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Monday, June 15, 2009

5 steps to creating your own trading strategy: A different view

Most traders start off by trying to find the right trading system – a set of trading rules to be used repeatedly over time. Finding a profitable trading system or strategy takes time, a lot of time if you are not good with quanlitative or quantitative analysis. A profitable strategy on paper can even blow up on live trading due to poor execution. This is why I recommend beginning traders to start by first taking a strategic view towards trading for faster paper and live results.

When a company formulates its future business strategy, it typically begins by carefully studying its internal and external environment to best position itself for success. Likewise, trading is very much like a business. Traders should examine their own goals, resources and capabilities, study the possible types of trading strategies, the markets that they can trade, set profitability targets for their strategies before researching on the exact trading rules or procedures that best suit them.

Don’t be fooled by claims that trading makes you rich easily. Money doesn’t drop from the sky. My experience shows that you have to tailor your strategy to fit your attributes and behavioral tendencies to avoid gambling and to make money systematically.

For example, an engineer might be more suited for building complex automated trading models rather than the business student who has more experience in the financial markets. The business student might instead study financial statements and make value judgments as part of his strategy.

1) Your profit targets and risk limits. Having a clear picture of your desired risk reward scenario helps you to decide if your chosen strategy is profitable enough when you back-test or actually go live. Psychologically, it helps you deal with uncertainty in your trading profits and losses better. Risk limits also include your preference for small consistent profits (losses) or large windfall profits (losses) once in a while.

2) Internal resources. Your resources dictate how aggressive your trading style should be and what general types of trading strategies are suited for you. The amount of capital you have versus your profit and risk targets coupled with expected profits from your chosen strategy later will set the amount of leverage you should use in trading. More capital also means that you can afford to invest in sophisticated trading software and data feed services which are the “infrastructure” of your business.

Time available determines how frequently you should be trading. If you do not have the time to actively monitor the markets, you should not have a high frequency trading strategy unless you have the programming know-how to automate your system. Even value investing requires considerable time to analyze company developments.

Knowledge, as mentioned earlier, dictates the type of trading strategy and market that you should choose. If you have good knowledge of the cattle industry, why not trade cattle futures? If you studied economics and are good in analyzing business cycles, why not pursue a strategy that is discretionary in nature? In general, experience and emotional maturity decrease the need for a purely mechanical strategy as you are less likely to lose control and start gambling. If you have a sufficiently large network of trader friends, brokers and financial advisors, you can tap your network to find out what other people are buying and selling in order to predict where the market will go next.

3) External Environment. Different markets behave very differently. The stock market is highly sensitive towards earnings releases, while the commodities market might just be more wary of the weather and inventory stockpiles. Certain markets move very slowly, with new information being priced in gracefully over time. The foreign exchange market, on the other hand, is known for short-lived, but large bursts of movement in reaction to market news. Your risk appetite, how well you can stomach losses and large changes in your account balance, should best be well suited for the market you intend to trade. The same goes for your trading strategy. Certain strategies yield a consistent profit everyday with an occasional big loss or vice versa.

4) Selecting a trading style, type of strategy, possible markets to trade. At this stage, you should have an idea of your risk appetite, how much money you want to make, what you are good at doing and what are the types of markets, trading styles and generic strategies available out there. You should also have an idea on how profitable and consistent your preferred strategy should be based on the above. The objective is to obtain a good fit between your resources, style, strategy and market.

5) Research on your exact trading technique. Either back-test or paper trade, and go live. This is when you go into the details. Suppose you want to have a strategy based on technical analysis, you should start back-testing at this stage. Mechanical systems typically take more time to develop. Your system would probably have to pass your desired level of profitability and consistency before you want to go live. On the other hand, discretionary trading strategies are best tested by paper trading over half a year or so to see if you can make the right decisions at the right time.

The markets are full of professional and retail traders each with different time horizons and objectives. However, you can be sure that they will not let you win their money easily. The only exception lies in the stock market and the commodities market. The stock market indices have made money historically over long periods of time, while commodity prices will tend to rise when inflation is high. Therefore, you need to carefully plan your search for a profitable strategy and be sure that you are able to handle the ups and downs of your trading account.

Exhibit: Relationship between your internal resources and trading style

Exhibit: Relationship between your internal resources and type of trading strategy

Exhibit: Relationship between your internal resources and financial market

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The objective of Finance4Traders is to help traders get started by bringing them unbiased research and ideas. Since late 2005, I have been developing trading strategies on a personal basis. Not all of these models are suitable for me, but other investors or traders might find them useful. After all, people have different investment/trading goals and habits. Thus, Finance4Traders becomes a convenient platform to disseminate my work...(Read more about Finance4Traders)


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