What Is A Trading Strategy And How To Build One?
A trading strategy is a set of predefined rules that a trader follows when opening, managing and closing a position. This means that specific criteria must be met before any trades are placed or modified.
Trading strategies dictate when you should be participating in the market vs. when you should stay out, which essentially means that the rules are making the trading decisions.
Your principles determine what criteria will be used at the different stages of the process. It is vital to form a strategy beforehand and not alter it while participating in the market.
On our menu today:
- Why should we use a strategy?
- The different components.
- How to build your own trading strategy (step by step)?
- Example and trades.
Side note – Some market participants will use the terms trading strategy and trading system interchangeably. There is nothing wrong with this, although the term trading system in more commonly used when referring to statistical/ data-based strategies.
Why should we use a strategy?
I would suggest to all those starting out to implement a systematic approach to trading the Forex market. The following are some benefits:
All traders know this game is won or lost through psychology and the ability to control our emotions. Strategies reduce the potential harm that these can do to our trading by telling us what decisions to make, thereby preventing any irrational thoughts or feelings from impacting our results.
Consistency is key when it comes to trading. We have all heard this, but why is it the case? Because without a consistent set of rules, set out in our strategy, it is impossible to determine what is actually making money and what is not, bringing us to the next point.
As soon as you have a set of criteria to guide your trading decisions, you can objectively test the system and determine if it has a positive expectancy (edge). Furthermore, once you find something that works, you can simply continue trading it over and over again since you know the probabilities are on your side and you will make money overall.
Once you implement a consistent approach, it is easy to measure performance and make adjustments to improve profitability. You can also track how your trading strategy performs in different market environments and create a framework according to the conditions.
When you boil Forex trading down into a set of objective rules, this makes it easier to use some form of automation, reducing the burden on you as a trader. Some examples include – Notifications when a setup meets certain criteria, the automatic management of positions, and even the opening of trades.
As you can see, the benefits of using a consistent methodology are massive. Next, we will look at what forms part of a trading strategy.
The different components
Method of analysis
Firstly trading decisions must be based on some form of analysis of the Forex market, which can be technical, fundamental, statistical, or a combination.
Every form of analysis is then boiled down into an approach. Here is an example of each.
Technical analysis – Using support and resistance levels to trade ranges.
Fundamental analysis – Buying currencies with high interest rates against currencies with low interest rates.
Statistical analysis – Entering positions based on a certain % market move.
A trading strategy is always implemented on a specific timeframe, which should remain the same to ensure the consistency we discussed earlier.
Our system entry rules tell us exactly what criteria must be met for any trade to be placed. These rules also specify under what conditions we should not be trading.
The exit rules tell us where potential take profits should be set, when a trade should be closed manually, as well as any other trade management rules such as trailing the stop loss or closing partial positions.
Risk can be considered as its own topic, but I have included it because the risk levels that a trader sets can make or break a system (even a good one). The 3 most important risk parameters to set are the % risk per trade, the maximum open risk at any given time, and the maximum drawdown before you stop trading and regroup.
Those are the main components of a trading strategy. Now its time for the star of the show. Let us look at the step by step guide to building your own.
How to build your own trading strategy?
All strategies are composed of 3 elements – Criteria for entering trades, the rules for trade management and exit, as well as risk management.
Usually, traders will study the various techniques of traders they look up to and will eventually come to their own version of an established strategy. Here is a step by step guide to developing a trading strategy.
1. Discover your preferred analysis and study it
It may seem a bit daunting at first to choose how you would like to analyze the market. Most people quickly hop on Google and search which method makes the most money. Let me break that mental barrier – The best analysis, and the one YOU will make the most profit with, is the one that suits your personality. So choose the one you gravitate towards.
After choosing, it is time to put the work in and study until you know the theory like the back of your hand. You may even use a combination of different types of analysis but make sure to keep it as simple as possible when beginning your Forex trading journey.
2. Which approach will you use?
The next question you have to answer is which approach you will use? An approach still means you use the same form of analysis, but you will focus on a specific aspect of it e.g. using technical analysis but only trend trading using support and resistance levels.
Once decided, you must stick to the same method until you have determined if it has a positive expectancy. Constantly chopping and changing equals no progress.
3. Timeframe you will trade
Up next, you have to ask what timeframe you will be trading on. The timeframe chosen will determine trade frequency and how often you will have to look at the market.
Thus the best option depends on how often you can look at the market (depending on your responsibilities) and whether you want to be a scalper, swing trader, or position trader.
4. Entry rules
Here us traders take our approach and from this derive a set of criteria that must be met before entering a trade. Entry rules usually contain a mixture of different tools e.g. levels, Fibonacci retracements, and candlesticks.
When first developing a strategy creating these rules is difficult since you don’t know what works and what does not. Therefore, it is best to keep them simple and, once tested, you can adjust accordingly.
5. Exit rules
Good trade management and exits are just as important as the reason you got into a position. Most importantly, you need a way to limit your losses so when the market goes against you, all your capital doesn’t go with it. For this reason, I will always be an advocate of a stop loss.
Many traders will also put in a take profit to automatically close out winning trades at a given price. On the contrary, some do not because this limits profit potential.
That’s not all. Most of the time it’s beneficial to add some other trade management rules such as when to trail the stop loss or when to close a position manually.
6. Risk management parameters
Again, this depends on YOU. While trading in the live markets, you will slowly begin to gauge your risk appetite, which is how much risk you are comfortable taking without it affecting your execution. Certain people can take large risks naturally, because of their personality, while others are only able to risk a small piece of the pie.
A good place to start in terms of risk per position is between 2-3%. Try that out and see if you are comfortable.
For the max account risk at a given time, try setting a limit of 10%, and increase it over time if you can handle more.
Max drawdown % is also subjective, but if you have lost 20% or more of your account, it may be a good time to pause your trading and analyze your approach.
7. Write everything down
All of the above should be written down so you can remain grounded and stay true to the rules during all parts of the process.
8. Test your system
You should now have a blueprint for participating in the Forex market. The next step is to rigorously backtest the system in different market conditions to determine if the strategy has a positive expectancy. If so, you can dive into the live markets and test your real risk appetite.
To become great at anything, you have to strive for constant improvement. Always remember to analyze your system and see if any improvements can be made, a great way to do so is keeping a journal.
10. Execute objectively
Once you have found something that works, the only thing left to is executing it with rigorous discipline. Because of the psychological challenges the market poses, this is easier said than done but having a strategy to guide you makes it a lot easier.
Example and trades
We have covered a lot of ground to get to this point, so much that this process may seem daunting. I want to show you that creating a system can still be simple, and I will do that via an example. This strategy is taken out of the How To Trade Breakouts In Forex article.
- Identify key levels of support and resistance on the chart.
- Wait for price to break through the level of support or resistance.
- Enter if a candlestick closes past the zone on the timeframe that you are trading. This candle must represent strong buying or selling. When buying, this would be a strong bullish candlestick past the resistance zone and when selling a strong bearish candle past the support zone. If you are unsure about how to judge the strength of candlesticks, then read this.
- Place the SL past the broken level/ zone, buy trades would be below the previous resistance level and sell trades would be above the previous support level. Leave some room in case of spread and slight moves past the level on potential retracements.
- Place the TP at the next major inflection point where the market could reverse against your trade. In buy trades, this would be at resistance, in sell trades this would be at support. Another possible TP placement could be at the price of a measured move e.g. if a range is 100 pips and price breaks out, the TP could be set 100 pips away.
- Trail the SL as the market makes new highs (uptrend) or lows (downtrend) in the direction of the trade.
- Risk a maximum of 2,5% per trade.
- Maximum open risk of 10%.
- Maximum drawdown % of 20%.
Buy trade example
Sell trade example
You may have noticed a common trend that most decisions related to trading strategies depend on YOU – Your trading objectives, analysis preference, risk tolerance, and time horizon. This process will take some time and work, but persisting is worth it.
The ball is in your court, follow the recommendations in this article, and soon you will be on the way to profitability.
Follow the rules!