What is a Trading Strategy?

A trading strategy is the method of buying and selling in markets that is based on predefined rules used to make trading decisions.

Understanding Trading Strategies

A trading strategy includes a well-considered investing and trading plan that specifies investing objectives, risk tolerance, time horizon and tax implications. Ideas and best practices need to be researched and adopted then adhered to. Planning for trading includes developing methods that include buying or selling stocks, bonds, ETFs or other investments and may extend to more complex trades such as options or futures. Placing trades means working with a broker or broker dealer and identifying and managing trading costs including spreads, commissions and fees. Once executed, trading positions are monitored and managed, including adjusting or closing them as needed. Risk and return are measured as well as portfolio impacts of trades. The longer term tax results of trading are a major factor and may encompass capital gains or tax-loss harvesting strategies to offset gains with losses.

Key Takeaways

  • A trading strategy can be likened to a trading plan that takes into account various factors and exigencies for an investor.
  • It consists of three stages: planning, placing trades, and executing trades. At each stage of the process, metrics relating to the strategy are measured and changed based on the change in markets.

Developing a Trading Strategy

There are many types of trading strategies, but they are based largely on either technicals or fundamentals. The common thread is that both rely on quantifiable information that can be back tested for accuracy. Technical trading strategies rely on technical indicators to generate trading signals. Technical traders believe all information about a given security is contained in its price and it moves in trends. For example, a simple trading strategy may be a moving average crossover whereby a short-term moving average crosses above or below a long-term moving average.

Fundamental trading strategies take fundamental factors into account. For instance, an investor may have a set of screening criteria to generate a list of opportunities. These criteria are developed by analyzing factors such as revenue growth and profitability.

Another third type of trading strategy has gained prominence in recent times. A quantitative trading strategy is similar to technical trading in that it uses information relating to the stock to arrive at a purchase or sale decision. However, the matrix of factors that it takes into account to arrive at a purchase or sale decision regarding a security is considerably larger as compared to technical analysis. A quantitative trader uses several data points - regression analysis of trading ratios, technical data, price - to exploit inefficiencies in the market and conduct quick trades using technology.

Trading strategies are employed to avoid behavioral finance biases and ensure consistent results. For example, traders following rules governing when to exit a trade would be less likely to succumb to the disposition effect, which causes investors to hold on to stocks that have lost value and sell those that rise in value. Trading strategies can be stress tested under varying market conditions to measure consistency.

Profitable trading strategies are difficult to develop, however, and there is a risk of becoming over-reliant on a strategy. For instance, a trader may curve fit a trading strategy to specific back testing data, which may engender false confidence. The strategy may have worked well in theory based on past market data, but past performance does not guarantee future success in real time market conditions, which may vary significantly from the test period.