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How to develop your own trading strategy.
Every novice trader will reach a point of understanding the need to create his own trading strategy sooner or later. Of course, it is possible to use one of many existing forex trading strategies, although they have to be adopted for the personal trading style. The problem of such strategies is that they have a more of a general view on such important factors as money management and trading approach. Sometimes a shift in any particular trading condition might cause a complete change of any trading technique steps and actions. At the same time, some of the existing approaches do not meet traders’ requirements for managing the risk, identifying the depth of potential losses, finding entry points, etc. This article is dedicated to mandatory components of a trading strategy, why traders need it and what questions must be asked while developing a trading system suitable to you personally.
What is the trading strategy?
Any trading strategy is a list of rules which allows to systematize the trading process, give a clear concept to a trader when it’s worth entering a deal, when is the best time to exit the market, and when it’s better to abstain from trading at all. The system also covers when and what timeframe the trading should be taken, what currency pairs should be chosen and what lot size should be picked up for entering the market. The trading strategy helps also avoiding the emotions’ negative impact on the process.
Trading system’s advantages.
There are several obvious benefits of trading by a strategy:
Statistical advantage. A trader knows that the number of profitable deals will soar if the trading systems’ conditions are followed correctly, and the overall profit will be the result at the end of the day. Of course, a preliminary historic test of any trading strategy should confirm that suggestion. Even though another series of losing deals happened, the trader knows that, most likely, the situation will get better. A trader does not need to guess every time about whether it’s worth entering the market or not. He simply follows the strategy’s trading signals. It’s easier psychologically for a trader. Greed, fear and wish to recover previous losses, increasing the lot size, are getting easier for the trader’s control when clear and exact rules exist, turning a trader to an executor rather than a person making decisions.
In other words, a trading strategy turns Forex trading in a routine rather than an exciting adventure, although the majority of traders come to the market in order to make some money but not gamble, and the trading strategy helps them to achieve the goal.
Why an own trading system should be developed?
An awful lot of trading strategies exists in the market. Some of them are quite simple, the others are too complicated and only professionals can understand them. Beginners usually start trading, using a ready trading strategy, choosing one of the most simple among others. However, almost all of them understand with time that it’s possible to trade in a really effective way of just using a strategy, developed by their own, and based on experience and preferences.
Trading strategies are not always developed from scratch. It often happens (especially if that’s trader’s first experience of developing a system) that an existing strategy is taken as a base, and some of the changes are imposed: technical indicators are added, installed instrument settings are modified, etc.
Regardless of whether a trader is willing to develop his own trading strategy from scratch, or to modify an existing one, the key factor should be a character match. So, a thoughtful and reasonable person would not like to use scalping, while another person would not prefer to use a long-term trading approach.
Mandatory components of a trading strategy.
Every strategy must include certain points which are going to provide trading stability in the complex:
Logical background. That should be the main idea, on which the trading strategy is developed. It has to be a sild foundation, supporting all of the rest components. Currency pairs to trade on. Timeframe and trading session. Entry rules (signals for positions to open). Exit rules. How to set take-profit and stop-loss orders. Lot size of the trading and risks restrictions.
If all of these parameters are considered, then it’s time to start testing the trading strategy on historical data or a demo account.
Example of developing a trading strategy structure.
The first step is to identify the main trading idea, whether it’s going to be a trend strategy, which suggests a continuation of the same-directional price action and entries on retracements, or it’s going to be a reversal strategy which is based on attempts to find reversal points and ranges. It also can be a certain dependence of a tendency in the market behaviour, on which further movement predictions can be based.
For example, you have noticed that the market, even though being in a trend, never moves straight and in a steepening way. There are always some retracements or price fluctuations which are opposite to the main direction of the price action. This will be our key idea to develop our trading strategy, as entering the market after a retracement, it’s easier to get more profits as the result, increasing the chances for the price to go in the right direction.
Entry rules are identified right after the main idea is clear. The direction is by-trend in our case and we’ll be looking for price reversals after corrections. Technical instruments, perfect timeframe and currency pair have to be chosen for identifying entry conditions.
Another example: you’ve noticed that EUR/USD and USD/CHF currency pairs often move in the opposite direction to each other, and once an upside movement starts in one currency pair, the other one drops immediately, and vice a verse. Therefore, once you’ve noticed that an uptrend started on one of the pairs, you can easily open a deal in the opposite direction on the other asset, given the fact of the correlation rule. In this case, the question of the assets to choose for trading is already resolved, whereas the market does not have such strongly correlating currency pairs any more.
Choosing the best timeframe depends on several factors. One is how much time a trader can dedicate to trading process on a daily and weekly basis. If the daily chart takes 24 hours to form one single candle, accordingly, it will take a couple of minutes to make a decision, considering the given trend and analysing the current situation. But the one-minute chart is an extremely fast-changing environment and the trader will be required to be present in front of the trading terminal all the time. The less timeframe is, the more trading signals will occur, hence, a potential profit would be larger. Although, not everyone can afford to spend all of the days behind the chart, and busy people would prefer trading on the daily timeframe.
It is also considered that the technical analysis works better on larger timeframes, such as daily and weekly, than on hourly chart. D1 would be an optimal choice for beginners. The most often range widely used by traders is M15 - D1, as five-minutes and one-minute charts, are too unpredictable, and making a stable profit on those timeframes is possible for highly specialized professionals.
In most cases, EUR/USD is the best option, given the trading volume of this currency pair. It’s the most popular asset to trade on also because of lower volatility and tighter spreads compared to other currency pairs. Any other major currency pair could be considered. An important factor of the right choice is to understand fundamental processes which have the largest impact on the asset’s price action. It would tough to make a stable profit on exotic pairs for a beginner, as sometimes the market is completely unpredictable for those instruments. Sometimes it happens that the main trading idea is based on exact assets like gold or S&P500. In that case, the choice is obvious.
Choosing analytical instruments.
After the main idea is clear, the timeframe and the currency pair for trading are chosen, it’s necessary to pick up instruments for analysis and setting entry and exit points. The key rule for that is to avoid an exaggeration. As practice shows, the most effective trading strategies are the most simple ones. Those systems, which have a glut of technical indicators, different setups and other signals, come together with contradiction to each separate conclusions, misleading the trader and creating mistake-driven provocatives.
If the system is based on indicators, then it does not have to contain more than 2 - 5 technical indicators. The required minimum is one trend indicator, identifying the deal direction and one indicator measuring overbought and oversold levels (oscillator), which will help to avoid false signals.
If the strategy is based on candlestick pattern analysis, then the trader must have a deep knowledge of the price action patterns. If the graphical analysis is planned to use, then it would be required to know well several figures such as triangles, flags, double tops, etc.
It’s also worth deciding whether news and other fundamental events will be considered in the decision-making process (if the strategy is based on technical analysis only). If the system is developed on fundamental analysis, then it’s better having a preliminary list of what news should be taken as the main reasons to trade on. News can be followed with help of the economic calendar and special indicators.
Entry and exit rules.
The main important decision has to be made on what type of orders the trading will be operated: postponed orders or market execution. On one hand, postponed orders help to avoid fake entries, but on the other, they limit a potential profit due to the fact that the price goes for a certain distance before the order is triggered.
It’s also the best way to decide what relation should have take-profit and stop-loss orders. Some trading systems suggest an obligatory setting of take-profit orders with a fixed requirement in the number of pips. Others allow a tentative profit with the condition of trailing stop order. Although, the stop-loss order is a requirement for both options. That’s the risk limitation, protecting trader’s capital from unpredictable market events like internet line access or electricity cut.
All of the rules have to be fixed on paper or in a separate file, as the check-list is necessary. After that, you can proceed with the trading strategy testing.
Testing on history or demo account.
The main step is to test the strategy using historical data. That would give statistics, as well as a preliminary understanding of its profitability. Although historical data is not actual forever, and the strategy’s results will show more effectiveness in real market conditions.
Before setting the system on the real account, a demo-account test should be made. The testing time depends on the timeframe chosen. Intraday timeframes like H1 and H4, especially D1 would take months to analyse, while a scalping trading technique could be tested in one single week.
Every trade must have a trading strategy. Sometimes beginners might think that they would be able to trade on own intuition only, especially if that delusion is supported by a couple of profitable deals. Moreover, some cases are known when experienced traders made enormous money while opening deals based on intuition or even against their own strategies rules.
However, the key factor in that exception is the experience. A professional trader is able to understand when its time to turn on the intuition, and when it’s necessary to trade on strict system. Usually, intuition is used very rarely, and in most cases, to enter the market without expecting the signal to occur, but not to open a deal against the rules and get the loss as the result.
Anyway, only professionals can allow themselves to open such an action without any significant consequence for their capital. The key answer here is the experience. Years, if not decades, of hard work. Novice traders, who decided to start making money by FOrex trading, have just one way - the way of systematic trading.
Moreover, there's one nuance which is missed even by experienced traders sometimes. That’s the logic background of the trading strategy. That’s extremely important. This is why if you do have a large experience of Forex trading, you should remember about the main trading idea which is the base of any trading system.