The Essential Parts of a Trading Strategy

In this post I’m going to explain the bare essentials that are necessary in a trading strategy. As part of a trading strategy you must, at the very least know: the markets you are trading, your trading time frame, entry reasons, risk of the trade and how you manage your trades. I’ll be discussing that next with the help of some examples. Let’s start.

The Market / Markets you are Trading:

There are different markets that can be traded, like the stock, bond, forex and commodity markets, and all their derivatives (options, futures, CFDs, etc) of course. Which market / markets you trade should be part of your trading plan. This sounds obvious, but knowing the markets you trade is very important and there are normally important reasons as to why some markets are chosen over others.

For example a trader might choose the forex market, because it’s trading 24 / 5 a week, making it easier to choose when you want to trade.

Time Frame:

Part of your trading strategy is the  time frame you use to generate trades. Do you use the daily, 4 hour, 1 hour, 15 min, or 5 min charts for your trading? Or do you trade using multiple time frames (a combination of different time frames for analysis and entry)? Time frame will guide you towards your trading style, or vice versa. For example, daily charts are often associated with swing and position trading, day trading and scalping with much smaller time frames such as the 15 / 5 / 1 minute charts.

Also, it doesn’t really make sense for a trader that has a full time job to trade 5 minute charts while at work. He / she will put unnecessary stress on him / herself on an already demanding endeavour. 

Lastly, picking and sticking to a time frame helps the trader from getting distracted by all the noise that can be generated by markets. Imagine trading the daily chart, but checking 15 minute charts during the day; the noise and volatility of intraday charts can easily scare a trader out of a position (closing position prematurely). Sticking to your time frame is sort of a filter.

Entry:

For me, in most cases, there are two parts to entering a trade. The first is some condition (criteria) that must be setting up with regards to market structure (I’ll explain shortly ) and the second is the entry trigger itself. 

As an example, let’s say a trader trades the triangle patterns. A trader would scan for market action where he / she sees the price action is coiling. Once such price action is found he / she will draw the necessary trendlines to see if a valid triangle is in the making. If so, that would be the first condition and the breakout itself would be the entry trigger.

Another example would be someone trading support and resistance. The first condition might be price hitting support / resistance and the entry trigger would be an engulfing candle as confirmation.

The above are just examples which are very vague too. Entry rules need to be as objective as possible. A rule like the testing of support plus a bullish engulfing candle is not objective enough. All support and resistance zones are not equal, a trader needs  to specify what constitutes valid support and resistance for his / strategy. Also, does the strategy use only engulfing candles as an entry trigger, or maybe pin bars (such as the hammer and shooting star) or maybe entry triggers is based on some trendline break on a lower time frame. Do you see how many possibilities there are? And there are many other ways, I only mentioned a few. That’s why, in my opinion, it’s better for a trader to be as objective as possible with entry rules.

Risk:

This is where the risk per trade is defined, meaning how much money a trader is willing to lose on a trade. It can be called risk management, position sizing or money management, it doesn’t really matter much to me. What does matter to me is that at this point you have an entry and should have a stop loss (the point where a trade is invalidated) which gives you the means to calculate how much you are going to risk on your trade. Risk tolerance is different for each trader. Only risk what you are comfortable losing on a single trade.

Trade Management:

Up to now I never mentioned anything about profit targets. Profits targets should always be taken into consideration. That is it should be considered with entries, when risk is defined and with trade management. The reason is that profit targets play a role in a strategy’s reward to risk ratio and if it’s not adequate, the trade should be passed. So you can see how it plays a role in entries and exits. 

Anyways, trade management is how the trader manages a trade once in it; that is entry, stop loss and profit targets are all in place. Do you use ‘set and forget’ trade management which is binary, where once the trade is entered, you leave it till either your stop loss or profit target is hit? Do you trade using multiple positions, like scaling in and out of the trade as the trade goes for and against you? Do you trail your stop (move stop loss in direction of profit target) as the trade moves in your favour? 

There are other ways of managing a trade, but the above gives you a pretty good idea of what can be done. With trade management your rules also have to be very objective to make it easier not to deviate from your strategy.

Final Thoughts:

The above is only a guide as to what should be in a trading strategy; only the bare essentials, but it should be enough for you to understand the basics and get started. 

I’ve mentioned a couple of times of trying to make your rules as objective as possible. The more objective you are with your rules, the better you can measure your results. Also, should you deviate from your strategy, it will be easier to find where and why you deviated.

I wrote about breakout and support and resistance strategies. In no way are those full strategies that you can take and go out and trade. What I tried to do is take strategies that are popular and explain the different ways entries can be generated and why it is important to be objective with your rules. 

This brings me to backtesting. Backtesting is important. In my personal opinion, if you find a strategy you think can work for you or resonates with you, do more research into it. Make sure you understand why it has an edge, make sure you understand why it works, why it makes sense to you. Then write out the trading strategy, and then backtest it to see if there is an edge and take it from there. Unfortunately I can’t go into every detail about backtesting here, so I will have to leave here.

Thanks so much for reading. Hope this post was useful. I hope you’re still safe.

Thanks and Regards,

Trading SOS SOS