A trading strategy is a set of regulations designed to help successful traders manage the risk and reward associated with any trade. While no perfect trading strategy can guarantee profits, having a disciplined approach and a well-defined trading plan can help traders mitigate risks and maximize returns.
Understanding Trading Strategies
It is not realistic to assume that all trades would result in profits. In order to have a successful trading experience, it is essential to have a trading strategy that helps you (the trader) reduce the risk of losing money rapidly. A trader should know when to cut their losses if the trade goes against them and when to grab onto the profits when the trade moves in their favor. It also helps traders stay disciplined, which is vital for success.
Developing a trading strategy is important for every trading activity as it defines your selection criteria for trading opportunities. A trading strategy includes judging an asset’s prices, quality, availability, and suitability to meet your trading needs. It also ensures that you make decisions based on evidence from historical prices and current financial market movements.
Trading strategies help you stay on track by keeping emotions at bay. They also help in improving risk management by setting profit targets for trades and deciding when to exit trades that are not performing as expected. A good trading strategy should also outline how much capital you are willing to put at risk.
There are four key components to a trading strategy –
- The entry market price level
- The exit market price level
- The money management process
- The trading process.
The entry and exit price levels define the moment you wish to open a trade when the market is in your favor and the point where you wish to exit the trade as the market moves against you, respectively.
Money management helps you determine the capital needed for each trade based on your risk tolerance and account size. It also helps you manage your capital to realize gains in favorable markets and minimize losses when markets are not doing well.
The trading process includes all the tasks necessary to maintain discipline and follow the rules of your strategy while taking into account current market conditions.
Trading strategies are categorized differently. Each trader has a unique trading style and level of experience, and so, different strategies suit each trader. Some traders prefer shorter time frames to capture small price fluctuations, while others like longer time frames where they can take advantage of trends over several months or years.
Some professional traders prefer using technical indicators such as moving averages, MACD (moving average convergence/divergence), stochastics oscillators, etc., that are purely based on the stock’s price and volume. On the other hand, some of them prefer incorporating fundamental analysis into their decision-making process, that is purely based on additional information about the company whose stock they are willing to trade. Fundamental analysis includes factors like return on equity, dividend yield ratio, projected earnings growth and more.
How to develop a trading strategy?
The best trading strategies are simple and flexible, but they also need to be practical. The ideal strategy is to make decisions based on key indicators and statistics.
A good strategy should be simple and flexible. Some of the most successful traders use a simple, flexible strategy that’s easy to implement and adjust based on changing market conditions.
More experienced traders will find it useful to have an adaptable strategy to the trader’s changing market conditions or circumstances.
With an adaptable strategy, you can easily change your parameters depending on what works best for you, whether adjusting your time frame or adding more filters to your trading signals.
Every successful trader needs a risk management plan because no matter how good of a trader you become, there will always be losses along the way. A good way to limit your losses is by setting stop-loss orders for each trade and limiting position size relative to capital in an account (i.e., max exposure per trade).
The first thing to keep in mind during developing an effective trading strategy is technical analysis because historical price movements enable traders to predict future market trend. Technical analysis includes research on the price level and the trading volume over time. Charting techniques, such as trend lines and support and resistance levels, predict future price movements.
Trend lines connect two or more past price points, then continue the line into the future to predict a trend for future prices. Technical analysis is an effective way to develop trading strategies because it allows patterns in the market to be identified and exploited.
Fundamental analysis is as important as technical analysis during trading. This is because along with historical price movements, you should also consider the current economic condition to predict the stock’s future price movement. Fundamental analysis examines economic data and other news events that might indicate what direction or changes in a stock’s price may occur.
Fundamental analysts take a different approach altogether. They look at the current economic environment and try to predict future price movements based on those conditions. Such traders look at factors like supply and demand, interest rates, and political stability as indicators of whether they should invest or not. They do not use past prices because they believe that prices are “random.”
The third thing to keep in mind is quantitative trading, where you build computer programs that generate signals based on technical indicators. The programs and algorithms automatically execute trades based on those signals. Quantitative traders use technical and fundamental analysis to collect data about past performance and current market conditions to create models for predicting future market performance.
Lastly, while developing a trading strategy, traders should have a solid risk management strategy when trading a particular trend. A risk management strategy is a way to mitigate the risk involved in stock trading. They also allow you to limit losses and help in keeping your investment safe.
Risk management strategies can be used over a short period, such as within one trading day, or over a long time. As you decide how to limit your losses in the stock market, you should consider the timeframe in which you want to implement your strategy. For example, a short-term risk management strategy may include placing a stop loss order right at the lowest price level of the stock in a particular trading day.
However, a long-term risk management strategy may involve transferring the risk of losing money by opting for an insurance policy or opening an opposite position in the same trade to offset the losses.
8 popular trading strategies most traders use
Every trader has a unique strategy. But whether you’re a new trader or have been trading for years, some strategies have been proven to generate profits more often than not.
The markets are constantly changing, so you want to ensure that your strategy is flexible enough to handle these changes. That’s why learning about as many different strategies as possible is recommended. Once you have some experience under your belt, you can develop your trading style and approach.
Trend trading is a strategy that involves following the general prevailing trend or direction of prices. It attempts to capture gains through the size of the trend. It is the strategy of identifying a current price trend of an asset and then entering into a trade in the same direction.
As we can see from the image below, a few trend trading strategies traders use.
Traders who follow this type of strategy anticipate that the market will continue moving in the same direction as it has been doing for some time, with minimal price retracements. Trend traders enter trades when the market is trending in one direction and exit when it begins to reverse direction.
Range trading is a strategy that uses support and resistance levels to predict the price movements of an asset. Traders look for areas where they can buy low and sell high or sell high and buy low, depending on their preference.
Range traders typically use technical indicators that identify oversold or overbought conditions to help them find profitable entry points. It is a strategy that assumes a stock will remain within a given range. The trader buys at the lower limit and sells at the upper, or vice versa.
Range traders sell or buy when they see certain patterns that indicate the asset is nearing its top or bottom value, respectively.
Breakout trading is one of those trading strategies that assume that once prices break out of a range, the new price movement will continue in the same direction. A breakout can occur above resistance (once prices rise above a previously established high) or below support (once prices fall below a previously established low).
Breakout traders look for periods of consolidation followed by a strong directional move out of that area. They typically use support/resistance zones to identify these periods and then wait for a breakout from those zones, entering into trades once they see confirmation that the price is breaking out in either direction.
For example, if there’s an upward breakout in price from INR 1,000 to INR 1,100 or higher, we would expect a bullish market trend, which signals trader to enter buy order and push prices even higher over time. On the other hand, a downward breakout from INR 1,000 to INR 900 would indicate a bearish market move, signalling traders to exit or short the market.
Reversal trading is a strategy that assumes a stock’s price movement will reverse after it reaches its topmost or bottom-most level. This is considered an ideal exit or entry point, respectively.
A reversal trading strategy is a short-term trend following strategy. Many traders use it because it is easy to understand and implement.
The trader watches the market and looks for when the market makes a big move up or down. A trader will then buy or sell in the opposite direction of that big move, hoping that it will reverse and the trader will make money.
For example, if an ABC stock makes a jump from INR 100 to 200 in one hour of trading, traders who already have a position opened in this trade would place a sell order with an expectation of the stock price falling thereafter. However, if the stock falls from INR 100 to 50, traders who do not have a position in this stock would place a buy order at INR 50 with an expectation of the market reversing upwards.
A momentum trading strategy is a trend following strategy that involves buying stocks in the direction they are already trading. Momentum traders buy a stock when the prices are moving upwards and sell them when they are moving downwards.
If a stock increases from INR 100 to INR 150, a momentum trader will buy it because it has just gone up, believing that the stock will continue to rise as per the market trends. On the other hand, if the stock price drops from INR 100 to INR 80, traders will sell the stock, believing that the prices will continue to fall. With this strategy, momentum traders also use technical indicators to help them time their trades at suitable trading costs.
Swing trading is a strategy where you hold onto a stock for a few days or weeks, in order to profit from the price swings that occur during the course of this time. Swing traders typically hold positions for one to two weeks but can hold them for as long as a month.
For example, if you want to make a profitable trade in ABC stock, you will enter the trade when the stock is moving around its low price level, which we can assume to be INR 50. After holding this stock for two weeks, the stock price moves to INR 60, providing a profit of INR 10 per stock. A this point, you can exit the trade to refit from the upward price swing in the market.
Day traders are even more hands-on than swing traders—they open and close all their trades within the same day, taking advantage of short-term trends. This makes it possible to make money quickly through several trade positions in the same trading day.
Day traders look for opportunities in rising and falling markets using technical analysis tools. They are constantly looking to make trades based on small price movements throughout the day, which adds to big gains with enough trades.
For example, as a day trader you might open five different positions in five different stocks in order to profit from the five different price moves they will offer.
Scalping is another popular trading strategy that most people use. This involves selling very quickly after entering into a trade, usually within seconds or minutes. It is often used with other strategies such as reversal or swing trading because it can be difficult to make money from just scalping alone.
Frequently Asked Questions
What is the best strategy for trading?
The best trading strategy depends on the trader’s personal goals and time horizon. Generally, most traders begin with day trading or short-term strategies, as it is easier to learn than longer-term strategies.
When short-term trades become your best part, you can consider moving up to a medium-term strategy with more potential for long-term growth.
Some of the best trading strategies you can use are- Day trading, Trend trading, Momentum trading, and Swing trading. These are a few, but not limited to, strategies that help in understanding trading positions with the help of basic technical analysis.
What trading strategy should beginner traders use?
When picking a trading strategy as a novice, you should pick one simple, and easy to understand trading strategy with clear rules for entry, exit, risk management, position-sizing, etc. It will help you with your discipline as a trader. It would be best to research the different types of trading strategies before choosing one.
If you are beginning your trading journey, one good trading strategy is trend trading. Trend trading means: going with the flow of the market. It is a simple way to make money in the financial markets. It does not require a lot of time or effort to learn. While there are several others you can put to use, however, this is one of the ways to get you started. It is low-risk, required less monetary investment, and is a good way to learn more about trading styles in the financial market.
How can I improve my trading skills?
Trading skills can only be improved by practicing. Devise a trading strategy that aligns with your trading goals and practice trading first with a demo account and then move forward with trading the live markets.
Don’t spread yourself too thin by investing in different currencies or stocks. It is advisable to take calculated risks at the beginning of your trading journey.
Beware of frauds and scams that are quite rampant in the financial market. Consulting with learned trend traders, instead of relying on many traders, will help you get better with your trading skills.
One of the biggest pieces of investment advice you must always bear in mind is- the financial market is a gamble, but if you play your cards prudently, you will see steady improvement in your financial situation and rise up the ladder to become one of the best traders in the market.