Creating Your Trading Strategy: Simple Steps and Common PitfallsWhen it comes to using technical analysis for making trading decisions, a solid, simple, yet robust trading strategy is an essential foundation for traders to achieve consistent profits. However, constructing that strategy can be a challenge, especially for those new to trading, as there is an overwhelming amount of information out there. There are nearly countless books written on the subject of trading strategies. We want to simplify the process so that you can develop your own approach and get started.
Step 1: Determine your market, timeframe, and trading methodology
The overall first step in constructing a trading strategy is to determine: the market, trading methodology, and time frames you wish to take on. This will help you choose the appropriate indicators and approach to your trades.
There are several markets to choose from, but it is highly recommended that you pick one when you first start trading. It is easy to look at all of the opportunities present in the market and potentially overplay your hand by trading too many, which can lead to devastating losses. As an example, if you wanted to scalp the forex market, it would be best to pick one or two currency pairs to trade rather than trying to monitor all major currency pairs for opportunities.
Defining your trading methodology is another aspect of this step. Are you intending to hold stock or ETFs long-term? Do you want to swing trade or day trade cryptocurrencies? Maybe you believe you want to scalp the forex market. Doing your own research into these varying methodologies is a paramount step in formulating your strategy. Research all of them to better understand what they are and how they may fit your overall goals and risk tolerance.
Your trading style can help determine what overall time frames you are looking at. A long-term holder will typically rely on higher time frames such as the daily or weekly timeframe. While a trader who predominantly scalps may rely more heavily on the 1-minute or 5-minute timeframes. Choosing the appropriate time frames and sticking with them for your trading decisions will help you achieve discipline and consistency.
Step 2: Choose your indicators
When choosing indicators for your trading strategy, it is important to know that there are several broad indicator categories to choose from. Included in these categories are: trend-following indicators, momentum indicators, volatility indicators, and volume indicators. Trend-following indicators help traders identify the direction of the trend, while momentum indicators measure the overall strength of a trend. Volatility indicators help traders identify the level of price volatility in the market, and volume indicators measure the amount of trading activity taking place. Traders commonly pick a combination of these to be included in their strategy to help give a clearer overall picture of the potential market direction.
It is crucial to keep your strategy simple, so we recommend using 2-4 indicators at most. Choosing the right indicator combinations can be difficult, but is crucial to the success of your trading strategy.
While it may be tempting to use multiple indicators in the hope of finding the perfect combination, having too many indicators can do more harm than good. When you have too many indicators, it becomes difficult to make clear decisions. You may end up with conflicting signals that can cause confusion and lead to losses or missed opportunities.
It's important to choose only a few indicators that complement each other and provide valuable information about the market conditions. This will allow you to make more informed decisions and stick to your trading plan with greater confidence.
Step 3: Define your entry and exit rules
Once you have chosen your indicators, the next step is to define your entry and exit rules. This will help you determine when to open and close trades. For entries, you are taking the signals generated by the indicators you have chosen in step two and making a clear and definable set of rules for entering a trade. There can be other factors, such as market structure that play a role, but from an indicator standpoint, it is good to make these rules easy to follow.
Your chosen technical indicators can also be used to exit trades. For example, traders may incorporate moving averages into their strategies, and moving averages can be used for both entries and exits. Other exit conditions include having hard set take profit or stop losses. We covered this topic in our stop loss article a few weeks back (and we highly recommend you check it out). No matter how you decide to make your entry and exit rules, please ensure you implement proper risk mitigation techniques to protect your account, and in turn, help you grow.
Step 4: Backtest your strategy and practice, practice, practice
Before putting your strategy into action it is essential to backtest it using historical data. This will help you determine if your strategy is profitable and identify any areas that need improvement. Note that while backtesting is an important part of determining if your strategy is successful, past results are not indicative of future success.
Another aspect of this step is putting your strategy into practice. We never recommend diving straight into the deep end with your money before practicing. There are many free demo account options out there to get started. It is recommended that you find one that fits your needs based on the market you will be trading. The key part of this step is patience and carrying over that patience for when you are ready to go live with your strategy.
Common pitfalls to avoid:
When constructing a trading strategy, it is important to avoid common pitfalls that can lead to losses or missed trading opportunities. Some common pitfalls include:
Overcomplicating your strategy: Using too many indicators or rules can make your strategy overly complex and difficult to follow.
Failing to backtest and practice: Backtesting is essential to ensure your strategy is profitable and identify areas that need improvement.
Ignoring risk management: Proper risk management is essential to minimize losses and maximize profits.
Losing patience and jumping right in: It is easy for anyone to find a hot new indicator they believe is their edge in the market and to subsequently jump right into trading. Don’t fall into this trap as the outcome is seldom good! Take your time and become a student of the market you are trading, and a student of your strategy
In conclusion, constructing a robust yet simple trading strategy using indicators requires careful consideration of your market and timeframe, choosing the appropriate indicators defining your entry and exit rules, and backtesting your strategy. There are other aspects of technical analysis that could be tied in between the steps listed above such as market structure and patterns. However, the goal of this article was to make the process as simple as possible to help traders get on the right path. By avoiding common pitfalls such as overcomplicating your strategy, failing to backtest, ignoring risk management, and chasing after losses, traders can increase their chances of success in the markets.
