How to develop a trading strategy

Develop your trading strategy based on an edge

A trading strategy is a set of rules that help a trader make decisions in the market. It takes away subjective judgement and guessing. A strategy is based on an edge and the rules identify when that edge in the market is present.

A trading strategy answers the following questions:

• What are the best conditions in order to enter the market?
• What are the best conditions in order to exit the market, i.e. where are your stop losses and profit targets?

The basis of a strategy therefore consists of the following elements: an entry, a profit target and a stop loss.

First you find an edge in the markets

Observing the markets over time will help you understand that market behaviour repeats itself.

Let’s say you have identified a price level where the price seems to reverse back to the upside. In other words, at this price buyers are entering the markets.

If the price seems to reverse back to the upside at this level, then you have identified a market condition where something seems to happen. You have identified an edge – a level where there is a higher probability of the price reversing. This price level is known as a support level.

There is always the possibility that the price may not reverse and that it could break through the support level. Most of the time, however, it does not – the probability of the price reversing back to the upside is higher and this presents an opportunity to buy. This is illustrated by the chart below:

1. Support
2. Price finds support at this level
3. Possible long entry when the price finds support at this level a second time

Note that in the chart above, the price does eventually break through the support level. This illustrates that even though a condition has been identified where the price reverses, it is only a higher probability that this will happen, as sometimes it does not.

You develop the rules of the strategy based on an edge

You can use a similar basis to exit the trade. For example, you may have also identified a price level where selling takes place and the price starts to reverse to the downside. This is known as a resistance level. This is illustrated by the chart below:

1. Support
2. Price finds support at this level and reverses to the upside
3. Possible long entry when the price finds support at this level a second time
4. Resistance level where the price reverses to the downside

You have identified a set of conditions: a price level where the price reverses to the upside and a price level where the price reverses to the downside. There are multiple levels at which the price will reverse the other way, in other words, there will be other support and resistance levels.

If you then buy at support levels and take your profit at resistance levels, you now have a rule for an entry and a rule for an exit.

If you buy at a support level and place your stop loss below the support level, in the event that the price does not reverse to the upside, then you have a rule for placing your stop loss too. You now have the basis of a strategy: an entry at support levels, an exit at resistance levels and a stop loss below the support levels.

Elements of a trading strategy

To recap, a trading strategy consists of the following elements: an entry, a profit target and a stop loss.

So to use the support and resistance level example above, the basis of a strategy would be as follows:

• Entry: Buy at the support level.
• Exit: Take profit at the next resistance level up.
• Stop loss: Place your stop loss just below the support level.

The entry and exits are not the entire strategy. You need to incorporate money management for example. However you have identified a set of markets conditions on which you can develop a set of rules and build a trading strategy on.

The difference with random entries

Let’s take a different approach. Say you enter into the markets randomly. The price may go up or down, however, you have no basis for why you entered and so you do not have a reason to exit either. This leaves you with the following questions:

• Even if the trade has gone straight into profit, at what point do you take your profit?
• What happens if the profitable trade then starts to reverse and go against you?
• How much of the profit do you give back to the market until you decide to take what is left?
• Do you let your trade run into a loss?
• What if the trade goes straight into a loss?
• How much of a loss do you take?

Without a reason to enter or exit the trade, you are simply buying or selling something with the hope that your trade will somehow end up in profit. Then, even if your trade does go into profit, you will still not know when or how much to take of your profit.

Developing a trading strategy allows you to enter and exit the market in the right conditions and you know exactly where you will take your profit and loss.

Summary

So far, you have learned that ...

• ... a strategy is a set of rules that help you to make trading decisions in the market.
• ... observing the markets you will find that market behaviour repeats itself in which you can identify an edge.
• ... you can use the edge you find to develop a set of rules to enter and exit the market.
• ... a strategy consists of an entry, take profit and a stop loss.
• ... entering the markets randomly will mean you will not know how to exit the trade.