How to create a trading strategy

Every financial market trader will, before too long, be asked by market veterans about their trading strategy, how it works, how it was drawn up and whether it is delivering in terms of returns.

Confess to having no strategy at all and you’ll probably be met with looks of blank disbelief…

Which is odd on the face of it. After all, diets and other nutritional regimes work well for some people, but others can cheerfully eat what they like. So, why can’t anyone so inclined simply duck in and out of the market as the fancy takes them, trusting to instinct?

The answer comes in two parts. One is that such behavior is itself a trading strategy, known as opportunistic trading. The other is that having a well-formulated strategy of any type is the trader’s shield against chaos and financial loss.

The wisdom of crowds

This is its real value — not as a get-rich-quick scheme but as a discipline that roots the trader in the view of the market that informs their trades and, in turn, grows out of that view. This is the starting point of how to build a trading strategy: what is it that you believe moves the market?

Your strategy will also be informed by the type of asset being traded: shares, indices, commodities or foreign exchange. So, how to create a trading strategy?

Here are some of the better-known varieties of what is hoped to be a winning trading strategy.

First, there is “momentum trading”. This is based on the view that “the trend is your friend” and that the surest way to make money is to follow the current direction of travel.

To an extent, those who take this approach are putting their trust in “the wisdom of crowds”, the belief that one trader can never know more than the market as a whole and that market movements represent the sum total of financial knowledge.

More plainly, momentum investors seek to capitalize on the actions of many thousands of other traders and investors.

The great economist Lord Keynes practiced momentum investing in the early part of his career, of which more later.

Directly opposed to momentum are the “contrarians”. These are the traders who not only disbelieve the wisdom of crowds but are convinced that, in the words of the late financial guru Robert Beckman, markets will do whatever they have to do to ensure that most people are mostly wrong most of the time.

Sharp and swift reactions

How, they argue, can it be otherwise? If all that is needed to succeed as a trader is to do the same as everyone else, why don’t we all do it and become rich? In reality, they add, plenty of “losers” are needed to keep markets turning over and the most prominent losers will be those who follow “the word from the herd”.

The time to bet against the market, according to contrarians, is when pretty much every last trader, including the small fry, has bought into the current trend, because there is no longer anyone left to whom to sell the securities in question and a bubble is about to burst.

Similar to the contrarians but distinct from them are so-called “reversionary” traders. Like the contrarians, they believe markets can head off in the wrong direction, opening opportunities to trade against the trend. Unlike the contrarians, they do not believe markets are invariably wrong.

Rather, they suggest individual securities can “overshoot” in price terms, either up or down, and that they are likely to “revert to the mean”, in other words, return to their average medium-term value. Markets sometimes “over-punish” company shares in the wake of disappointing results or “over-reward” them for good figures.

In the gap between either of these events and a return to market level-headedness, a reversionary trader can buy or sell the securities concerned.

One example of the above-mentioned ducking in and out of markets in an opportunistic fashion is a strategy called “trading news-flow”. Very sharp and swift reactions are needed to make a success of this trading style, which relies on near-instant reaction to unfolding events that could not have been forecast.

Such events can range from a surprise change in interest rates via corporate collapses and political scandals to an outbreak of war.

Robust but flexible

Earlier, we mention Lord Keynes and his early adoption of momentum investing. Keynes became disillusioned with this strategy and swung in the opposite direction, believing the best returns arose from careful research into a relatively small number of stocks and unearthing hidden gems.

This “value” style may sound more suitable to investing than trading, but good research can inform either type of market activity and a good trading strategy can be based on snapping up securities that, for whatever reason, other players have overlooked.

The late Jim Slater, a legendary British market participant, employed a highly personal trading style that he called “press-jack” that was derived from the way be played backgammon. He would bet a single chip and, if the belt came off, would add another.

Continued success would prompt him to take some pieces off the board to preserve some of his winnings, but the moment he lost, he would cut the stake back to one chip. The point, he said, was to run profits and cut losses.

In developing a trading strategy you need to remember that it will be a good servant but a bad master. It is there to organize and channel your trading activity, to work for you. If you find yourself working for the strategy, then something has gone wrong.

Your strategy should be robust enough to withstand short-term market squalls but flexible enough to adapt to longer-term changes. What is more, it should be reviewed on a regular basis to judge how well it is delivering the returns you seek.

Finally, there is no shame in switching from one type of strategy to another as circumstances alter. A final word from Lord Keynes, who famously said: “When the facts change, I change my mind.”