A trading model is a clearly defined, step-by-step rule-based structure for governing trading activities. In this article, we introduce the basic concept of trading models, explain their benefits, and provide instructions on how to build your own trading model.
The Benefits of Building a Trading Model
Using a rule-based trading model offers many benefits:
- Models are based on a set of proven rules. This helps remove human emotions from decision making.
- Models can be easily backtested on historical data to check their worth before taking the dive with real money.
- Model-based backtesting allows verification of associated costs so the trader can see profit potential more realistically. A theoretical $2 profit may look attractive, but a brokerage charge of $2.50 changes the equation.
- Models can be automated to send mobile alerts, pop-up messages, and charts. This can eliminate the need for manual monitoring and action. With a model, a trader can easily track 10 stocks for 50-day moving average (DMA) crossing over 15‑day moving average. Without such automation, manually tracking even one stock DMA can be difficult.
How to Build Your Own Trading Model
To build a trading model, you do not need advanced-level trading knowledge. However, you do need an understanding of how and why prices move (for example, due to world events), where profit opportunities exist, and how to practically capitalize on opportunities. Novices and moderately experienced traders can start by becoming familiar with a few technical indicators. These offer meaningful insights to trading patterns. Understanding technical indicators will also help traders conceptualize trends and make customized strategies and alterations to their models. In this article, we will focus on trading based on technical indicators.
Example of a Simple Trading Model Strategy
Based on the principle of trend reversal, some traders act on the assumption that what goes down will comes back up (and vice versa). Using the assumption of trend reversal as a strategy, we will build a trading model. In the steps below, we will walk through a series of steps to create a trading model and test if it is profitable.
Flowchart for Building a Trading Model
1. Conceptualize the trading model.
In this step, the trader studies historical stock movements to identify predictive trends and create a concept. The concept may be a result of extensive data analysis or it could be a hunch based on chance observations.
For this article, we are using trend reversal to build the strategy. The initial concept is: if a stock goes down x percent compared to the previous day’s closing price, expect the trend to reverse in next few days.
From here, look at past data and ask questions to refine the concept: Is the concept true? Will this concept apply to only a few selected high-volatility stocks or will it fit any and all stocks? What is the duration of expected trend reversal (1 day, 1 week, or 1 month)? What should be set as the down level to enter a trade? What is the goal profit level?
An initial concept usually contains many unknowns. A trader needs a few deciding points or numbers to begin. These may be based on certain assumptions. For example: this strategy may apply on moderately volatile stocks having a beta value between 2 and 3. Buy if stock goes down by 3 percent and wait for next 15 days for trend reversal and expect a 4 percent return. These numbers are based on a trader’s assumptions and experience. Again, a basic understanding of technical indicators is important.
2. Identify the opportunities.
In this step, identify the right opportunities or stocks to trade. This involves verifying the concept against historical data. In the example concept, we buy on a 3 percent dip. Start by choosing high‑volatility stocks for the assessment. You can download historical data of commonly traded stocks from exchange websites or financial portals like Yahoo! Finance. Using spreadsheet formulas, calculate the percentage change from the previous day’s closing price, filter out the results matching the criteria, and observe the pattern for following days. Below is an example spreadsheet.
In this example, the stock’s closing price is going down below 3 percent on 2 days (February 4 and February 7). Careful observation of the following days will reveal if the trend reversal is visible or not. The price on February 5 shoots up to 4.59 percent change. By February 8, the change is below expected at 1.96 percent.
Are the results conclusive? No. One observation matches the expectation of the concept (4 percent and above change) while one observation does not.
Next, we need to further check our concept across more data points and more stocks. Run the test across multiple stocks with daily prices over at least 5 years. Observe which stocks give positive trend reversals within a defined duration. If the number of positive results is better than negative ones, then continue with the concept. If not, tweak the concept and retest or discard the concept completely and return to step 1.
3. Develop the trading model.
In this stage, we fine tune the trading model and introduce necessary variations based on assessment results of the concept. We continue to verify across large datasets and observe for more variations. Does the strategy outcome improve if we consider specific weekdays? For example does the stock price dipping by 3 percent on a Friday result in a cumulative 5 percent or more increase within the next week? Does the outcome improve if we take high-volatility stocks with beta values above 4?
We can verify these customizations whether or not the original concept shows positive results. You can keep exploring multiple patterns. At this stage you can also use computer programming to identify profitable trends by letting algorithms and computer programs analyze the data. Overall, the aim is to improve the positive outcomes from our strategy leading to more profitability.
Some traders get stuck in this stage, analyzing large datasets endlessly with slight variations in parameters. There is no perfect trading model. Remember to draw a line on testing and make a decision.
4. Perform a practicality study:
Our model is now looking great. It shows a positive profit for a majority of trades (for example, 70 percent wins of $2 and 30 percent losses of $1). We conclude that for every 10 trades, we can make a handsome profit of 7*$2 – 3*$1 = $11.
This stage requires a practicality study which can be based on following points:
- Is the brokerage cost-per-trade leaving sufficient room for profit?
- I may have to make up to 20 trades of $500 each to realize a profit, but my available capital is just $8000.Does my trading model account for capital limits?
- How frequently can I trade? Is the model showing too frequent trades above my capital available, or too few trades keeping profits very low?
- Does the theoretical outcome match with necessary regulations. Does it require short selling or long dated options trade which may be banned, or holding of simultaneous buy and sell positions which may also not be allowed?
5. Go live or abandon and move to a new model.
Considering the results of the above testing, analysis, and adjustment, make a decision. Go live by investing real money using the trading model or abandon the model and start again from step 1.
Remember, once you go live with real money it is important to continue to track, analyze, and assess the result, especially in the beginning.
6. Be prepared for failures and restarts.
Trading requires constant attention and improvements to strategy. Even if your trading model has consistently made money for years, market developments can change at any time. Be prepared for failures and losses. Be open to further customizations and improvements. Be ready to trash the model and move on to a new one if you lose money and can find no more customizations.
7. Ensure risk management by building in what-if scenarios.
It may not be possible to include risk management in selected trading model depending on chosen strategies, but it is wise to have a backup plan if things don’t appear to be as expected. What if you buy the stock that went down 3 percent, but it did not show trend reversal for the next month? Should you dump that stock at a limited loss or keep holding on to that position? What should you do in the case of a corporate action like a rights issue?
The Bottom Line
Hundreds of established trading concepts exist and are growing daily with the customizations of new traders. To successfully build a trading model, the trader must have discipline, knowledge, perseverance, and fair risk assessment. One of the major challenges comes from the trader’s emotional attachment to a self-developed trading strategy. Such blind faith in the model can lead to mounting losses. Model-based trading is about emotional detachment. Dump the model if it is failing and devise a new one, even if it comes at a limited loss and time delay. Trading is about profitability, and loss aversion is in-built in the rule‑based trading models.