In the third part of the “Essentials of a Trading Plan” series, Milan Cutkovic is looking at the actual trading strategy.
It is important to describe your strategy as detailed as possible. Some of them might be quite discretionary and difficult to define, but the more details the better.
Essentials of a Trading Plan – Part 1: Why Do I Need a Trading Plan?
Essentials of a Trading Plan – Part 2: Goals and Risk Management
Furthermore, each trader should try to identify his/her edge. This might be a set of skills that the trader possesses. Some traders might have a short attention span but are quick with numbers and can handle the stress of intraday trading extremely well. On the other side, a different type of trader may not be able to function efficiently in this kind of environment but could be a skilled strategist who can always keep the bigger picture in his/her mind.
For beginners it is especially important to identify your skills and suit your trading strategy to your personality, not the other way around.
How could the description of a basic trading strategy look like?
Example 1: Buy if the 5-day moving average crosses above the 20-day moving average and the RSI is below 70.
Example 2: Sell if the 5-day moving average declines below the 20-day moving average and the RSI is above 30.
This is a simplified example that contains two of the most popular technical indicators. The trader who may use this strategy could potentially see the MA crossover as a sign that momentum is building – either to the up- or downside. He/she might have added the RSI (Relative Strength Indicator) as an additional filter, as the trader wants to avoid buying a currency pair when the RSI is showing overbought conditions or selling a currency pair when the indicator is showing oversold conditions.
They could even come up with the idea to add further indicators to prevent trades in a low volatility environment, like the Average True Range (ATR) or the Bollinger Bands.
The logic behind this could be the following: The 5-20 DMA crossover may signal that the current trend could extend further as momentum is accelerating. However, the trader does not wish to take trades in a low volatility environment as this may decrease the quality of the signals.
The example above is a simplified one. A more detailed description of a trading strategy may include:
- Logic (the thinking behind the strategy and why you think it will work)
- Objectives (your goals)
- Characteristics (e.g. you decide you only want to trade during the Asian trading session as your tests showed the strategy performs the best at that time of the day)
- Risk Management Rules
- Entry Rules (when to enter a trade)
- Trade Management Rules (stop loss and/or take profit – fixed or trailing)
- Exit Rules
Very few traders find the right strategy straight away. The majority will spend a significant amount of time testing various strategies in a demo environment and/or back testing. Even if a trader gets to the point where he finds a strategy that has promising results and feels right, it is unlikely that he/she will stick with that exact strategy for an extended period of time. The markets are evolving constantly, and so are traders and their preferences.
In the next article, we will discuss the topics “Entry”, “Trade Management” and “Trade Analysis”.