How to Develop a Trading Strategy
Learning how to develop a trading strategy is key to your long term success as a trader. Equally as important is learning how to properly execute your trading strategy which will be discussed in great detail in the next chapter.
Before we jump into creating a strategy, you have to understand what a trading strategy is. I know, you’re probably saying to yourself, “Adam, I’m not dumb.”
However, failing to properly understand the definition of trading strategy is why most people fail at trading no matter how valiant their efforts.
What is a trading strategy?
A trading strategy is a mathematical formula or pattern recognition that provides a trader with a statistical advantage over a given series of trades.
I repeat… statistical advantage over a given series of trades.
Sounds pretty simple right? Well… we have this thing called a brain that can overcomplicate things.
For the time being just remember this simple definition and reflect on it as you finish this guide.
Skills Required to Develop A Trading Strategy
Like most things in life, learning something new takes time. If you’re brand new to day trading it’s going to be some time before you begin to recognize the elements that can lead to a profitable strategy.
When I first began trading at GPC I had no clue of how to build a trading strategy, nor should I. I learned a proven trading strategy from my mentors and how to effectively execute that strategy.
Only after years of screen time had I begun to notice different price patterns, the value of certain indicators, and particular statistical anomalies that would repeat. After 20 years I have filled several journals with these ideas. Some I’ve never even thought twice about while others have been refined and developed into the strategies I trade today.
Now here’s the good news. I’m going to help you save a lot of time by outlining the exact steps you need to follow. I also will be sharing with you some indicators and tools to start looking at to generate some ideas and to help speed up that process.
With that being said, let’s get into it.
Step 1: Set Realistic Expectations
The internet is full of trading gurus (AKA Professional Marketers) pitching how they became ultra millionaires trading in a short period of time! All you have to do is follow their trading system!
They have flashy cars, amazing homes, and stress free lifestyles!
Let’s get back to reality. I personally know and have traded alongside some of the world’s best traders for years. The first thing I will tell you is 99% of them are nothing like the trading gurus you see all over the internet.
Successful traders, traders who are consistently profitable over a long period of time, are experts at managing money not only when in a trade, but when pulling out their wallet.
But wait… if traders make so much, why not enjoy life?
Trading is one of the few professions where you can go into work, do everything perfectly, yet end the day have less money than you started with. Ultimately, your income is very unpredictable as a trader. The market decides when there’s opportunities for you to make money, not the other way around.
Living a lifestyle beyond your means is a sure way to destroy even the greatest traders. I’ve personally seen it countless times. Trading is a mentally taxing job. Adding the additional stress of worrying about upcoming bills is a sure way to blow up your trading account.
Next, successful traders are some of the hardest working people I’ve ever met. It takes extreme passion and discipline to become a successful trader and the same amount of effort and passion to remain successful.
90% of traders will be out of the business within 24 months. You will learn in the next chapter why this number is so high but in reality this isn’t a profession where you can be average. The “average” trader loses money.
Follow these steps and I promise your odds of success will be MUCH higher than your peers.
Step 2: Identify Potential Edges
There is no secret sauce when it comes to finding your edge other than hard work and experimentation.
All of my personal strategies are a result of screen time, testing indicators and running statistical models. Any time I’ve ever wondered if a price pattern or idea based on a mathematical formula could provide an edge I wrote it down for potential development down the road.
If you’re new to trading this will be more difficult as you lack the knowledge on the different indicators and tools you can use to develop a trading edge.
To help with that here are some indicators that I personally have used over the years and some yet today. Learning more about and testing out some of these indicators is a perfect place to start.
Footprint charts provide additional information over standard candlesticks by allowing you to see the individual trades that occur within the candle
Volume Delta is the difference between buying and selling power. Volume Delta is calculated by taking the difference of the volume that traded at the offer price and the volume that traded at the bid price.
Learn More: Volume Delta – The Ultimate Order Flow Indicator
A tick index compares the number of stocks that are rising to the number of stocks that are falling for a given exchange. A tick index gives traders a short term snapshot of market sentiment.
Fib retracements are great for finding support and resistance as well as determining take profits on trades. Why do they work? Because enough traders use them.
I personally find pin bars a great pattern to pay attention to.
Learn More: Pin Bar Trading Strategies
Tick, Volume, and Range Charts
Tick, volume and range bar charts are data-based interval charts. Unlike a traditional time based chart, these chart styles print a bar at the end of a set data interval.
Time Price Opportunity (TPO) Charts
TPO charts show price distribution over a specified time, forming a profile. Visually this allows you to see which levels price spent the most time at. Great for determining support and resistance.
A Volume Profile indicator takes the total volume traded at a specific price level during the specified time period and partitions the total volume into either buy volume or sell volume, making the information easily visible.
High volume nodes are great for determining key support and resistance levels.
Volume Weighted Average Price (VWAP)
VWAP represents the average price a security has traded at throughout the day, based on both volume and price. It gives a good representation of what long term money considers fair value for a security.
Moving averages are a very simple technical analysis tool that smooths out price by taking the average price over a given time period.
Basic Support & Resistance Indicators
- Overnight High and Low
- Prior Day High and Low
- Volume Weighted Average Price (VWAP
In the past I’ve built mathematical based trading strategies based on economic releases.
If you have a statistical background some of the primary economic releases are:
- Consumer Price Index (CPI)
- Non-Farm Employment Change
- Unemployment Rate
- Rate Changes
- Flash Manufacturing PMI
- Core Retail Sales
Try these indicators on your charts, watch them during a live market, and look for any repeating patterns that could provide an edge.
Step 3: Understand The Logic
Whether you’re creating your own trading system or trying to learn someone else’s strategy, you have to understand the logic behind the trading strategy.
Saying, “I will buy when X indicator does this and I see X pattern”…simply isn’t enough.
You need to understand the logic behind your strategy and why it gives you an edge. Without this basic understanding you won’t be able to monitor and adjust your strategy over time, which is a never ending task.
If you want to make it long term in this business, and I assume you do or you wouldn’t be here, you always have to be adapting and looking for new opportunities. Like any other business or profession, overtime new rules and technology change the trading landscape and a strategy that may have been profitable for years may see diminishing returns or simply no longer work.
When I began my career at GPC I was purely a Level II trader. Around 2008 algorithms began to greatly diminish the value of a Level II. I saw the writing on the wall (as well as my P&L) and had to adapt and completely change how I looked at the markets and the strategies I traded.
I’ve spent the last 10 years developing the strategy I trade today, and it’s been a constant process of evaluating my performance and implementing new tools to improve my edge.
Only when you understand the logic behind your strategy can you truly understand how to implement new technology into your trading system.
I first became aware of Footprint Charts somewhere around 2012. At the time I was primarily trading Index Futures using several different order flow indicators.
I knew how valuable footprint charts could be when implemented along with my current strategy the second I understood what they were. They instantly gave me a better picture of price action than some of the traditional means like watching time and sales.
Now that we set the basis for developing a strategy, let’s actually get into doing it.
Step 4: Define Your Trading Strategy
Every strategy you ever develop will be made up of 5 main components. To examine each of these components let’s build an example strategy together.
Your strategy’s trigger is the set of variables your strategy uses to signal an opportunity to go long or short a security. Typically it’s the key element of your strategy that you will be scanning for when looking for a trade.
Example Strategy Trigger:
Take a long position when the 10 EMA crosses above the 30 EMA
Take a short position when the 10 EMA crosses below the 30 EMA
Most likely you’re not going to build a profitable trading strategy solely based on the trigger. You add additional confirmations that have to be met in order to take a trade.
Example Strategy Confirmations:
Divergence on MACD
Above 30 minute Opening Range when going long
Below 30 minute Opening Range when going short
Breaking out your trigger and confirmations makes it easier if you’re physically daytrading your strategy versus automating it. In a fast paced market you want to be able to quickly identify potential setups. Scanning through different securities and just looking for your trigger is much more efficient.
3. Trade Management
You can have the best trigger and confirmations in the world but without proper trade management you will likely fail.
When developing a new strategy it’s important to test several trade management techniques. Let’s look at the two main categories, fixed and dynamic trade management.
Fixed Trade Management (FTM)
Using a fixed trade management system involves a predetermined stop loss and take profit. Typically I use fixed trade management when I’m initially testing a new system. I will start testing the system with a 2:1 reward to risk and then test it at 3:1.
The main reason I start with FTM is due to speed. When initially backtesting a strategy I’m simply looking to see if it has potential. If I can see the potential with FTM I know it’s worth further development.
Dynamic Trade Management (DTM)
When using a dynamic trade management system you have a stop loss that will vary depending on the setup and your take profit fluctuates throughout the trade determined by your interpretation of market data.
A simple example of DTM is trailing stop loss behind swing highs or lows as they form.
Generally speaking DTM is going to boost your performance when compared to FTM. However, DTM is going to require more elite trading skills than FTM.
4. Risk Management
Risk management is where traders fail the most. Keep it simple and you’re 90 percent of the way there.
You will learn more about this in the next chapter but for now just follow this rule. Determine what you’re comfortable losing in your account and divide it by 20.
$1,000 / 20 = $50 risked per trade
Your risk management rules should also incorporate max loss per day, week, and month.
Step 5: Backtesting
Trading is a unique profession in the fact that you can develop new strategies and see how they would have actually performed in the past.
Backtesting is essential to your trading success. It’s something I’ve been doing for 20 years and will continue to do for the rest of my career.
When initially testing a new idea I typically backtest 50 – 100 trades over different periods of volatility. To do this simply open a daily chart to find periods of higher and lower volatility to test your strategy.
I personally like a good old fashioned spreadsheet as I can manipulate the data however I want.
There’s nothing complicated about backtesting. Simply go through chart one candle at a time and determine if there was a setup. Track your results in a spreadsheet and repeat.
After I’ve gone through 50-100 trades I examine the results. If it looks profitable using a fixed trade management study then I go into phase 2 of backtesting.
Phase 2 I begin to optimize the strategy. This is where you want to begin testing different trade and risk management settings to find where the strategy performs the best. Generally in this phase I’m backtesting several hundred trades.
Step 6: Simulated Trading
Prior to trading any strategy on a live account I recommend you sim trade the strategy for 30 days. If your results don’t reflect the results you had backtesting, trade on sim for another 30 days and repeat this process until you’re confident your results are close to your backtested results.
No matter your experience, learning to recognize a new strategy in a live market takes screen time. You may find that the strategy simply doesn’t work for you and your personal characteristics.
I’ve always gravitated towards shorter time frames and higher volatility environments. Primarily because it’s where I began my career but also because it fits some of my personal characteristics like being impatient.
Recognizing your own personal traits and strengths and weaknesses are important if you want to grow as a trader.
You may be more analytical and like a slower pace. All of us have different personality traits, and thinking about your traits can help you modify a system so it’s more suitable for you.
Step 7: Read Chapter 6
DON’T EVEN THINK about taking a strategy live before reading the next chapter. If you can’t master what is taught in the next chapter you will fail as a trader. PLAIN AND SIMPLE.
Typically new traders will abandon a strategy the second they begin to experience failure. In reality the problem typically isn’t with the strategy, it’s with the person trading it and their poor execution.
Without perfect execution even the best strategies will fail. In the next chapter I teach you how to think like a trader and rules to implement to help you close the profit gap.
Step 8: Going Live
After you have proven over 30 days that your sim traded results are replicating your backtesting results, it’s time to go live.
Here are some key pieces of advice when taking any new strategy live.
- Create a well defined trading plan. Need help? Here’s a post that will help you write a solid trading plan.
- Trade the smallest contract size for the security of your trading for 30 days. Only increase your trading size after you’ve proven your trading results reflect your backtesting and sim results.
- Keep extremely accurate records so you can manipulate your data down the road. At a minimum track the following:
- Long or Short
- Entry Date
- Entry Strategy
- Entry Time
- Entry Price
- Stop Price
- Exit Price
- Exit Time
- Exit Date
- Take screenshots of your trades. Screenshots will save you time when doing weekly and monthly reviews.
Step 9: Evolve
Like any profession, things change overtime. Over the years I’ve seen major shifts in the trading arena that have definitely influenced my trading strategies that have required me to evolve or I’d be looking for a new profession..
When properly tracking and reviewing your performance it’s much easier to notice when your strategy is underperforming your expectations. Proper tracking can help you determine the causes and how to improve your strategy.
Your strategies will evolve over time as market conditions change and your skill level improves. Always be looking for additional edges.
The reality of developing a trading strategy is it takes time and hard work. The best way to start is by getting your hands a little dirty and testing different indicators and tools.
You will be going through this same process over and over again throughout your trading career. Track everything you do including simple ideas that you may find down the road can be implemented into your strategy to improve it.
Have some indicators you like to use with your trading strategies? Leave a comment below!