s positions is also important, considering that market conditions frequently change.
3. Leverage technical analysis
Technical analysis identifies trading opportunities and potential risks before getting into a trade. Technical indicators such as a stochastic oscillator, on-balance volume, and the relative strength index can help the investor gauge the market movements and generate buying and selling signals for the right strike price.
Developing a Trading Strategy
Technical and fundamental trading strategies
Most trading strategies are based on either technical analysis or fundamental analysis, and they are informed by quantifiable and verifiable market information.
Strategies that rely on technical indicators tend to focus on market strikes and their movements. A technical indicator such as a moving average, for example, can be used to devise a trading strategy in which a short-term moving average overlaps below or above a long-term moving average.
As with technical trading strategies, fundamental trading strategies rely heavily on fundamental factors. For example, a strategy may be based on a list of criteria such as profitability and revenue growth to generate a series of trading opportunities.
Quantitative trading strategy
The quantitative trading strategy’s buy or sell decision is developed by analyzing the existing information on a particular security. While the strategy appears similar to technical trading, it incorporates a larger matrix when arriving at the selling or buying decision compared to technical trading. Market inefficiencies are highlighted using key data points, such as price, regression, or trading ratios.
The use of trading strategies in investments is meant to ensure consistent results and evade behavioral financial biases. Traders can decide to use either discretionary trading or automated trading. Discretionary trading is executed by the trader, and it requires a great deal of discipline since traders may be tempted to deviate from the strategy.
On the other hand, automated trading uses advanced computer modeling techniques to automate part or all of the investor’s portfolio. Compared to discretionary trading, automated trading gives traders an upper hand in trade execution, and they choose between a conservative or aggressive or trading method.
CFI offers the Capital Markets & Securities Analyst (CMSA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: