The first step in the process of designing a trading strategy is to choose which type of strategy will be used and a timeframe to trade. As stated earlier, the strategy can seek different goals and should be according to each person’s preferences and trading style. The different strategies are designed to take advantage of some market conditions or market inefficiencies.
Once the type of strategy is selected, the researcher should come with different ideas about the strategy by reading research papers, perform statistical analysis for a group of assets, evaluate technical indicators on stocks and conduct exploratory data analysis to get better insights about the assets.
A common workflow in generating a trading strategy after the research activities consists of:
- Signal generation process of the strategy
- Trade execution
- Risk management
Let’s look at each of these in detail.
1. Signal Generation
A trade signal is a trigger for buying or selling a security. This forms the primary trading logic of a strategy. The process of generating the trading signals is at the heart of any trading strategy.
The analysis to generate these trading signals can be based on multiple disciplines such as technical analysis, fundamental analysis or quantitative analysis, as well as economics.
- Signals can be generated based on technical indicators such as Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), Bollinger Bands (BB), Stochastic Lines and Moving Average Crossover. These are only a few examples as there are tons of technical indicators to create signals.
- Signals can also be created based on resistance and support lines as well as chart patterns that lead to breakouts. These types of signals try to ride the volatility of stocks and are used in momentum strategies.
- Signals can also be based on statistical approaches as is the case in pairs trading or mean reverting strategies. For example, if the mean reverting strategy was built on two assets when the relative returns of both assets deviates one or two standard deviations from a certain threshold, a signal to go long and to go short is generated.
So the first step is to find signals that would produce some alpha in the short or long term. Once we have the signals generated, we should analyze how the orders will be triggered and what would be our approach to risk management.
2. Strategy Execution
Strategy execution is one of the key aspects in building a trading strategy. Transactions of the strategy are executed based on different order types.
Market Orders and Limit Orders
The most common order types are the market orders and limit orders. Market orders trigger transactions immediately and the final price could be different from the order price.
On the contrary limit orders trigger transactions at a specific price, and the final price is identical to the order price.
An important concept which arises while using market orders is called slippage. Slippage happens when trades get a different price than the price expected on an entry or exit from a trade.
Slippage increases when a fundamental news is coming such as an Earnings Report or a Federal Reserve Announcement. To avoid slippage, one can use limit orders to enter or exit a position.
Stop Orders and Stop Limit Orders
Traders also uses stop orders and stop limit orders. Stop orders can be used to enter or exit a position but are only processed if the price reaches a certain level. In case of a buy stop order, if the current price is at USD 15.50, the stop order would be placed at USD15.60, and it is only triggered if the current price reached the USD 15.60 level.
The stop order, also known as stop loss order, can also be affected by slippage. On the contrary, a stop limit order is a combination of a stop and a limit order and ensures that the trader gets the desired price. In this order type the stop and limit prices might be different.
If the current market price is at USD 15.75, a trader could place a stop limit order to exit position with a stop of USD 15.40 and a limit of USD 15.30. When the price reaches USD 15.40 the order becomes a live sell limit order and will be filled only at USD 15.30 or better price. As long as the price is above 15.30 which is the limit price, the trade will be fulfilled. Stop limit orders for exit are used because investors don’t want to sell below the limit price and wait for the price to rise back to the limit price.
Other Order Types
Finally there are more complex orders that brokers provide such as Immediate or Cancel (IOC), Market on Open, Market on Close, Good-till-Canceled (GTC), Good-till-Date/Time (GTD), Iceberg/Reserve that allow traders to create more complex executions models.