The importance of the trading strategy
Content of the lesson
- Why it is so important to have a trading strategy
- What an edge is
What is a trading strategy?
A trading strategy is basically a set of rules that determine when we should enter and exit the market. It is often based on technical/quantitative analysis and may involve moving averages and other trading indicators, as well as price patterns.
The goal of a trading strategy is to define the market behavior that is likely to precede a particular market movement. For example, if we know that the market usually rises after two days of decline, we can use it as a buy signal in a trading strategy.
Patterns in price data or other data that have some form of predictive value are called trading edges. You may want to memorize the word because we’ll use it a lot in the future.
As you can see, the very purpose of a trading strategy is to capture a market behavior that has an edge and establish the rules and criteria for using that edge. Without an edge, we cannot make money on the stock market, because we would have no idea where the market is headed at any given time.
Market noise and edge
If you understand what an edge is, you have come a long way towards understanding what is required to achieve profitable trading. Finding an edge, on the other hand, is a difficult task because most of the market’s movements are pure noise. For the most part, the observations we make are the result of sheer coincidence. And this is what makes it so difficult to find a real strategy.
Even if you simulate a strategy on historical data, you can never be sure that it will work in a real-time market. In fact, testing a strategy on historical data alone is not enough to ensure profitability if you do not know how to deal with the impact of chance on your results. There are plenty of reasons why strategies don’t work in live trading.
Hence, there is always a need to test for robustness, any strategy that performs well on historical data, before using it to trade a real account.
The day trading strategies that we have developed have been live for several years and have passed our “incubation period”.
The trading edge is your most important asset
When it comes to trading, the trading edge or the strategy is by far the most important factor. In trading, there is a lot of discussion about having the right mindset or the right market behavior. But at the end of the day, this is valueless if you don’t have an edge in the first place. A trading edge is by far the most important thing!
Just as important as the strategies themselves, you need to know how your strategies correlate and behave as a portfolio of strategies. This aspect is often neglected and most traders find out the hard way: by losses when all your strategies are losing at the same time.
Thus, first, you need to make sure you have good trading strategies with some real edges that work well together as a portfolio of strategies.
Secondly, you need to focus on your mindset and risk management rules.
Summary
As a trader, you need a good trading strategy to make money, and that is the most important competitive advantage you can have. Without a trading strategy with a proven edge, you will not succeed as a trader.
Further reading
Tharp, V.K. (2006). Trade Your Way to Financial Freedom. McGraw-Hill Education.
Schwager, J.D. (2012). Market Wizards, Updated: Interviews with Top Traders. Wiley Trading.