Essentials of a Trading Plan - Part 3: The Strategy

Education / 4 Min Read
Milan Cutkovic / 09 Feb 2021

Introduction

In the third part of the “Essentials of a Trading Plan” series, let us take a look at how to approach an actual trading strategy. It is important for a trader to ensure that their strategy is as detailed as possible. While some portions of it can be discretionary and difficult to define, the general rule of thumb to follow is to include as many details where possible.

A Trader’s Edge

Furthermore, each trader should try to identify his/her edge. This might be a set of skills that the trader possesses. For example, some traders might have a short attention span but are quick with numbers and can handle the stress of intraday trading extremely well. Whereas a different type of trader may not be able to function efficiently in this kind of environment, but could instead be a skilled strategist who can always keep sight of the bigger picture.

For beginner traders, it is especially important to identify what skills they may have and tailor the trading strategy according to each individual’s personality, not the other way around.

What does a basic trading strategy look like?

  • Example 1: Buy if the 5-day moving average crosses above the 20-day moving average and the RSI is below 70.
  • Example 2: Sell if the 5-day moving average declines below the 20-day moving average and the RSI is above 30.

This is a simplified example that contains two of the most popular technical indicators. The trader who uses this strategy could potentially see the MA crossover as a sign that momentum is building – either to the up- or downside. He/she might have added the RSI (Relative Strength Indicator) as an additional filter, as the trader wants to avoid buying a currency pair when the RSI is showing overbought conditions or selling a currency pair when the indicator is showing oversold conditions.

They could even come up with the idea to add further indicators to prevent trades in a low volatility environment, like the Average True Range (ATR) or the Bollinger Bands.

The logic behind this could be the following: The 5-20 DMA crossover may signal that the current trend could extend further as momentum is accelerating. However, the trader does not wish to take trades in a low volatility environment as this may decrease the quality of the signals.

The above example shows a very simplified take on what a trading strategy may look like. However, there are other requirements for a trader to take note of. 

Outline of a trading strategy

  1. Logic - (the thinking behind the strategy and why you think it will work)
  2. Objectives - (your goals)
  3. Characteristics - (e.g. you decide you only want to trade during the Asian trading session as your tests showed the strategy performs the best at that time of the day)
  4. Risk Management Rules
  5. Entry Rules - (when to enter a trade)
  6. Trade Management Rules - (stop loss and/or take profit – fixed or trailing)
  7. Exit Rules

Very few traders find the right strategy straight away. The majority will spend a significant amount of time testing various strategies in a demo environment and/or back testing. Even if a trader gets to the point where they find a strategy that has promising results and feels right, it is unlikely that they will stick with that exact strategy for an extended period of time. The markets are evolving constantly, so traders must changes too!

Stay tuned for the final article where we will be discussing the topics “Entry”, “Trade Management” and “Trade Analysis”.

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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