Last Updated on 11 September, 2023 by Samuelsson

Just googling the term “trading strategies”, you will see all sorts of information and misinformation that can easily get a newbie confused. Many even mix up trading strategies with trading styles. You begin to wonder how new traders can navigate through all the confusion to be able to create their own strategies that suit their personality and trading objectives.

Anyone who wants to trade the financial markets must develop his or her own strategy or buy a suitable one from strategy vendors. The point is that trading strategies are personalized and market-dependent, and not just the general types of trading styles that people can adopt.

When you start trading in the financial markets, you will encounter several trading strategies. In fact, there are as many strategies as there are many traders, and some traders even use more than one strategy. One thing you will realize is that one’s success using any strategy will be different from another person’s success.

Since any anomaly or inefficiency in the market can be developed into a trading strategy, the number of trading strategies out there is uncountable. It’s up to you to decide the market inefficiencies you want to exploit and the strategies to make out of them. Some important factors to consider include your personality type, lifestyle, and available resources.

Trading strategies are the methods used by traders to determine when and how to enter and exit the market in order to make a profit. There are many different types of trading strategies, ranging from simple ones to more complex ones. These strategies can be applied to any market, including the stock market, forex, commodities, and options.

The most basic trading strategy is to buy low and sell high. This is known as the buy–and–hold trading strategy and it is used by many traders. It involves buying a security at a low price and holding it until it reaches its peak value, at which point it is sold for a profit. This strategy is simple and generally has a low risk–reward ratio. Another common trading strategy is to take advantage of short–term price movements in a security. This is known as day trading and involves buying and selling a security multiple times within a single day.

This strategy is more risky than the buy–and–hold strategy, but if done correctly can yield higher returns. There are also more complex trading strategies such as swing trading, scalping, and arbitrage. Swing trading involves buying and selling securities over a longer period of time, usually several days to a few weeks. Scalping involves taking advantage of small price movements in the market. Arbitrage involves taking advantage of price differences between two markets in order to generate a profit. These are just a few of the many trading strategies available.

Different strategies will work better for different traders depending on the markets they are trading in and their own risk tolerance. It is important for traders to understand the different strategies and to find the one that works best for them.

So, are you overwhelmed by the confusing information out there and want to know what trading strategies are and how to create yours? This post is for you. In the post, we will address the topic under the following subheadings:

• What are trading strategies?

• Understanding trading strategies

• Types of trading strategies: discretionary vs. algorithmic

• Examples of trading strategies

• Trading strategies vs. trading styles: How do trading strategies differ from trading styles?

• The different trading styles in details

• Creating a trading strategy

• The difference between a trading strategy and a trading plan

What are trading strategies?

A trading strategy is a fixed set of rules used by a trader or many traders to determine when to buy and sell a security so as to generate a profitable return on investments. It is an established method of planning and making trades that you can follow in the hope of making a profit. In essence, a strategy defines a system that a trader uses to determine when to buy or sell a specific financial instrument.

A good trading strategy allows for a trader to analyze the market and confidently execute trades with sound risk management techniques. Typically, a trading strategy should be objective, consistent, quantifiable, and verifiable. But most new and naïve traders just make assumptions about the market and trade based on those assumptions without verifying (testing) them. A trading strategy that works for one instrument may not work for another due to the peculiarities of each market.

Trading strategies can be based on fundamental analysis, technical analysis, sentiment analysis, or a combination of any two of them or all of them. The key is to create something robust enough so that the inevitable systemic risks cannot lead to catastrophic effects on the trading results.

When building a trading strategy, traders have to formulate clear goals that they aim to achieve. With the trading strategies, they have set out specifications about the market to trade, what defines a trading opportunity in the market, when to make the trades, when to exit from their trades, and how much capital you should risk on each position.

Since a trading strategy is based on predefined rules and criteria used when making trading decisions, we can say that it is not a systematic methodology used for buying and selling in the securities markets but also a reference for assessing the trading processes and results. That is, if a trading strategy is followed correctly, it offers the trader a means of objectively assessing whether a trade is worth the risk at the outset.

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Some traders can make their trading strategy simple, only including their entry and exit criteria, while others create complex strategies that involve several factors, such as the investment approach (value vs. growth), industry sector, market cap, level of portfolio diversification, time horizon or holding period, fundamental analysis, technical analysis, risk tolerance, leverage, tax considerations, and so on.

In summary, a trading strategy can be likened to a trading plan that takes into account various factors a trader relies on to take a position in the market and exit from the market. It is often based on either technical or fundamental analysis and its parameters should be quantifiable and verifiable — that is, it can be backtested to determine accuracy. Creating and using a trading strategy typically involves three stages — planning, placing trades, and executing trades — and at each stage of the process, the parameters of the strategy can be measured and changed to reflect the current situation of the market. So, the key thing about a trading strategy is to use objective data and analysis when implementing it. And, the trading strategy should be periodically re-evaluated and tweaked as market conditions or individual goals change.

Understanding trading strategies

To understand trading strategies, you need to understand the concept of active trading. Rather than just buy a few stocks or securities and holding them for life until you need to sell them to raise money for whatever you need, active trading involves buying and selling securities based on certain price movements to profit from those price movements. In essence, it requires timing the market to know when to buy and when to sell.

As you can see, the mentality associated with an active trading strategy differs from the long-term, buy-and-hold strategy found among passive or indexed investors who don’t need to have a specific way of identifying an opportunity in the market. For active traders, identifying recurring price movements and capturing the market trend are where the profits are made. So, they try to find certain patterns that occur with reasonable consistency in the market and use them to determine when to enter and exit the market.

Those patterns that identify market inefficiencies are known as trading edges, which can be developed into trading strategies. The key thing in transforming a trading edge to a trading strategy is to stipulate the criteria or rules for trade entry and exits and, then, testing these criteria to know how well they perform. The testing and optimization of the parameters in a trading strategy are essential for creating a robust strategy that can perform in a live market environment.

Most times, traders create their own strategies by themselves so that they can have something personalized; something that fits their trading personality and goals. While there are strategy vendors that create, test, and sell trading strategies to traders, it is easier for a trader to trust and implement a strategy he developed by himself than the ones gotten from a strategy vendor.

Trading strategies are also tailored to specific trading styles — scalping, day trading, swing trading, or position trading. While some strategies can work across all timeframes and trading styles, a strategy that works in position trading may not work so well when implemented on intraday timeframes for scalping or day trading. So, traders try to make strategies that suit their trading styles.

Strategies are also tailored to suit specific markets. Different markets tend to have specific characteristics such that a strategy that works in one market may not work in another. A strategy that is used for trading stocks may not perform well when used to trade bonds or futures, and a strategy that works in the Forex market may not work for stocks.

Fundamental, technical, and sentiment analysis

Basically, every trading strategy is based on fundamental, technical, or sentiment analysis or a combination of any two of them or even a combination of the three. The main thing is that a strategy relies on quantifiable information that can be backtested for accuracy.

A strategy that is based on fundamental analysis considers fundamental factors, such as financial ratios (EPS and P/E ratio), revenue growth, profit margins, etc. For example, you may decide to use a set of financial ratios as the criteria to screen the stocks to buy. You could use revenue growth and profitability for your screening.

Technical trading strategies, on the other hand, make use of historical price and volume data to generate trading signals. The signals may be based on price action patterns or a combination of technical indicators. Traders who use this method believe that all information about a given security is contained in its price and volume data and that the pattern of price movements in the past can be used to forecast future movement. For instance, one may create a simple trading strategy that is based on a short-period moving average crossing over a long-period moving average — a cross above is taken as a buy signal, while a cross below is taken as a sell signal.

A strategy can also be based on sentiment analysis, which is basically about determining investors’ opinions of a specific stock or asset. Sentiment analysis helps traders to understand the prevailing market psychology which may at times hint at future price action. Some factors that influence stock sentiment include social media trends and news, which may be economic, political, or industry-related. These factors impact stock market volatility, trading volume, and price trends. However, sentiment analysis alone may not always predict changes in share prices. But when combined with technical analysis, a better understanding can be gained to determine possible scenarios.

Examples of trading strategies

Now that you understand what a trading strategy is, you would agree that there are a potentially inexhaustible number of trading strategies out there. In fact, there may be more strategies than there are traders. However, in this post, we will only consider these common ones:

• Mean-reversion strategies
• Buying on dips
• Breakout strategies
• Trend-following strategies
• Momentum-based strategies

Mean-reversion strategies

Mean-reversion strategies are very common in trading, especially among stock swing traders, because the equity market has been mean-reverting since the turn of the millennium. The concept of mean reversion is simple: the market tends to make extended moves to either side of its mean but always tries to revert to the mean, and in the process of going back to the mean, it overshoots again and tries again to revert to the mean again.

The swinging movement creates tradable opportunities that swing traders try to profit from using different indicators and methods. Examples include the following:

• The RSI method
• The Bollinger Band method
• The moving average method
• The double seven method

While most of those methods can show buy and sell setups, we will only focus on the buy setups.

The RSI method

This method uses a 2-day RSI and a 200-day moving average. A buy setup is formed as follows:

• When the price is above the 200-day moving average, implying that there is an uptrend
• The 2-day RSI crosses below 10, indicating that the market is temporarily oversold
• The 2-day RSI crossing above 60 is an indication to close the trade

The Bollinger band method

In this method, the Bollinger Bands indicator is used to determine the mean price and when the price is at the oversold level. The Bollinger Bands indicator consists of three lines, which are the 20-period moving average line at the middle plus a lower band and an upper band that are two standard deviations away from the middle band. A buy signal occurs when the price closes below the lower band of the Bollinger Bands indicator. The exit signal should be when the price climbs above the middle band.

The moving average method

In this method, the buy setup forms when the price falls lower than the predetermined level below the moving average that indicates an oversold market. The trader can use a bullish reversal candlestick pattern, such as the hammer, bullish engulfing pattern, or the three outside up pattern, as the trade entry trigger. An exit signal occurs when the price climbs above the moving average.

The double seven method

For this method, a 200-day moving average is used to identify an uptrend. A buy setup is formed in an uptrend when the price closes at a new seven-day low. The exit signal occurs when the price makes a new seven-day high.

Buying on dips

This strategy is used by traders and investors who prefer value to momentum. The idea is to buy cheaper and sell higher, so the traders wait for the price to decline in order to buy at a better value. Buying on a dip means waiting for the price to make a pullback before placing your trades. The investors call it value investing or buying on the dip, while traders call it buying on a pullback.

While this may seem like an easy strategy, it is not; you will need to know when the decline is about to end to avoid cashing a falling knife. One of the ways to estimate where a decline would end is to look for well-known support levels. There’s a higher chance that the price would reverse around a known support level because of the huge number of buy limit orders that usually lie in wait around such levels.

Other things to look out for are signs of potential price reversal. Oscillators, such as the RSI, stochastic, Williams %R, CCI, OsMA, and even MACD, are good for this purpose. They tend to show that the market is oversold. Even better than the oversold signal is the bullish divergence signals that occur when the indicator and the price swing are not in phase. Another one is to look for reversal candlestick patterns, such as hammer, morning star, bullish engulfing, and bullish hikakke. Reversal chart patterns, such as the triple bottom, inverse head and shoulder, double bottom, and falling wedge.

Breakout strategies

A breakout occurs when the price rises above a specified price level where the price had reversed in the past. When the price breaks above that level, it shows that there is a huge buying potential in the market, which might continue pushing the price higher.

Unlike buying on the dip, some traders prefer to jump in when the market breaks out of a resistance level so they can ride on the resultant increase in momentum. A breakout strategy aims to buy the stock when the price breaks above a known resistance level. Since a breakout indicates a huge buying momentum in the market, which might push the price higher, traders try to ride on that momentum.

There are many ways to use this strategy. It can be a breakout of a known resistance level or a certain day’s high. The famous Turtle experiment used a breakout strategy — the breakout of a 20-day high indicates a buy setup, while the breakdown of a 20-day low indicates a sell setup. 

Other breakout strategies can be trading price action patterns the traditional way — for example, the breakout of a triangle, wedge, rectangle, flag, and pennant, as well as the breakout of the neckline of a double or triple bottom and head and shoulder.

Trend-following strategies

Trend-following strategies are used by long-term investors and position traders. The idea is to get into a trend at the early stages and ride it to the end. It is not easy to use trend-following strategies as they tend to have low win rates, so they can have huge drawdowns and easily affect the trader’s psychology.

The primary thing is to identify a new trend early enough. For this, some traders make use of price action patterns — a higher swing high and a higher swing low. Other traders use technical indicators, such as the moving averages, ADX, and MACD. Most commonly, traders use moving average crossover, whereby a short-period moving average rising above a long-period moving average is seen as the emergence of a new uptrend.

To use a trend-following strategy effectively, you must prepare your mind to lose more trades than you win because of the poor win rate associated with the strategy. The reason for the too many losses is that most new trends fail to continue. However, the few winners usually offer huge profits to offset the losses. The reward/risk ratio of the strategy can be as high as 10-20 times or more.

Momentum-based strategies

Momentum-based strategies are often used by investors to rotate their capital among various assets or sectors, such that at every point in time, they stay invested in assets with the highest momentum. Some refer to them as rotational strategies.

With this method, an investor measures the relative momentum of the various securities he is interested in buying and ranks them. He then buys the top three performing securities. After a certain period, say 1 month, he reassesses the momentum of those assets again and sells those that have fallen out of the top three, and uses the funds to buy the ones that are in the top three.

There are many methods for estimating the momentum of an asset. They include the rate of change, a certain-period moving average, RSI, stochastic, and even breakouts above a certain-period high.

Types of trading strategies: discretionary vs. algorithmic

Depending on how a strategy is set up and implemented, it could be classified as follows:

• Discretionary
• Algorithmic

The discretionary trading approach

A discretionary trading strategy is manually implemented. It consists of a set of rules that a trader uses to identify trading opportunities and to know when to exit from the market. While the trader follows the rules all through his trading, he can modify the rules or even replace them based on his experience and what works best for him. Some traders tend to follow their strategy rules rigorously, but others may prefer to experiment till the time they feel they have cracked the code and would still continue to make required modifications in their strategy.

Someone who trades discretionarily has to study the signals and charts and then make a decision on whether to buy or sell the asset. With discretionary trading, the trader calls the shots in everything — when to enter a trade or when to exit positions. Thus, most of the risks come from decisions taken under the influence of uncontrolled emotions of the trader. In some cases, these emotions can lead to trades that cannot be logically defended. As such, to trade profitably, it becomes extremely important to not just have a profitable strategy but also have a check on one’s emotions.

The algorithmic trading method

The algorithmic trading method, sometimes known as systematic trading, converts the trading strategy into computer algorithms that monitor the markets to identify the trade setups, place trades, and at the right time, close them. In other words, computer algorithms, rather than the trader, make trading-related decisions or predict their best chance of making a profit out of the investments that they make. The trader could, from time to time, change the algorithms based on the market conditions and other factors.

The algo trader does not study the charts manually and interprets trading signals on a per-trade basis. Instead, he prefers to use historical market data to build a trading strategy that suits the market conditions, code it into a computer algorithm, and switch it on to do the trading for him. The trader’s role becomes that of a spectator who monitors the performance of the algorithms based on the logic that has been built and makes the required changes once the algo has dropped in performance or has stopped working.

An advanced form of algorithmic trading is known as quantitative trading. While most ordinary algo trading uses basic technical analysis to identify trading opportunities, quantitative trading uses a much larger matrix of factors to analyze the market and arrive at a buy or sell decision. A quantitative trader uses several data points, including regression analysis of trading ratios, technical data, and price and volume data, to exploit inefficiencies in the market and conduct quick trades using AI technology.

The key differences between discretionary and algorithmic trading

Trading strategies vs. trading styles: How do trading strategies differ from trading styles?

It is very common to confuse trading styles with trading strategies. In fact, most people mix them up; but they are obviously not the same. While trading strategies refer to unique rules and criteria each trader uses to identify trading opportunities in the markets, trading styles are different approaches to trading based on the trading duration — that is, how long the trade stays in the market on average.

There is an uncountable number of possible trading strategies; virtually everyone can develop his own unique trading strategy using any factor he believes has an edge in the market. However, there are only four basic trading styles — scalping, day trading, swing trading, and position trading — based on trade duration.

Day trading, for example, is a trading style and not a trading strategy. A day trader would have to find a trading strategy that would tell him when to actually place a trade and when to close them.

The different trading styles in details

Let’s take a look at the different trading styles:

Position trading

Position trading, also known as long-term trading, is the kind of trading that tries to benefit from the long-term price trend rather than the short-term price fluctuations. This style of trading is suited for patient traders with a long-term outlook. Position traders usually keep their trades from several weeks to months and, sometimes, years.

Some position traders base their trading strategies on technical analysis, while others base theirs on fundamental analysis. But most of them use a combination of both. These traders create their strategies to work on the weekly and daily timeframes.

Position trading saves the trader a lot of time, as there’s less need to analyze the market often. Each trade lasts for a long time, so there’s less frequent trading. As a result, the cost of transaction is less. Despite the benefits, there are a few disadvantages that come with the trading style. The main one is the risk of overnight price gaps that can render your stop-loss order useless. Another disadvantage is that your capital is tied down for a long time, so there’s the issue of opportunity cost.

Swing trading

In swing trading, the trader tries to profit from short-term price swings. Swing traders normally hold their trades from a few days to a few weeks, as they try to capture the individual price swings on the daily timeframe.

Most swing traders build their trading strategies on technical indicators and price action patterns. They aim to identify price reversals early enough and ride the next price swing. Swing trading is often done on the daily timeframe, but some traders may step down to the 4-hourly timeframe.

Swing traders don’t trade as frequently as day traders or scalpers, but when compared to position traders, they make many trades and as such, they incur higher trading costs. As with position traders, swing traders are exposed to the risk of overnight price gaps because their trades last for several days.

Day trading

Day trading is a style of trading where the asset (stock, for example) is bought and sold within a single trading day. In other words, the position must be closed before the market closes for the trading day. A day trader tries to profit from the predominant price trend of the day.

So if the trader thinks that the stock will trend up for the day, he goes long, and if his analysis indicates a downtrend, he either goes short or stays out of the market. Day traders often base their trading strategies on technical analysis, but they are also mindful of important news releases that can affect their positions. Day traders often optimize their strategies for intraday timeframes, especially the hourly, 30-minute, 15-minute, and 5-minute timeframes.

Most day traders use leverage to increase their trade size because the profit they make per trade is small. However, the pattern day trading rule applies for stock trading: you will need to maintain a minimum of $25,000 in your trading account. Most stockbrokers allow 2:1 leverage, but some may allow up to a maximum of 4:1 leverage. Leverage can enhance profitability, but it increases the risk of huge losses. Furthermore, owing to the huge number of trades, commissions can easily add up to a huge amount.

Scalping

Scalping is a highly fast-paced trading style that tries to exploit all the various price fluctuations that occur throughout the day. Scalpers can make up to 20 or more trades in a single day, and the trades don’t stay long — each lasting from a few seconds to a few minutes.

Scalpers monitor price movements in the shortest possible timeframes, such as the 1-minute to 10-minute timeframes and even the tick charts. Most scalpers base their trading strategies on technical analysis alone and often automate their strategies because it is almost impossible to implement them manually in such a fast-paced environment.

Since they try to capture little price movements, scalpers often use the four-to-one leverage available to intraday traders to maximize profits. Profits can quickly compound if a scalper uses an effective exit strategy to minimize losses, but the overtrading and over-leveraging associated with this style of trading makes it extremely risky. Moreover, scalping incurs heavy commissions because of the huge number of transactions.

Creating a trading strategy

Although the process of creating a trading strategy can be quite demanding, you can create your own strategy if you put in the effort. But first, you need to understand what a trading edge is because that is the core of any trading strategy.

What is a trading edge?

A trading edge is a recurring inefficiency in the market that, if exploited, can give you an advantage over the other players in that market. It is a persistent anomaly you identify in the market and exploit to gain an edge over the other players in the market. The edge is the central factor in a trading strategy. In other words, it is an advantage the trading strategy aim to exploit.

So, you have to identify an edge first and then build your trading strategy around it. A trading edge should show better returns than the average returns for you to make it the basis of your trading system. If an edge is not profitable or consistent enough, there’s no need to develop it into a trading strategy.

There are various ways you can find a trading edge, but the commonest ones are reading financial journals, brainstorming, and interacting with other traders.

How does a trading edge differ from a trading strategy?

A trading strategy is a complete system with rules for identifying trade setups and when to exit from the market, while the trading edge is just an inefficiency in the market that can be exploited to form a trading strategy.

An edge is basically something that deviates from the normal and creates an inefficiency that can be exploited with the right rules and criteria. It has the potential to become a complete strategy when the criteria for defining when to buy and when to sell are established. The beauty of trading is that of creativity, so you’re the one to turn the trading idea into an implementable trading strategy.

The steps in creating a trading strategy

Here are the steps to follow when trying to create a trading strategy:

1. Understand your trading style and personality

One of the very first things to do when trying to develop your own trading strategy is to define the type of trader you are and set your trading objectives. You have to understand your trading personality and determine the style of trading that suits you — which can be scalping, day trading, swing trading, or position trading.

If you are the type of person who loves to work in a fast-paced environment and can make quick decisions in the heat of the moment, day trading and scalping may be suitable for you. On the other hand, if you are the type that loves to take time to carefully analyze data before making a decision, you will likely prefer swing trading or position trading. One of the factors that can also determine your choice of trading style is your availability — if you have a 9-5 job, you can only choose swing trading or position trading.

It’s when you understand the style of trading that is suitable for you that you can aim to develop a trading strategy that can work. If you research and find a trading edge for day trading when you are suited for position trading, it would be a waste of time.

2. Find an edge

Now, you know what you want in your trading, so you have to go all out and make it happen. It starts with finding the right edge in the markets you want to trade. But how do you find a trading edge? Well, the only answer is: Do your research!

You may start by reading financial journals; those journals often have research papers on certain market phenomena that present consistent anomalies in the market. Whatever you find interesting, you can brainstorm to see how you can tweak it into something better. Other places you can find trading ideas include trading forums and trading blogs. You will get to learn some new ideas from other traders.

By interacting and sharing ideas with other traders, you will get fresh perspectives and know what works and what does not work.

3. Formulate a trading hypothesis

When you have found a trading edge, it is time to formulate a trading hypothesis. By this, we mean a technical basis for why the market inefficiency (the edge) exists and how you can exploit it. This is a time to brainstorm, using your trading knowledge and experience to explain the edge and how to take advantage of it.

For example, let’s say you noticed that the market usually reverts after three consecutive down days with lower closes. Your experience may lead you to apply a trend line and Fibonacci retracement tool to see how that fits into the overall price action. You may notice that the ones that revert strongly are ones that the third day’s low touches a 60% Fibonacci retracement level or the trend line. With this, you can formulate the rules of your trading strategy.

4. Create the trading rules to make it a strategy

After studying your trading edge to see all the factors that can affect its result, you can then create the trading rules that would become your trading strategy. These would include the rules for trade entry and the criteria for trade exit.

You may include your risk management (stop loss) rules, as well as your money management (amount to risk per trade) rules.

5. Test and optimize the strategy

It is time to test your strategy with historical price data to see how well it performs. While this can be done for a manual strategy, it is much easier for an automated strategy. So, it’s better you code your strategy into a trading algorithm so you can easily backtest and optimize it.

When your backtesting result is promising, you can optimize the parameters of your strategy. You can do this in a live market (forward testing), but a faster way is to use an out-of-data portion (not used for backtesting) of the historical price data — walk forward optimization.

The difference between a trading strategy and a trading plan

You may be wondering whether a trading strategy is the same as a trading plan. Well, they are very different. While a trading strategy is a fixed set of rules you use to determine when to buy and when to sell a security to be able to make a profit, the trading plan is much broader than that.

A trading plan is a sort of guide you use to navigate your trading journey. It covers every aspect of your trading, including your trading strategies, money management, risk management, trade management, the markets to trade, when to trade them, how to keep a trading journal, and how often you review your trading journal. Your trading plan is like a roadmap that guides you through the entire trading process.

A trading strategy focuses on criteria for trade entry and exit, but the trading plan addresses all aspects of your trading, including how you plan to manage and grow your trading account. The trading plan shows how you should implement your trading strategy, along with other elements that make will make your trading successful.

Final words

A trading strategy is the criteria you use to determine when to buy and sell a security to stand a chance of making profits. A good trading strategy allows for a trader to analyze the market and confidently execute trades with sound risk management techniques. Common examples of trading strategies include mean-reversion, buying on dips, breakout, trend-following, and momentum strategies. Typically, a trading strategy should be objective, consistent, quantifiable, and verifiable — whether it is discretionarily executed or automated.