Before You Trade You Must:
Build Your Trading Strategy
By: Ahmed Nasr, CFTe,CPM.
Trading with an edge is what separates the professionals from the amateurs .Ignore this and you will be eaten by those who don't.
Introduction:
Strategy of trading provides answers for the decisions a trader should make while trading. It is not left up to the judgment of the trader. If you are relying on your judgment when you are trading, you may find that you are fearful when you should be bold and courageous when you should be cautious.
A complete trading strategy required six key parts to cover each of the decisions:
1- Markets
2-Entries
3-stops
4-Exits
5-Position sizing
6- Tactics
1-Market :
The first thing in good strategy is the market you trade. First, you must select the market, which is suitable for you, .To chooses market you can see the following:
1- Liquidity:
When you chose liquid market you protect yourself from wide spread between bid and ask price .you can buy and sell your instrument at any time .when you are large trader in illiquid market your order will move price with significant amount. In addition, if you have small capital in illiquid market you will pay large price between ask and bid price.
2- Newness of the market:
New market may be dangerous for you because you have little information of what the stock or future contract will do in the future. However, after one year you can make a better idea about what to expect.
3- What makes the market and rules of trading:
Who are the market maker and what is their reputation .How can you execute your order .What about the commission, swaps and leverage .Who regulate market and market makers.
4- Volatility:
How much price movement has occurred within specific period? Volatility is very important especially for short-term trader because he need to enter and exit the market many time .Forex, liquid stocks, future indexes are highly volatile.
5- Capitalization:
If you can tolerate sharp change in stocks to up or down you will choose small capital stocks .But if you are conservative investors and you prefer small and smooth price change you will search about large capital stocks and markets.
6- Market follow your trading concept:
No matter what your trading concept is but you must choose the market that fit your trading concept .If you are value investor you must find undervalue market .if you are trend follower trader you will find the market that show trend several times each year.
2 - Entry point "Market Timing":
Most traders and investors assume the entry is the most important thing in trading system. They are trying to find great entry point. The entry point plays only a small part of the game .The most important thing is position sizing and how to exit.
In technical analysis, you can use many entry techniques such as:
1-By using classical chart analysis:
You may depend on channel breakout or chart pattern.
Channel breakout: You enter the market on either the highest high of the last X days on the long side or the lowest low of the last X days on the short side .if you on one of those new high or new lows you will not miss uptrend or downtrend .This techniques was used by trend follower trader. Look at Chart "A"
Chart pattern: May be daily chart pattern as key reversal day, open close day, pivot point and gaps .Short term trader may use these daily chart patterns.
Long-term trader can depend on long chart pattern that may be reversal pattern as head and shoulder, double top and double bottom. On the other hand, may be continuation pattern these include triangular, flags, and pennants.
Chart "A"
2- By using indicators:
Directional Movement and the Average Directional Movement:
By using this indicator, you can know when the market is really trending
Moving Average and Adaptive moving Average:
MA is very popular trading indicator because they are simple and easy to calculate. You can use simple MA or weighted MA or Exponential MA .You may use single, double or triple moving average. MA is suitable for trend follower traders.Chart"B"
Momentum Oscillators:
Such as Relative Strength Index, Momentum, Oscillators, Williams's percent these indicators help traders to pick tops & bottoms of market and swing traders use them.
Chart "B"
3- Prediction Techniques:
Prediction techniques include Elliott wave, Fibonacci number, Gann and various forms of the countertrend trading that predict tops and bottoms. However, do not trade it until the market shows you some sort of confirmation that it is turning.
3 -Stop loss:
"The whole secret to winning in the stock market is to lose the least amount possible when you are not right" William O'Neil.
Getting out of a losing trade is very important if you want to be successful trader. When you set a stop loss, you set a maximum risk that you are willing to take. There are many criteria, which may be useful in a stop loss.
1- Going behind the noise:
Activity of the day could be considered noise, because many traders are fight for order. In addition, when there is a lot of activity, it is better for you to place your order out of the noise. Some trader are placed stop loss order under trendline away from noise .other traders use support and resistance line to place stop order.Chart"C"
Chart "C"
2- Dollar stop:
You determine how much you are willing to lose on trade and set that as stop loss .this type of stop is good when it will be beyond technical stop .
3- Percent retracement:
Some traders set stop loss by allowing price to retrace by certain amount of percentage from the entry price .For example if you buy stock with 20 dollar/share and you will get out from that trade when the price retrace 15% to $17.
4- Channel Breakout and Moving –Average stops:
Channel break out you may enter market when the price makes a new high than previous 40 days and your stop will be when the price makes a new low than previous 20 days. In this method, you give price a lot of room to retrace. However, you take high risk.
Moving –Average Stops by using MA indicators you can use tow moving average system, your stop will be when the short MA line crosses Long MA line. In addition, you can triple MA; your stop will be when the short MA line crosses Medium MA line.
5- Time stop:
Time stop is the stop you can use it if your position does not go in your favor fairly after certain time. You determine you favorite time according framework of your method, if you are long-term trader you can use 1 month as time stop .If you are a day trader you can use 15-minute time stop. However, the disadvantage of it you may loss big expected move of the price.
6- Psychological stops:
Unless you are long term trader you may use psychological stop loss .you use it when you are psychologically exhausted from events of life such as divorce, death
On the other hand, when you so excited about the market because your position doubling overnight.
4 -Exits "Taking Profit":
If you take a position and the worst case does not happen, then the job of your trading strategy is to allow you to make the most profit possible and give the least amount of it back. There are four groups of exits:
1- Time exit:
It occurs when you take a position in the market and after a period, your position does not move as you expect. In this case, you liquidate your position and search for another new good position. This Exit produces a loss, but reduces your initial risk.
2- Trailing stops:
Trailing stop it is type of exits that maximize your profits. It helps you to gain large profit but it will always give some of your profit back, you can use this stops by different ways as:
Dollar trailing stop: You decide amount of dollar you will lose before you close your position and keep your trailing stop behind yesterday close.
Channel breakout trailing stop: You decide to close your position when the price decline than lowest low of last X days in case of long position. In addition, when the price exceeds than highest high of last X days in case of short position.
Moving average trailing stop: All types of M.A. can used as trailing stop.
Trailing stop based on chart pattern: Every time the market moves beyond chart pattern, this old chart pattern become the basis of the new stop.
3- Percent retracement stop:
Another type of profit taking technique that maximizes your profit in long run. Percent retracement means you initially set your exit at certain percent as 20% drop in price. When the stock makes a new high, you set 20% retracement as new stop.
4- Profit objective:
This type of profit taking technique minimizes drawdown and keeps you from giving back too much profit. You can use this stop by predict profit target system as Gann and Elliot Wave. In addition, you can determine your objective before you take a position. Based on historical testing and the percent of risk you take.
5- Parabolic stop:
By using that indicator, you can minimize drawdown and keep yourself from profit giving back too much profit.
6- Psychological exits:
This type of exits depends more in you than market .You exit from your trade when you do not feel well because of health or psychological problem .also when you must be away from the market due to business or vacation.
5 -Position sizing:
The most important aspect of trading strategy .Position sizing means how much to invest in any given position.It`s about money management and asset allocation. I will give you some information about three Models of position sizing.
1- Unit per fixed amount of money:
This model tell you how mush you trade per fixed amount of dollar. For Example you will trade 1 contract or 100 shares per 10,000$ in your portfolio.
2- Equal value units:
This model used for stock which are not leverage .You divide your capital in 5: 10 equal unit .each unit would then dictate how much product you could buy.
For example if you have 100000$ in your portfolio you will divide them into 5 units of $20000 .Then you'd buy $20000worth of share A, $20000 worth of share B and so on .
3- Percent risk model:
When you take a position you know the point at which you will get out of it to save your money .This is your risk. In percent risk model, you control your position sizing as a function of this risk. for example if you want to buy 1000 shares "A" around 30 and your stop loss at 27,your worst case when stop out will be "30-27" *1000 =$3000. You have $ 50000 account and you want to limit your risk to 5 % of this equity which equal 50000*5%=$2500.remember your risk according stop loss point =$3000.So you cannot buy 1000 stock with 30 and you can only buy 833 shares to limit your risk into $2500.
6-Tactics:
Once you build your trading system and you become involved in trading process, Tactical consideration become very important.
1. Entry and Exits:
Entry and exit tactic is important especially for larger accounts where the entry and exit of position can result in significant adverse price movement. Therefore, you must know how you can deal with this problem. Do you enter or exit the position with limit order or market order? Do you give stop loss order to the broker or you exit the trade when the price reached to stop loss point? How can you deal with broker problems if it occurs?
2. Market:
If you are trend follower trader, what can you do if the market goes in trading range for long period? you will change your strategy or leave the market. In addition, what will you do in case of financial crisis?
3. Psychology:
When you trade with trading strategy sometimes your system make consecutive losses and these losses make a serious impact in your emotion. So how can you deal with these losses and control your emotion. In addition, when you get large windfall and your position doubling overnight. Therefore, you must learn how to deal with these events.
Conclusion:
Finally, to build a good trading strategy you must answer these questions:
· What to trade " Market
· When to trade "Entry point"
· When to get out of the losing position" Stop loss"
· When to get out of the winning position "Taking Profit"
· How much to trade "Position sizing"
· How to trade " Tactics"
The End
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