Building an effective trading strategy requires having a clear sense of your financial goals. This should include knowing your risk tolerance, determining your short- and long-term financial needs, and understanding how trading can add value to your portfolio. 

Whether you’re just getting started or looking to optimize your existing strategy, it’s important to spend some time analyzing these factors and determining the approach that feels appropriate to your circumstances.

Key Takeaways

  • An effective trading strategy should take into account your risk tolerance and long-term financial goals.
  • Options, futures, and other derivatives can each play an important role in building your portfolio.
  • Technical analysis can help you identify trading opportunities by analyzing trends such as price movement and volume.

Assess Your Risk Tolerance

Risk tolerance is frequently discussed in relation to trading, and it’s a key factor in determining the best type of strategy to adopt. But risk tolerance is likely to change throughout your lifetime, so it’s crucial to reassess your appetite for risk regularly, especially when faced with financial or lifestyle changes. 

Time-based risk tolerance assessment is one popular approach and it can help to determine both your immediate and long-term strategies. If you have a longer investment horizon, you may be able to tolerate a higher level of risk and it may be beneficial to look for trading opportunities during periods of volatility. If you have a shorter investment horizon, you may do best with lower-risk asset classes that can help to diversify your portfolio while keeping your overall risk at bay.

Risk capital is another important consideration and one you should assess even more frequently. If you’re new to trading, limiting your risk capital to 10% of your overall portfolio can limit your risk exposure as you build your portfolio. If you’re an active and experienced trader, you may choose to allocate 25% or more of your portfolio to higher-risk investments, though we recommend doing this slowly to hedge against losses and market volatility.

Choose the Right Trading Products

Whether you’re interested in trading options, futures or other securities, understanding the value they can add to your portfolio is an important part of developing a balanced trading strategy. While options are complex and carry some level of risk, they can also offer more flexibility and a lower upfront investment than stock trading.

Futures, on the other hand, generally carry a higher level of risk and therefore require an even more precise strategy. Despite the risks, futures can also offer increased liquidity as well as exposure to a wide range of financial instruments including stocks, currencies, and commodities. With a well-implemented strategy, they can also offset the risk to other parts of your portfolio and serve as a way to hedge against market swings. 

If you’re a seasoned trader and have already chosen a trading strategy that fits your market outlook and trading objective, determining the right combination of options, futures, and other financial instruments can help you optimize your portfolio and lead to better returns. As market conditions change, and especially during periods of significant volatility, adjusting your position frequently can help you limit losses and protect against large declines.

Leverage Technical Analysis

As you ramp up your trading, employing technical analysis can help you identify new trading opportunities and serve as a way to gauge the strength of market moves. Focusing on technical indicators such as on-balance volume, the relative strength index (RSI), and the stochastic oscillator can help you generate buying and selling signals and decide which strike prices to choose. 

While it may be tempting to employ as many indicators as possible, selecting the ones that are most relevant to you and incorporating them into your existing strategy can make a significant difference without the need to overhaul your entire strategy.

The Bottom Line

Developing an effective trading strategy requires having a solid understanding of your circumstances and your overall goals. It’s also not a set-it-and-forget-it type of solution. To develop the kind of trading strategy that will add value to your portfolio and lead to solid returns, you’ll need to frequently reassess your strategy and adapt it based on your individual risk tolerance, market conditions, and your financial needs.