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Saturday, June 13, 2009

Types of trading strategies

A quick note on some of the common types of trading strategies

Choose a trading strategy that suits you. Trading strategies differ by trading frequency, number of instruments traded, holding period (how long you hold your position), risk reward profile etc. If you have a daytime job and do not know how to automate your strategy, you could start off with a low frequency strategy (the one to two trade a day type, or the trade of the week type). You may also prefer a trading strategy that yields a consistent profit (with a huge loss once in a while), or a strategy that yields the unexpected large windfall from time to time (with small losses on a regular basis). Hence, it is very important that you choose an appropriate strategy.

Statistical Arbitrage

This is by far the one of the most common strategy used by most professional trading desks in banks or in proprieptary shops. A common strategy would be index arbitrage. Long/Short the index futures with an offsetting position in the underlying basket of stocks, when fair values between both instruments diverge. Various arbitrage opportunities exist, e.g. between futures contracts of the same underlying asset, denominated in different currencies, or between contracts on the same instrument but trading in different markets, such as in Singapore and Hong Kong. Basically, arbitrage strategies take advantage of short term mispricings in similar instruments.

What's the challenge?

Speed. More and more players are entering into the more commonly known arbitrage strategies. You need to have the fastest computer to calculate if there is an arbitrage opportunity and the fastest connection to ensure that your trade gets filled. Most arbitrage opportunities disappear in seconds as players move in to remove any mispricing found. You will generally need to be competent in programming etc.

Risks. When prices diverge persistently between two similar instruments, there has to be a reason for it that you do not know. Prices can diverge further for an unknown amount of time before converging. Hence, the once in a while huge losses in an arbitrage strategy.

Directional Plays

Most technical indicators are directional plays, be it mean reversion or trend type indicators. Neural network models and other similar quantitative models that aim to make price predictions are also directional plays. Going for undervalued stocks and market timing etc are both directional in nature. In general, if you are taking an unhedged position in any instrument you are making a directional bet on prices. The good news of such strategies is that you can adjust the trading frequency, even the risk reward profile etc to your liking/aggressiveness. E.g. you can make daily, weekly, monthly or even annual bets on market direction. However, such strategies are at best a probablistic bet. You tend to lose money more often than arbitrage strategies. Nonetheless, if your strategy is truly profitable, why not? There are other issues when dealing with market predictions, such as market stationarity etc. More will be elaborated in other posts.

Market Rumors

I decided to include this as a viable strategy, simply because of the supposedly buy on rumor sell on fact possibility. The best way to profit from the market is to have information that other people do not have. Nonetheless such a strategy is the reserve of people who are highly connected. Alternatively, you can maintain a network of remisiers who are very good at passing you timely market rumors.


Ultimately, it is important to discover your competitive advantage and work on it. Playing to your edge minimizes the risk. Otherwise you can build an advantage of your own. We decided to write this post, as we realized that this decision is very important for starting traders as different strategies will require different competencies - computer knowledge, mathematics or good people skills.

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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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