Bull markets like the one that stocks experienced from the spring of 2020 tend to encourage investors into a form of complacency. Complacent traders simply follow their instincts. Because they are confident in their ability to set up winning trades at every interesting opportunity.
What reinforces this feeling of infallibility among traders is the fact that the markets often prove them right. In a bull market, timid declines quickly give way to a new rise. And this increase generally allows buyers to pocket a profit. Until the day the trend reverses, as happened in January 2022.
When markets become volatile, they can erase in a few days all the profits accumulated during previous months or years. Instinctive traders then understand the need for tested and proven rules. If you are looking for a broker to create your own trading strategy, click here .
What is a trading strategy?
A trading strategy is a set of rules that automatically or almost automatically determine the opening and closing of a trading position. A trading strategy must therefore include:
an entry rule
risk control rules to know where to place an initial stop and where to place a target level
a money management rule allowing you to know how many shares or contracts you can buy or sell with a particular trade
The rules of a trading strategy are therefore instructions so precise that they leave little or no room for human judgment in decision-making. This is why a trading system can be subject to statistical testing. With this type of test, we study what would have happened during a given period if we had used the buy or sell signals sent by the strategy. What would have been the total profit or loss? What about average profit or average loss, win rate, highest loss, etc.? ?
A trading strategy does not need to have a large number of rules. Truth be told, simplicity often equals efficiency when it comes to trading systems.
Here is an example of a trading strategy:
Buy 1 lot if the 10-day simple moving average becomes above the 20-day simple moving average.
Profit taking : close the position if stock price = entry price + 1 ATR
Stop loss : close the position if stock price = entry price – 1 ATR
This trading strategy consists of betting on an increase in the price of the stock in question in the event of a bullish crossover of the slow moving average with the short moving average. It may not have real-world validity. But it has the merit of illustrating by example our definition of what a trading strategy is. The rules here are sufficiently precise to determine market entry and exit, without leaving room for judgment.
Why use a trading strategy
Financial markets are ruthless. If you want to be able to prevail in the face of fierce competition in a sustainable manner, you must use one or more trading systems. Without these essential tools, you will see your trading account balance decrease inexorably. Without doubt, there are investors who, using their intuition alone, are able to predict in which direction the market will evolve. But these diviners are the exception, not the rule. If you want to succeed in trading, you must develop and practice a tested and proven system.
So how do you develop a trading strategy? There are numerous works on the subject. The book by U. Jaekle and E.Tomasini entitled Trading Systems goes into detail on the development of an automatic system. In a more summary manner, we present here some essential steps.
Choosing a time frame
You must choose the time frame(s) in which your buy or sell signals will be sent: weekly, daily, 4 hours, 1 minute, etc. This choice largely depends on your trading style. If you are a day trader, you may identify the direction of the trend on a 25-minute chart, and you may look for your buy or sell signals on a 5-minute chart. On the other hand, if you are a swing trader, you will probably prefer weekly or daily charts. And if you are a fan of the “buy and hold” strategy, you will look for your signals on the monthly charts.