7 Steps For Building a Trading Strategy
In order to be a successful trader, you need to have a successful trading strategy. But for beginner traders, it can be hard to know where to start when creating one. Fortunately for you, we have put together a seven step guide to use when building a trading strategy. Read on to find out what they are!
Table of Contents
What Is a Trading Strategy?
Put simply, a trading strategy is a set of predefined rules which combine to determine when, and how, a trader enters and exits a financial market.
A trading strategy is essential for any trader, professional or otherwise. Traders who enter and exit the financial markets at will, without ever creating a list of conditions and rules for doing so, are very unlikely to ever be successful.
Trading strategies depend largely on the individual trader, their trading profile, style, appetite for risk and available capital. There is no one "holy grail" type trading strategy which will be suitable and successful for every trader.
The prospect of building a trading strategy yourself may appear a daunting one. The good news is that creating a trading strategy is really quite straightforward. The bad news is that creating a profitable one is a lot more difficult.
In order to help you out, we have compiled a list of seven steps to help you on your way to successfully building a trading strategy.
1) Choose Your Market
The first step is to decide which financial market you will be trading. Will it be Forex? Commodities? Perhaps the stock market?
Although this may seem like an obvious first step, it is by all means an important one. Trading strategies will depend on the market which it is being traded on. What might work on the commodity market will not necessarily work in the stock market.
Once you have chosen your desired market, if you have not done so already, ensure that you educate yourself thoroughly on that particular market.
2) Choose Your Style
Next you must pick your style of trading. This is largely determined by which time frame you want to trade on.
Are you happy sitting in front of your trading terminal all day, entering and exiting multiple trades throughout the session? If so, scalping could be a good fit.
Perhaps you are only planning to trade part-time around other commitments, if so swing trading may be more suitable for you.
The amount of time you plan to put into trading is a very important factor when building a trading strategy. Scalpers trade in large volumes each day, constantly entering and exiting the market, seeking just a few pips of profit per trade. Swing traders, on the other hand, will leave trades open for days, weeks or even months at a time.
This is something that very much depends on each trader; there is no "best" trading style which will apply to everyone.
3) Fundamental or Technical?
Which type of analysis will your trading strategy use? Technical or fundamental? Or perhaps a mixture of the two?
Fundamental analysis is the practice of analysing an asset's intrinsic value based on micro and macroeconomic factors. For example, fundamental analysis of a Forex currency pair might involve evaluating the health of two countries' economies and looking at their central bank's monetary policy for an indication of which direction those currencies will move in.
Proponents of technical analysis subscribe to the theory that every possible bit of available information is already reflected in the price of an asset. They believe that historical prices can give an indication of how the price may behave in the future.
The most successful trading strategies will generally use a mixture of the two. There are certain economic events or announcements that even technical traders will avoid trading around due to the impact this will have on the market, whilst others may flock to the markets during these times. A good way of keeping track of planned economic announcements is by using an economic calendar.
4) Plan Your Market Entry
Now we get to the actual trading itself. The next step to building a trading strategy is to plan what your trigger will be to enter the market.
For fundamental traders, this could be something like a change in monetary policy from a particular country. Perhaps when a central bank reduces its base rate, the fundamental trader will take a short position against that particular currency, or vice versa.
A technical trader's entry to the market will be triggered by technical indicators or patterns on a candlestick chart. For example, a simple trading strategy might involve two Simple Moving Averages (SMAs); a short-term 30 period SMA (dotted black line below) and a longer term 100 period SMA (thick blue line below).
In our example, whenever the short-term dotted SMA crosses the long-term blue SMA, a position is taken in the market. If it crosses above, the position is long, whereas a cross below would prompt a short position.
This is just one example of how a trader may use technical indicators to enter the market. In reality, there are a whole host of different indicators that traders can use within their trading strategies.
5) Plan Your Exit
Some traders do not appreciate that knowing when to exit the market is just as, if not more, important as knowing when to enter.
Exit too early and you might not realise your profit target, exit too late and you may end up losing more than you should have. Take profits and stop losses are very important tools that every trader must use to manage their risk when trading.
But as well as these tools, your trading strategy should include conditions for exiting the market. It might be a certain level of profit or a certain amount of loss. Or just as technical indicators trigger traders to enter the market, there may be another signal which causes them to leave.
In our example above, every time the 30-SMA crossed the 100-SMA it acted as a signal to enter the market. This could also act as the signal to exit the market from the previous position.
Once you have finished building a trading strategy, it is important to backtest it. Backtesting involves looking back at historical prices of the financial instrument which you are trading, identifying all the instances where you would have been prompted to enter the market and seeing how your trade would have fared.
Backtesting is a helpful way of getting an idea of how effective your trading strategy will be on the live markets. Although it is important to note that past performance is not a reliable indicator of future results.
Backtesting can either be conducted manually by the trader going back through price charts, identifying a trading signal and recording what the result would have been or by using specially designed backtesting software.
7) Keep Improving
You should not ever think of your trading strategy as something which is set in stone. It should be adaptable and you should continue to improve your strategy where possible. After successfully building a trading strategy and implementing it on the markets, it is inevitable that you will identify ways in which it can be improved.
Building a Trading Strategy - Final Thoughts
Our seven step guide should help you on your way to building a trading strategy. Remember that not every trading strategy will be successful. Trading strategies take hard work and require constant improvement.
Whether you are a professional or a beginner trader, you should always practice a new strategy on a demo account before heading to the live markets.
Trade on a Risk-Free Demo Account
A demo trading account from Admirals is an incredibly useful tool for traders when building a trading strategy. Instead of risking your capital on the live markets straight away, practice and perfect your strategy with virtual currency, in real-market conditions! Click the banner below to open a free demo trading account today:
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.