On the world's financial markets and stock exchanges. Part 11
1. What is a trading strategy?
A trading system or strategy is the result of careful and meticulous study of the financial markets. It is the apogee and logical outcome of the future trader or active investor. It reflects all analytical work and willingness to react to any changes on the market.
A trading system allows bringing orderliness into trading operations, adjusting prognostic methods to individual needs of a trader, removing or reducing the psychological burden during the decision-making process. Professionally built trading system is a pledge of success in carrying out operations.
It is not enough just to analyze the market, it is also necessary to build a forecast and implement it, as well as take into account risks that the trader assumes.
A trading system includes a certain set of conditions and rules that determine moments and order of performing the following actions:
- opening of a position
- position closing
When constructing a TS, a number of questions should be answered:
- what tools to use when carrying out operations (stocks, commodities, currency pairs)?
- which method of analysis to use (technical, fundamental or a combination of these)?
- what time interval should be used?
- which indicators to use?
- operating principle (trend, channel)
- What lot to work with?
- what rules apply for opening and closing the position?
- How long should the position be held?
- how to set a stop-loss?
2. Basic rules for building a TS
To build a trading strategy, the trader needs to consider the basic rules of constructing the TS:
- Positive expectation - a property of the system to be generally profitable over a long period of time. It is determined by the fact that the average profit of all trades during the testing period is greater than 0.
- Small number of rules.
- Stability of the system.
- Varying of trade lots
- Risk control, capital management and diversification.
- Mechanistic nature of the system.
To correctly approach the construction of TS, taking into account deep understanding of how financial markets work, you should remember about some principles:
- Principle 1.Price is determined by the supply and demand ratio.
Conclusion: Only the behaviour of the price is relevant.
- Principle 2. The future behaviour of prices is probabilistic.
Conclusion: You can make a lot of money in the market if you estimate the probabilities correctly;
the probability of winning increases with an investment horizon.
- Principle 3. The market moves along the path of least resistance.
Conclusion: Overcoming resistance levels indicates the path of further movement.
- Principle 4. The market has inertia.
Conclusion: do not count on a quick change in the direction of the price movement.
Based on the aforementioned conditions, the main examples of TS operation are working on the level breakout and rebound (it's recommended to remember the theory of Dow about the construction and purpose of support and resistance levels, and the candlestick analysis).
To begin with let's remember about types of resistance and support levels.
First of all they are not just lines on the chart plotted on price highs and lows, they are zones, which are several points wide and are determined by how participants react to certain movements (spread, expectations, aggressiveness or conservativeness of entry, etc.)
Resistance and support levels are of 2 types:
- inclined, which form price channels
- horizontal, which are divided into 3 types
- technical (built directly on the maximum and minimum price points or on the greatest contact)
- psychological (they are usually round figures or price comfort levels for central banks)
- historical (the same as technical but with a longer time horizon or built on a longer time frame).
The levels are described in increasing order of importance. The passage of such levels has several stages:
- Piercing - the price passes the level (resistance or support) only by the shadow of the candle and then goes back.
It is a "Warning!" signal and only confirms the presence of the level.
- A breakout is a signal to open a trading position.
It appears when the price closes below the support or above the resistance level. It can be of 2 types:
- Breakout with confirmation - when the price returns to the level, determining its changed status (resistance to support and vice versa). It is used for conservative strategy. It is the best signal! It is used less often, than the other varieties
- Classical breakout - when the price goes sharply below (above) the level. It is a good variant for a pending order and happens much more often.
As a rule, upon exiting the channel, the price makes a sure distance equal to the channel width - that's our profit according to TS work on breakout.
The placing of pending orders in such TS is determined by general rules (buy-stop, buy-limit, etc.).
A good example of breakout of a sloping price channel is a price exit from a triangle pattern.
Question: Find the points of opening a trading position here.
To determine the necessity of the concept of money management, you need to clearly understand the non-linear relationship between losses and profits that exists in trading in general. A loss of 10% would require you to make a subsequent profit of 11% to get back on track. And after a loss of 50%, you would need to make a profit of 100% to get back on track. The general consensus of analysts is that the maximum allowable loss, which would still allow a turnaround, is 30%. At this loss, it would be necessary to make a 50% profit afterwards - this is considered achievable. A loss of 50% or more is almost certain to result in the financial death of the investor.
What is capital management?
- Rules for placing a stop - order.
- Selection of trading lots.
- The % of TS in the ratio of profitable to losing trades.
- The ratio of risk-return.
- When to close a trade or where to place the profit?
The basic rule of stop-order installation:
Stop order is placed only where there is a high probability of price moves in the opposite direction!
Stops are placed on 2 principles:
- at levels of previous highs or lows
- in target zones restricted by our deposit.
The choice of trade lots is closely related to your deposit and is subject to the recommendation of not more than 10% of total trades at a time.
The average percentage return of the trading system is 3 / 7, i.e. 30% of profitable trades. This is a perfectly working TS. A good one is 50/50. Here the explanation will be the risk-profit ratio or the rule of stop and profit order placement. A simple recommendation: for each point of loss, the expected profit should be 3 points.
Example. A stop order is placed 30 pips away from the current price value. In this case the expected return should be 90 pips. Using the risk-profit ratio 3 / 7, the total loss after 10 trades will be 7x30 = 210 points, while the profit will be 3x90 = 270, which is a profit according to the results of the reporting period.
The most difficult thing in the future is to determine the profit point:
- Expected target zone (Fibonacci series, support and resistance levels)
- Indicative exit (the most popular) - an exit based on indicator signals.
- Statistical expectation (channels, triangles)