A trading strategy is a set of predefined and precise rules for entering, exiting, and managing capital in financial markets. Trading strategies can be formulated based on technical analysis, fundamental analysis, algorithmic trading, and liquidity analysis.
What is a Trading Strategy?
A trading strategy is a structured and fixed plan for controlling emotions, determining trading style, managing trade volume, setting entry and exit points, and applying risk/capital management.
The structured approach allows traders to make the best decisions under different market conditions.
Why Do We Need a Trading Strategy?
Market prices fluctuate due to supply and demand, economic news, and investor decisions. Entering trades without a predefined set of rules leads to impulsive decision-making. The key applications of a trading strategy:
- Capital Management and Risk Control: Defining the capital allocation for each trade and utilizing stop-loss orders to reduce unexpected losses and preserve capital;
- Avoiding Random and Emotional Decisions: A well-defined strategy prevents decision-making based on fear, greed, or market excitement;
- Consistency and Reproducibility in Trading: Executing a systematic approach across all trades allows performance assessment and strategy refinement while avoiding erratic results;
- Backtesting and Optimization Before Real Execution: A trading strategy is tested on historical data to assess profitability, win rate, and weaknesses before actual implementation.
An example of backtesting a trading strategy on the S&P500 index chart
Key Components of a Trading Strategy
A robust trade strategy must include precise and repeatable rules that define entry and exit points, risk exposure, and allocated capital per trade.
Entry Conditions
Trades should be based on predefined signals, enabling decision-making based on price patterns, key level breakouts, volume data, or indicators.
For example, in an ICT Style-based strategy, an entry is made when the price retraces to the Fair Value Gap (FVG). If the price does not return to this zone, no trade is executed.
Exit Conditions
A Trade strategy should clearly define when to lock in profits and how to minimize losses in case of incorrect analysis. The two most common exit methods:
- Take Profit: Closing a trade at predefined levels, such as key resistance or swing highs
- Stop Loss: Exiting a trade if the price falls below a support level or if there are false breakouts
Capital Management and Position Sizing
A trade strategy should specify the percentage of total capital allocated to each trade and the basis for determining trade volume.
Example: A trader with a $10,000 capital who risks 50% per trade will lose the entire account after two unsuccessful trades. However, if the risk is limited to 2% per trade, the trader can recover even after multiple consecutive losses.
Risk Management and Loss Control
Every trade should have a predefined risk exposure, and trades should not be executed if the risk is unreasonable. Common risk management tools:
- Trailing Stop: Adjusting stop-loss levels as the price moves toward the take-profit target
- Risk-Reward Ratio: Evaluating the risk exposure compared to the potential profit.
For example, if a trader risks $1 per trade to gain $2, the risk-reward ratio is 1:2.
Market Conditions and Suitable Timeframes
Price movements vary under different market conditions. A strategy should define trading decisions for different market phases (ranging from bullish to bearish) and the appropriate timeframe.
Example of Choosing the Right Timeframe
- Scalping: Analyzing small market movements where decisions are made quickly, with low risk-reward ratios and lower timeframes
- Swing Trading: Examining larger market movements where trades may remain open for weeks, using higher timeframes and higher risk-reward ratios
Types of Trading Strategies
Applications of a Trading strategy vary based on analysis methods, market types, and usage goals.
Technical Analysis-Based Trading Strategy
Entry and exit points are determined using price data, candlestick patterns, key-level breakouts, volume analysis, and indicators.
- Price Action: Analyzing price behavior and candlestick formations at support, resistance, and breakout levels
- Moving Averages: Using the Exponential Moving Average (EMA) indicator across different timeframes to identify trends
- Divergence Trading: Utilizing indicators such as RSI and MACD to identify overbought and oversold conditions
- Breakout Trading: Analyzing price breakouts of key levels alongside increased trading volume
An example of using the Moving Average indicator on the US100 index chart
Fundamental Analysis-Based Strategies
Fundamental analysis evaluates the intrinsic value of assets and medium and long-term price trends based on macroeconomic parameters.
- News Trading Strategy: Predicting medium and long-term trends based on economic reports such as employment data and GDP
- Financial Ratio Analysis: Evaluating stocks using P/E ratio, Earnings Per Share (EPS), Book Value metrics, and many more
- Monetary Policy Strategy: Assessing the impact of central bank interest rate changes
- Capital Flow Strategy: Analyzing the effects of foreign investments, industrial trends, and supply-demand changes
Algorithmic and Quantitative Trading Strategy
Algorithmic strategies employ mathematical equations, big data, and machine learning to optimize trade entry and exit points.
- High-Frequency Trading (HFT): Executing thousands of trades simultaneously to profit from small price differences
- Machine Learning Trading: Using AI and quantitative models to identify recurring patterns
- Arbitrage Trading: Buying and selling an asset in different markets simultaneously to capitalize on price discrepancies
- Volatility Trading: Trading high-risk assets in volatile market conditions for higher profitability
Liquidity and Institutional Trading Strategy (ICT & SMC)
The strategies identify trading opportunities based on liquidity flow, institutional orders, and the behavior of banks and large investors.
- Smart Money Concept (SMC): Entering trades at levels where banks and institutions place orders
- ICT Trading: Trading in line with market liquidity flow by identifying Order Blocks and price breakouts
Identifying the entry point and stop-loss using order blocks and fair value gaps in the ICT style on the Dow Jones chart
Steps to Build a Trading Strategy
Follow this step-by-step guide to create a trade strategy:
- Select Market and Timeframe: Choose the market type and timeframe based on volatility, liquidity, and trading volume;
- Define Trading Analysis Style: Select a market analysis style based on your expertise;
- Determine Entry and Exit Conditions: Set all criteria for placing trade orders, including entry points, stop-loss, and take-profit levels;
- Capital and Risk Management: Define trade volume, risk-reward ratio, and maximum allowable risk per period;
- Backtesting and Optimization: Test the strategy on past market data and refine it in a demo account to minimize weaknesses;
- Evaluate Performance in a Live Account: Start real trading and maintain a trading journal to track and improve strategy weaknesses.
Conclusion
Types of trading strategies play a crucial role in market execution and risk management, mitigating impulsive decisions driven by market psychology.
A well-defined strategy incorporates precise entry and exit criteria, risk-to-reward assessments, and adaptive measures for evolving market conditions.
