How To Create A Trading Strategy
STEP 1: LEARN ABOUT THE MARKET
Before you jump into creating your own trading strategy, you’ll want to develop an idea of how the market works. Most importantly, you’ll need to answer this question: Why do you think you can make money from the markets? Trading is a lot of work and if you’re going to step away from the traditional passive investing approach, you’ll need a good reason to believe you have what it takes to be successful. It won’t be easy to know this right out of the gate, so make a concerted effort to form some sort of framework for how the market operates by turning into an information sponge. Read as many books as you can, listen to all of the top podcasts, watch videos, follow prominent traders or investors on social media—just learn as much as you can to get a feel for the markets and any potential affinity (or lack thereof) you may have for them. Make sure to read about both technical and fundamental analysis, get a wide range of views and opinions, and avoid get-rich-quick schemes. Think deeply about macro forces like supply and demand and the role they both play in markets as well as micro forces like earnings and news releases. Nobody has the markets perfectly figured out so maintain a healthy degree of skepticism throughout your learning and doubt theories that claim people or markets are perfectly rational. Your understanding of markets will define every step you take as a trader so give it the attention it deserves. Yet regardless of what you learn or where your journey to unravel the mysteries of the market may take you, I urge you to follow one principle: Keep it as simple as possible. You don’t want to be overwhelmed by an overly complex explanation right from the beginning. Start with all the basics and work your way up. Sometimes the basics are all you need and they’ll serve as the pillars on which all your future ideas are based.
STEP 2: CHOOSE A MARKET FOR YOUR TRADING STRATEGY
There are a lot of markets to choose from and each one can resonate with someone more or less so you’ll want to explore all of them to some extent and see for yourself which best suits your style and personality. Do you want to trade currencies in forex? Stick to the stock market with equities? Experiment with leverage through options? Trade commodities with futures? Dive into the credit markets as a bond trader? Or direct your focus to the world of crypto? If you choose to trade forex, understand what you are buying and selling with each currency pair, what spread costs are, and what pips and lot sizes mean. If you choose to trade equities, know what a share means, what sectors there are, and the difference between a blue-chip and a penny stock. If you choose options, know what having that option actually means and how time decay affects your premium. If you trade commodities, know where those commodities and the demand for them comes from. For bonds, learn about maturity dates and the relationship between yields and face values. And if you choose crypto, learn about Bitcoin and the importance of liquidity and network effects. The point is there’s a lot to learn about each market and you’ll want to get a lot of learning in before you actually start trading in any of them. Explore all of them on at least a surface level and use what you learn to decide what market you think is the right fit—only then can you really begin to form your strategy. If you’re a beginner, I would probably recommend equities or forex, but the choice is obviously your own. The only rule is that you must understand the market you choose to trade.
STEP 3: CHOOSE A TRADING TIMEFRAME
As you become more accustomed to markets and trading, you’ll likely notice how differently markets seem to move when viewed through different timeframes. It can be very hard to decide on a trading timeframe and will probably require you to do some experimenting with several different ones. In your experimenting, you might find you’re more drawn to quick scalping through the 1m or 5m charts, or possibly swing trading through the 4h and daily charts. If you have the time to watch the market for extended periods, try intraday trading. When you trade fast timeframes, you get fast feedback to shorten the learning process and that’s a very important feature when you’re developing a strategy. Even if you end up trading on higher timeframes, what you learn from intraday price action will still be useful. Of course, if you are not able to watch the market for extended periods, you might have to be a higher timeframe trader so start with daily charts at the end of each trading day. The daily chart is one of (if not the) most important chart, meaning you’ll want to get accustomed to looking at regardless of what your preference for trading is. The important thing to remember is each timeframe acts differently, exhibits different patterns, and will influence your thinking in different ways. If you watch each timeframe closely with sustained effort, you’ll eventually learn enough to decide which one is right for you.
STEP 4: FIND A TOOL TO DETERMINE THE TREND
Identifying trends and direction is what trading is all about. If you don’t have a reliable means of determining a bullish, bearish, or neutral bias, you’re going to have tough time trading. There are far too many tools people use to determine trend and sentiment to discuss here, but you’ll need to look through all of them to find what tools (if any) you find useful in establishing your own bias. You don’t want your strategy simply being to trade when you see other people saying to or after you see a big price move. You want to trade when you judge that the market is headed a certain direction and your indicators, patterns, or other tools are telling you to enter the market. You can choose price action tools like candlestick patterns and trend lines or you can use technical indicators like moving averages, RSI, Bollinger bands, MACD, or whatever else. There is no shortage of indicators out there and you need to find which one or combination of ones help you reliably identify trends. Learn which tools work for you and your strategy and which ones don’t.
STEP 5: DEFINE YOUR ENTRY TRIGGER
Even with the right market bias, you need an objective entry trigger. This will help you enter the market without hesitation by giving you a clear and verifiable checklist for entering each trade. Traders frequently struggle to create definitive signals for entering positions and, as a result, fail to pull the trigger when they need to or choose to pull the trigger when they shouldn’t. The clearer your rules for entry are, the easier it will be to trade and find out if you actually have a working strategy. Defining a trigger will take much of the indecision out of trading and give you very distinct patterns or signals to look for that will streamline your entire trading process. Both bar and candlestick patterns are useful triggers, but if you prefer indicators, oscillators like the RSI and other stochastics are good options as well. Using technicals to define clear entries eliminates emotional trading and better highlights the effectiveness of your strategy. Have an entry trigger and stick to it.
STEP 6: DEFINE YOUR EXIT TRIGGER
Much like you’ll need a trigger to enter trades, you’ll want a trigger to exit them as well. The market can go against you, causing you losses beyond your imagination so you’ll need to plan how to exit when things go wrong. Having a stop-loss is critical. Even if things go perfectly according to plan, you’ll have to exit the trade eventually and having a definitive trigger or key level at which you decide to take your profits is an essential component to a successful trading strategy. Learn how and where to place stop-losses and take profits and incorporate them into your strategy. Don’t get cocky and ignore creating a plan. Losing trades are not just inevitable, they are regular, so you need to be prepared. Plan your losses just as much as you plan your wins. As mentioned, placing limit orders for taking profits or stopping losses at a predefined point is a great way to trade your plan and avoid emotions. How you decide what those points are will be up to you, but be disciplined and create clear rules or signals for when it’s time to exit a trade whether you’re in profit or or in the red.
STEP 7: DEFINE YOUR RISK
Once you have your entry and exit rules sorted out, you can work on limiting risk. The primary way to do this is through position sizing. For any given trading setup, your position size determines how much money you are putting on the line, which dictates how much you can make and how much you can lose. Double your position size and you will double your risk. Cut your piston size in half and you will cut your risk in half. This can also be accomplished by moving your stop-loss up or down, but that can often force you into having a stop-loss that is too tight when you put on a large position. I would recommend keeping it simple with a stop-loss risking 2% of your total account for each trade and then sizing your position according to your confidence, but that’s up to you. Either way, you have to be clear and mathematical with how much money you are willing to lose while ensuring you aren’t risking too much or too little to be successful..
The other way you’ll want to manage your risk is with an appropriate risk-to-reward ratio. Whatever you end up risking, you’ll want to aim for profiting even more. Risking the same amount as you aim to win (a 1:1 ratio) means you have to win more than half of all your trades where winning is defined as hitting your take profit, not just making a profit. With a 1:2 ratio, however, you only have to win a little more than 33% of all your trades to be profitable. Understanding this is crucial in determining what you can and should risk for any strategy. Once you’ve clearly defined how much you want to risk, you can figure out how much you need to make for that risk to be worth it. Knowing the win rate of your strategy will making defining this extremely clear, but regardless of what your win rate is, you should always view your risk within the context of your reward. It won’t always be obvious what your risk or your risk-to-reward ratio should be, just find an amount you’re comfortable losing every trade and a ratio that works for you and your strategy.
STEP 8: WRITE DOWN YOUR TRADING RULES
At this stage, your trading strategy is hopefully simple. Even many years into your trading, you’ll likely find yourself avoiding complexity and attempting to boil down your ideas into a clear and finite list of rules. If there are too many moving parts to your strategy, it won’t be easy to remember, backtest, or even execute on a frequent or semi-frequent basis because of how many stipulations you have. Writing down each rule and step to your strategy is a great way to ensure it isn’t overly complicated while also forcing you to solidify your rules in your mind. In doing so, you’ll begin to internalize all your rules and even feel more driven to avoid breaking them. Having a written plan creates discipline, consistency, and provides a record of your trading strategy you can constantly refer to while you’re trading or looking at markets. Putting thought to paper is also one of the best ways to polish and refine your strategy, so don’t be shy and just write your rules down.
STEP 9: TEST YOUR TRADING STRATEGY
Once you have your rules written down, it’s time to put them into action. Some traders like to jump straight into live markets, but forward testing a developing strategy is a great way to lose money. You can always forward test your trading strategy by paper trading if you’d like, but testing through live markets can take too long to deliver meaningful results. Backtesting, however, gives you immediate feedback, won’t lose you money, and still reflects real market history. Testing in general—whether through backtesting or forward testing—is probably the most important element to creating a successful strategy as it’s how you’ll know if your strategy is actually successful. If you have ambiguous or open-ended trading rules, testing can be an arduous process. Writing out your rules in a simple step-by-step checklist, though, will allow you to test your plan much more efficiently (and why it was stressed as a step right before this one). Efficiency is very important because the easier testing your strategy is and the faster you can do it, the more data you’ll get to accurately measure the quality of your strategy. Trading once or twice a day is going to take a very long time to give you the information you need to truly know if your strategy would perform well, so back and forward test your strategy as much as you can to reduce that delay. To backtest your ideas, simply run them through old charts or financial statements to see when your entries would have been triggered and what the results would have been. There’s no reason to expect a strategy that doesn’t show an edge through backtesting will make you any money in the future, so view it in the same way you would trading live markets. Throughout your testing you’ll also find yourself making key refinements that optimize your strategy. As long as markets are evolving, strategies must be, too, so you’ll want to avoid maintaining a strategy that is too static by adapting to your testing results as they come. And while you can attempt to internalize those results, I would suggest documenting them via a journal or whatever method works for you so you can sift through each one and identify clear patterns or weaknesses. Going through your trades one by one after the fact is really part of the testing process and a great way to develop your market instinct. Always strive to identify your mistakes and learn from them. Test your strategy to find solutions just as much as results
STEP 10: PLAN HOW TO IMPROVE YOUR TRADING STRATEGY
To put it bluntly, the reality is your first trading strategy will likely not be profitable. But it’s okay. Your trading strategy is a living object that should evolve over time. With your growing experience and knowledge, your trading strategy will slowly improve. Backtesting is a huge part of that, but there is also a great amount of experience and wisdom necessary to grow that is only attainable through time in the market. That said, you don’t want to rely purely on time in the market to become successful. Just like you plan out your strategy, plan how you will obtain feedback and improve your strategy. Take extensive notes of your market observations. Record your trades and constantly seek out areas of improvement. Brainstorm new ideas and always think about how your strategy can get better. Just be sure to remain patient throughout this journey because making drastic changes or rushing through your strategy without properly testing it will be counterproductive to the learning process. The goal is to test your ideas, not bounce from one to another as you think of them. Some ideas might be worth trashing altogether, but improving a strategy means expanding on the existing ideas and fine tuning them as you learn. For that reason, you must always be learning. Create a system for making positive changes to your strategy and its rules and you’ll eventually see that work reflected in your results.
CONCLUSION
With all that out of the way, let’s quickly recap all these steps. First, you want to learn everything you can about the markets. The more you know, the more capable you’ll be at making a plan and the more prepared you’ll be to tackle all the problems you face. Second, you have to choose the market you want to trade. There are a handful of options to choose from and each one is unique so find which one is best for you. Third, you need to pick a trading timeframe. You don’t have to be religious about what timeframes you use, but be attuned to your preferences as a short-, medium-, or long-term trader. Fourth, find a tool or mechanism that helps you identify the trend and direction of the market. Establishing a bias is half the battle in trading so you’ll want a reliable means of doing just that. Fifth, you want to establish an entry trigger that clearly defines exactly when and when not to enter a trade. Sixth, you want to establish an exit plan or trigger that clearly defines when it’s time to cut a loss or take some profit. Seventh, you want to define your risk by outlining exactly how much you are willing to lose and how much you can lose while still being profitable. Eighth, you want to write down all your trading rules to reference, refine, and internalize them. Ninth, you need to test your ideas through current or past price action to evolve your strategy, address any weaknesses, and polish any strengths. And last, you need to plan how you will improve your strategy and create a system that fosters positive change and growth. There isn’t a secret to mastering the markets—it’s just hundreds of small steps that eventually translate to big ones. Try to take each one of these steps in stride and dedicate the time they all deserve. If you can do all that, you will put yourself on a path to creating a successful trading strategy.