Trading strategy

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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.

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. [1]

Trading strategies are based on fundamental or technical analysis, or both. They 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. [2]

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. Technical strategies can be broadly divided into the mean-reversion and momentum groups. [3]

All these trading strategies are speculative. In the moral context speculative activities are considered negatively and to be avoided by each individual. [5] [6] who conversely should maintain a long term horizon avoiding any types of short term speculation.

Development

The trading strategy is developed by the following methods:

The development and application of a trading strategy preferably follows eight steps: [7] (1) Formulation, (2) Specification in computer-testable form, (3) Preliminary testing, (4) Optimization, (5) Evaluation of performance and robustness, [8] (6) Trading of the strategy, (7) Monitoring of trading performance, (8) Refinement and evolution.

Performance measurement

Usually the performance of a trading strategy is measured on the risk-adjusted basis. Probably the best-known risk-adjusted performance measure is the Sharpe ratio. However, in practice one usually compares the expected return against the volatility of returns 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. [9]

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.

See also

Related Research Articles

Day trading Buying and selling financial instruments within the same trading day

Day trading is speculation in securities, specifically buying and selling financial instruments within the same trading day, such that all positions are closed before the market closes for the trading day. Traders who trade in this capacity with the motive of profit are therefore speculators. The methods of quick trading contrast with the long-term trades underlying buy and hold and value investing strategies. Day traders exit positions before the market closes to avoid unmanageable risks and negative price gaps between one day's close and the next day's price at the open.

Hedge (finance)

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

In finance, statistical arbitrage is a class of short-term financial trading strategies that employ mean reversion models involving broadly diversified portfolios of securities held for short periods of time. These strategies are supported by substantial mathematical, computational, and trading platforms.

Long/short equity is an investment strategy generally associated with hedge funds, and more recently certain progressive traditional asset managers. It involves buying equities that are expected to increase in value and selling short equities that are expected to decrease in value. This is different from the risk reversal strategies where investors will simultaneously buy a call option and sell a put option to simulate being long in a stock.

Swing trading is a speculative trading strategy in financial markets where a tradable asset is held for between one and several days in an effort to profit from price changes or 'swings'. A swing trading position is typically held longer than a day trading position, but shorter than buy and hold investment strategies that can be held for months or years. Profits can be sought by either buying an asset or short selling. Momentum signals have been shown to be used by financial analysts in their buy and sell recommendations that can be applied in swing trading.

In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio. Individuals have different profit objectives, and their individual skills make different tactics and strategies appropriate. Some choices involve a tradeoff between risk and return. Most investors fall somewhere in between, accepting some risk for the expectation of higher returns.

Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading was developed to make use of the speed and data processing advantages that computers have over human traders. Popular "algos" include Percentage of Volume, Pegged, VWAP, TWAP, Implementation shortfall, Target close. In the twenty-first century, algorithmic trading has been gaining traction with both retail and institutional traders.

Pairs trade

A pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergence trading strategy. Pair trading was pioneered by Gerry Bamberger and later led by Nunzio Tartaglia's quantitative group at Morgan Stanley in the 1980s.

Stock trader a person or company involved in trading equity securities (share stock in companies)

A stock trader or equity trader or share trader is a person or company involved in trading equity securities. Stock traders may be an agent, hedger, arbitrageur, speculator, stockbroker. Such equity trading in large publicly traded companies may be through a stock exchange. Stock shares in smaller public companies may be bought and sold in over-the-counter (OTC) markets.

In finance, a calendar spread is a spread trade involving the simultaneous purchase of futures or options expiring on a particular date and the sale of the same instrument expiring on another date. These individual purchases, known as the legs of the spread, vary only in expiration date; they are based on the same underlying market and strike price.

Scalping, when used in reference to trading in securities, commodities and foreign exchange, may refer to

  1. a legitimate method of arbitrage of small price gaps created by the bid-ask spread.
  2. a fraudulent form of market manipulation

Trend following or trend trading is a trading strategy according to which one should buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue.

Option strategies are the simultaneous, and often mixed, buying or selling of one or more options that differ in one or more of the options' variables. Call options, simply known as calls, give the buyer a right to buy a particular stock at that option's strike price. Conversely, put options, simply known as puts, give the buyer the right to sell a particular stock at the option's strike price. This is often done to gain exposure to a specific type of opportunity or risk while eliminating other risks as part of a trading strategy. A very straightforward strategy might simply be the buying or selling of a single option; however, option strategies often refer to a combination of simultaneous buying and or selling of options.

Option (finance) Right to buy or sell a certain thing at a later date at an agreed price

In finance, an option is a contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price prior to or on a specified date, depending on the form of the option. The strike price may be set by reference to the spot price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium. The seller has the corresponding obligation to fulfill the transaction – to sell or buy – if the buyer (owner) "exercises" the option. An option that conveys to the owner the right to buy at a specific price is referred to as a call; an option that conveys the right of the owner to sell at a specific price is referred to as a put. Both are commonly traded, but the call option is more frequently discussed.

An automated trading system (ATS), a subset of algorithmic trading, uses a computer program to create buy and sell orders and automatically submits the orders to a market center or exchange. The computer program will automatically generate orders based on predefined set of rules using a trading strategy which is based on technical analysis, advanced statistical and mathematical computations or input from other electronic sources.

Strategy indices are indices that track the performance of an algorithmic trading strategy. The algorithm clearly and transparently specifies all the actions that must be taken. The following are examples of algorithms that strategies can be based on.

Forex autotrading is a slang term for automated trading on the foreign exchange market, wherein trades are executed by a computer system based on a trading strategy implemented as a program run by the computer system.

A forex signal is a suggestion for entering a trade on a currency pair, usually at a specific price and time. The signal is generated either by a human analyst or an automated Forex robot supplied to a subscriber of the forex signal service. Due to the timely nature of signals, they are usually communicated via email, website, SMS, RSS, tweet or other relatively immediate method.

Systematic trading is a way of defining trade goals, risk controls and rules that can make investment and trading decisions in a methodical way.

Brandywine Asset Management

Brandywine Asset Management, Inc. is an American investment management firm founded and managed by Michael Dever. The firm is registered as a commodity trading advisor.

References

  1. Nekrasov, V. Knowledge rather than Hope: A Book for Retail Investors and Mathematical Finance Students. 2014, pages 24-26. ISBN   978-3000465208
  2. "Day Trading Strategies: 4 Timeless Approach". DayTradeTheWorld.
  3. "Master One Strategy Before Learning Others". www.thebalance.com.
  4. Low, R.K.Y.; Tan, E. (2016). "The Role of Analysts' Forecasts in the Momentum Effect" (PDF). International Review of Financial Analysis. 48: 67–84. doi:10.1016/j.irfa.2016.09.007.
  5. Ryan, John A (1902). "The Ethics of Speculation". International Journal of Ethics. 12 (3): 335–347. doi:10.1086/intejethi.12.3.2376347. JSTOR   2376347.
  6. "CATHOLIC ENCYCLOPEDIA: Speculation". www.newadvent.org.
  7. Pardo, R. The Evaluation and Optimization of Trading Strategies. J. Wiley & Sons, 2008, page 18. ISBN   978-0-470-12801-5
  8. "R&D BLOG - Oxfordstrat". Oxfordstrat.
  9. Samuelson, P. (1971). The "fallacy" of maximizing the geometric mean in long sequences of investing or gambling. Proceedings of the National Academy of Sciences, 68(10):2493–2496