In finance, a trading strategy is a fixed plan that is designed to achieve a profitable return by going long or short in markets. The main reasons that a properly researched trading strategy helps are its verifiability, quantifiability, consistency, and objectivity. The development and application of a trading strategy follows eight steps: (1) Formulation, (2) Specification in computer-testable form, (3) Preliminary testing, (4) Optimization, (5) Evaluation of performance and robustness, (6) Trading of the strategy, (7) Monitoring of trading performance, (8) Refinement and evolution.
Contents
For every trading strategy one needs to define assets to trade, entry/exit points and money management rules. Bad money management can make a potentially profitable strategy unprofitable.
Trading strategies are based on fundamental or technical analysis, or engage them both. Technical strategies can be broadly divided into the mean-reversion and momentum groups. There are also specific strategies, like "Sell in May and go away but remember to get back in September". Trading strategies are usually verified by backtesting, where the process should follow the scientific method, and by forward testing (a.k.a. 'paper trading') where they are tested in a simulated trading environment. Momentum signals (e.g., 52-week high) have been shown to be successful in trading strategies and are used by financial analysts in their buy and sell recommendations.
Types of trading strategies
The term trading strategy can in brief be used by any fixed plan of trading a financial instrument, but the general use of the term is within computer assisted trading, where a trading strategy is implemented as computer program for automated trading.
Development
The trading strategy is developed by the following methods:
Performance measurement
Usually the performance of a trading strategy is measured on the risk-adjusted basis. Probably the most known risk-adjusted performance measure is the Sharpe ratio. However, in practice one usually compares the expected return against the volatility of returns and/or the maximum drawdown. Normally, higher expected return implies higher volatility and drawdown. The choice of the risk-reward trade-off strongly depends on trader's risk preferences. Often the performance is measured against a benchmark, the most common one is an Exchange-traded fund on a stock index. In the long term a strategy that acts according to Kelly criterion beats any other strategy. However, Kelly's approach was heavily criticized by Paul Samuelson.
Executing strategies
A trading strategy can be executed by a trader (Discretionary Trading) or automated (Automated Trading). Discretionary Trading requires a great deal of skill and discipline. It is tempting for the trader to deviate from the strategy, which usually reduces its performance.
An automated trading strategy wraps trading formulas into automated order and execution systems. Advanced computer modeling techniques, combined with electronic access to world market data and information, enable traders using a trading strategy to have a unique market vantage point. A trading strategy can automate all or part of your investment portfolio. Computer trading models can be adjusted for either conservative or aggressive trading styles.