How to Create a Trading Strategy
One of the first steps in learning how to trade is to develop a trading strategy. The first step in creating a trading strategy is to analyze your trading personality. If you are the kind of person that loves to hunt for bargains then you might want to consider becoming a contrarian trader that trades against the grain. If on the other hand you like to find momentum and bet with the favorite before others jump in, then breakout trading might be your ticket. By analyzing how you purchase merchandise or services, you might have a better idea of the type of strategy you will be successful creating.
Once you determine the type of personality you have and what might be successful, you can then evaluate whether you want a discretionary strategy or systematic strategy. A discretionary trading strategy is one where you decide based on your own criteria when to pull the trigger on a trade. It can be based on fundamental analysis which is determining if the most recent news is priced into an asset. Another way to trade is to use technical analysis which is determining if past price action will predict future price movements.
To create a systematic trading strategy you want to test to see if it has worked in the past. This process is referred to as back-testing. Back-testing allows you to set your criteria and see if your trading strategy would have worked at different periods in the past. One of the keys to back-testing is to make sure that you don’t set very stringent criteria, which makes it fit the curve. This means that you find a situation that only happens occasionally, and might have only worked in unusually circumstances. You also want to back-test on multiple periods to see if you strategy works when the market is moving higher as well as moving lower.
You can back-test technical indicators as well as fundamental indicators. Many might test actual versus expected earning or even macro events like jobs data or GDP. Many traders will combine both fundamental and technical analysis to generate a systematic trading strategy.
A discretionary trading strategy is one where you find either technical or fundamental criteria that helps you determine the best time to enter a trade. You are not following a specific routine, and it is up to you when to exit your trade.
Once you have found a strategy that you believe will work, you should then paper trade the strategy. This is the process of trading using a demonstration account, and real-time prices. You should manage a demonstration portfolio for a reasonable period before determining if it works and is a candidate for real capital.
There are a number of steps needed to generate a successful forex trading business. Besides prudent risk management a robust trading strategy is key to generating income over the long term.