There are many great trading strategies out there, and purchasing books or courses does save time, but trading can also be a "do it yourself" career. Many traders spend hundreds or even thousands of dollars looking for a great trading strategy. Building strategies can be fun, easy and surprisingly quick. (To read about available trading software check out Forex Automation Software For Hands-Free Trading.)
To create a strategy, you will need access to charts which reflect the time frame to be traded, an inquisitive and objective mind and a pad of paper to jot down your ideas. These ideas can then be formalized into a strategy and "visually backtested" on other charts. In this article, we go over this process from start to finish including the questions to ask along the way. Then you'll be ready to start creating your own strategies in any market and on any time frame.
Time and Place?
Before a strategy can be created, you need to narrow the chart options. Are you a day trader, swing trader or investor? Will we trade on a one-minute time frame or a monthly time frame? Be sure to choose a time frame that suits your needs. (For more information regarding choosing an appropriate investment time frame, please refer to Multiple Time Frames Can Multiply Returns.)
Then you'll want to focus on what market you will trade: stocks, options, futures, forex or commodities? Once you've chosen a time frame and market, decide what type of trading you would like to do. As an example, let's say you choose to look for stocks on a one-minute time frame for day-trading purposes and want to focus on stocks that move within a range. You can run a stock screener for stocks that are currently trading within a range and meet other requirements such a minimum volume and pricing criteria.
Stocks, of course, move over time, so run new screens when needed to find stocks that match your criteria for trading once former stocks are no longer trading in a way that is congruent with your strategy.
Creating and Testing Strategies
Creating a strategy that works makes it is much easier to stick to your trading plan because the strategy was your own work (as opposed to someone else's).
For example, suppose that a day trader decides to will look at stocks on a five-minute time frame. She has a stock selected from the list of stocks produced by the stock screen she ran for a certain criteria. On this five-minute chart, she will look for money-making opportunities.
Look at rises and falls in price and see if you can find anything that precipitated those movements. Indicators such as time of day, candlestick patterns, chart patterns, mini-cycles, volume and other patterns should all be looked at. Once a potential strategy has been found, go back and see if the same thing occurred for other movements on the chart. Could a profit have been made over the last day, week or month using this method? If you are trading on a five-minute time frame, continue to only look at five minute time frames but look back in time and at other stocks that have similar criteria to see if it would have worked there as well. (Other useful charting techniques are describes in Momentum Indicates Stock Price Strength.)
After you determine a set of rules that would have allowed you to enter the market to make a profit, look to those same examples and see what your risk would have been. Determine what your stops will need to be on future trades in order to capture profit without being stopped out.
Analyze price movement after entry and see where on your charts a stop should be placed. When you analyze the movements, look for profitable exit points. Where was the ideal exit point and what indicator or method can be used to capture most of this movement? When looking at exits, use indicators, candlestick patterns, chart patterns, percentage retracements, trailing stops, Fibonacci levels or other tactics to help capture profits from the opportunities we are seeing. (Some indicators of interest can be found in Trading Psychology And Technical Indicators.)
Depending on how often you want to look for strategies, you can look for tactics that work over very short periods of time. Often, short-term anomalies occur that allow the trader to extract consistent profits. These strategies may not last longer than several days, but those strategies can also likely be used again in the future. (To make sense of market anomalies refer to Making Sense Of Market Anomalies.)
Keep track of all the strategies you use in a journal and incorporate them into a trading plan. When conditions turn unfavorable for a certain strategy, you can avoid it. When conditions favor a strategy, you can capitalize on it in the market.
Additional Things to Consider
Using historical data and finding a strategy that works will not guarantee profits in any market. It is for this reason that many traders do not backtest their strategies; instead they do fly-by-the-seat-of-the-their-pants trading. This is where no real strategy is in place because they don't want to test something on historic data. But it is important to see if something worked in the recent past because if a strategy never worked, it is unlikely to suddenly start working. That's why visual backtesting – scanning over charts and applying new methods to the data you have on your selected time frame - is crucial.
Many strategies don't last forever. They fall in and out of profitability and that is why one should take full advantage of the ones that still work. If something has worked for the past few months or over the course of the last several decades, it will probably work tomorrow. But if we never looked to the past to test that strategy, we might not even realize it was there, or we might lack the confidence to apply it in the markets tomorrow to make money. Knowing that something has worked in the past will thus also give a psychological boost to your trading.
Trading needs to be done with confidence (not arrogance), and being able to pull the trigger on a position when there is a set up to make money will require the confidence attained from looking to the past and knowing that more often than not, this strategy worked.
Keep in mind that we do not need to look for strategies that work 100% of the time. In fact, if we do this we will likely find no strategies. Simply look for strategies that net a profit at the end of the day, week and/or year(s).
The Bottom Line
Strategies fall in and out of favor over different time frames; occasionally changes will need to be made to accommodate the current market and our personal situation. Create your own strategy or use someone else's and test it on a time frame that suits your preference. By using what the past has shown us, we can give ourselves some great starting points to making more money and avoid losses as we become more experienced traders. Track all strategies that you use so that you can use these strategies again when conditions favor it.
Technical IndicatorsAutocorrelation is the measure of an internal correlation with a given time series.
TermA public good is an item whose consumption is determined by society, not individual consumers.
Chart AdvisorWeekly technical summary of the major U.S. indexes.
Mutual Funds & ETFsLearn about the differences between actively and passively managed mutual funds, and for which types of investors each management style is best suited.
Investing BasicsLearn about the ultra rich and what normally comprises their net worth; understand the top three alternative investments usually owned by the ultra rich.
Stock AnalysisLearn about the top five dividend stocks of companies operating in the health care sector that generate substantial cash flows to afford high payouts.
InvestingWealth advisers who integrate philanthropy and finance planning can stand out with baby boomer clients.
Chart AdvisorIt's been a long downtrend for oil stock owners, but there's hope. These four oil and gas stocks have reversed and may keep trending to the upside.
Mutual Funds & ETFsFind out what kinds of mutual funds are unsuitable for millennial investors, especially when included in millennial retirement accounts.
Bonds & Fixed IncomeTaking on high-yield bond investments requires a thorough investigation. Here are looking the fundamentals.
There are some types of mutual funds, called stock funds or equity funds, which hold only stocks. However, there are a number ... Read Full Answer >>
The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>
Some mutual funds pay interest, though it depends on the types of assets held in the funds' portfolios. Specifically, bond ... Read Full Answer >>
Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
Depending on the specific assets in its portfolio, a mutual fund may generate income for shareholders in the form of capital ... Read Full Answer >>
There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>