What is a 'Trading Strategy'

A set of objective rules defining the conditions that must be met for a trade entry and exit to occur. Trading strategies include specifications for trade entries, including trade filters and triggers, as well as rules for trade exits, money management, timeframes, order types, and other relevant information. A trading strategy, if based on quantifiably specifications, can be analyzed based on historical data to project future performance.

BREAKING DOWN 'Trading Strategy'

A trading strategy outlines the specifications for making trades, including rules for trade entries, trade exits, and money management. When properly researched and executed, a trading strategy can provide a mathematical expectation for the specified rules, which helps trades and investors determine if a trading idea is potentially profitable. Investors should generally consider using a systemized trading strategy, but be aware of its many limitations. Trading strategies aren’t a guarantee for success, but they may be effective in increasing risk-adjusted returns.

Pros and Cons of a Trading Strategy

Trading strategies are a great way to avoid behavioral finance biases and ensure consistent results over time. For example, traders with a specific set of rules governing when to exit a trade will 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 also be stress tested under many different market conditions to ensure consistency.

The downside is that profitable trading strategies are difficult to develop and it’s easy to become overly reliant on the strategy. For instance, a trader may curve fit a trading strategy to specific back testing data, which can generate a false sense of confidence. The strategy may have performed great based on the past data, but that’s no guarantee that it will perform just as well using live market data since the conditions may be different.

Developing a Trading Strategy

There are many different types of trading strategies for investors and traders to consider, but they can be generally broken down into technical and fundamental trading strategies. The common thread between these two types of strategies is that they both rely on quantifiable information that can be back tested for accuracy.

Technical trading strategies rely on technical indicators to generate trading signals. 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 specific set of screening criteria to generate a list of opportunities. These criteria may look at things like revenue growth or profitability.

Investors and traders should find the strategy that works best for them through experimentation, back testing, and paper trading. For more, see How to Practice Day Trading. 

 

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