Trading Strategy

After 2 years of trading and learning about the stock market, I feel it’s about time to write about my trading strategy for anyone who trades similarly to me.  These rules are continually developed as I learn more about myself through introspective statistical analysis.  I’ll run through each top and write a little about why I think it’s important.

Mission statement
Conservative equity growth through high-probability trading of US equities with a focus on capital preservation and risk management.

Main goals

Protect my capital
Trade to trade well by focusing on trade metrics, rather than P/L
Acknowledge and control risk
Seek probability
Use rules and management to eliminate emotion
Statistical analysis of trading activity to identify areas of strength or weakness

Risk management
•    Define risk
-Outline the maximum percentage of your capital that you are prepared to lose in each trade.  My current maximum risk per trade is set at 0.75%.

•    Risk/Reward ratio
Using technical analysis, identify a logical price target and a price level that represents an exit area (stop loss).  The risk reward ratio is (target price-entry price)/(entry price-stop price).  Originally, this was set to 3 – but after a large sample size of trades was analysed, this has been moved to 4.  This means that as a minimum, I am risking $1 to make $4.

•    Position sizing
Using my defined risk% per trade and the trades risk reward ratio, I then calculate my position size using an excel calculator.  Generally, PS=(R%/(current price-stop price)).  My calculator also provides reduced position sizes if I want to scale-in

•    Allocation
Given that my rules state no more than 3 open trades at any given time, the initial position size is limited to an overall value of ¼ of my total capital.  It is not set to 1/3, as I like to have cash leftover should I look to add to the position.

•    Accept risk
At all times, I am prepared to lose all of my predefined risk per trade.  I acknowledge that risk is unavoidable in trading and that managing it is the only solution to a healthy equity curve.

•    Overall account drawdown
I will stop trading should my capital drop to 70% of its original value

•    In-a-row limit
I will cease trading for 4 trading weeks should I sustain 5 successive losing trades.  This is a mechanical method of avoiding tilt and emotion.

•    Maximum monthly loss limit
I will stop trading for the calendar month should my capital reduce by 5 times the starting maximum risk per trade value.

•    Win%
Aim for an overall win% rate of no less than 30%

•    Sharpe ratio (R)
Aim to maintain an R value above 1 (continuous)

•    Margin
Margin reduces the efficiency of risk management; therefore I shall never trade on margin.

Trade events

•    I acknowledge that each trade is a unique and separate event which is statistically independent of any other

•    Pre-defined trading plan

Each trade will have a pre-defined plan for the duration of the trade, which outlines entry criteria, position size, maximum risk, r/r ratio and targets.  Seek to only trade stocks that you have thoroughly analysed using technical analysis.
•    Entry criteria
-The entry of all trades is based on technical analysis of the stocks daily chart with volume and price action the primary indicators.  However, the following factors also influence the point of entry
—    Internals – Breadth, A/D & VIX (inverse) should be strong if seeking to enter long, and weak if looking to enter short.
—    Market trend – Seek to trade in the medium term (50 days) direction of the market
—    Inter market analysis – Evaluate potential reversal points in commodities, bonds and US dollar for added probability
—    Relative strength – find strength (long) or weakness (short) in the sector

•    Setup probability
-Trade continuation in direction of major trend only
-Seek to trade setups which have the best frequency to net% ratio

•    In-trade management
-Continue to review trade upon entry to determine whether bias is still in trade direction
-If trade is working well, try to find a logical price area to move your stop to either reduce or eliminate trade risk
-Seek opportunities to add to your position on continuation moves in the direction of the trade

•    Exit criteria
-Pre-defined target or stop loss area
-Trailing stop
—    To protect capital, I frequently trail a stop in profitable trades.  This is also to eliminate risk.  It is at discretion, but usually measured in terms of max risk (i.e. at ½ risk move a stop to breakeven) or near targets (at ¾ to target, move stop to ½ target).
-Locking-in and scaling out
—    Based on in-trade analysis, it may be worth offloading ¼, 1/3 or ½ of the position to secure profits and eliminate risk.  If the trade is finding some key resistance, then I may offload ½.  Should the price be approaching target on strength, I may offload ½ and move a hard stop.
-Change in sentiment
—    Should the technical setup consider taking the opposite direction of your trade either close trade, move a tight stop or scale-out depending on severity of correction and overall market sentiment
-Win to loss trade
—    Do not allow any trade that has had a maximum profit of ½R turn into a losing trade.

•    Stock selection
-NYSE and nasdaq equities and ETFs.  No forex or futures contracts.
-Seek to trade mid-cap or larger stocks
-Seek average dollar volume over US$5m per day
-Clean charts only
—    Avoid choppy charts; trendless, heavy candlestick wicking, erratic price action


•    Open position limit
-Set to a maximum of 3 at any time
•    Do not scalp
•    Do not day-trade

Trading journal

•    Maintain a journal of all trading activities; for each trade, record:
-Entry date
-Position size
-Entry price
-Stop price
-Limit price
-Entry reason
-Exit date
-Exit reason

•    This data allows you to discover your key metrics
-Risk reward ratio (per trade & x)
—    It is advisable to maintain a minimum, and to seek and average greater than 1.5 of your stated minimum ratio
-Sharpe ratio (per trade & x)
—    Essential trading statistic.  Measures your performance relative to your risk.  This is calculated by (Net profit/Max risk).  Use in relation to your other metrics e.g. – risk reward minimum = 1.5 with a Sharpe ratio of 0.5 and a win% rate of 40% would be bad for equity curve.  Mine is currently 1.40 (net average) or 1.30 (cumulative average)
-Expectancy (per trade & x)
—    Calculates ‘expectancy’ based on (average winning trade profit/win%)/(average losing trade loss/loss%).  Ideally, expectancy should be greater than your minimum risk percentage value.  Mine is currently $368 (0.8 max R) and needs improving.
-Win% (x)
—    I try to maintain a win% rate of 40.  With a min r/r ratio of 4 per trade and a Sharpe ratio of 1.3-4 and a win% currently at 58% the probability that my equity curve will continue to increase are high.

Journal sample

•    Other statistics
-Statistical analysis of my performance is paramount to understanding how you are performing, so other stats I include are:
—    Net P/L
—    Average net P/L
—    Predicted P/L in terms of Sharpe (similar to expectancy)
—    Gross win
—    Gross loss
—    Average profit per winning trade
—    Average loss per losing trade
—    Average risk reward ratio
—    Average risk exposure
—    Average risk exposure in terms of percentage of maximum risk per trade
—    Amount and percentage of times you have lost maximum risk
—    Amount and percentage of times you have exceeded maximum risk
—    Amount and percentage of times you have met or exceeded original price target
—    Amount of times you have closed positions at a net P/L less than original maximum risk
—    Number of trades
—    Average time in trade
—    Short %
—    Long%
—    Number of times exited trade on day of entry
—    Average distance of net p/l from original maximum reward
—    Month-on-month breakdown of net p/l, net %, number of trades, win %, average p/l, average Sharpe ratio, average r/r ratio
—    Statistical trade – using averages of all data, display your average trade in terms of size, direction, max risk, max reward, time held and net p/l


•    Graphical methods
-Bar chart of profit per stock – identify which stocks and sectors you trade most efficiently
-Area chart of R/R ratio to Sharpe ratio per trade – identify how often your trades perform relative to targets (seek parity)
-Donut chart showing setup efficiency – percentage of times used against percentage of net p/l for that setup.  Identify most effective setups in terms of profit performance
-Bar chart of each trade with max reward, max risk and net p/l.  The closer the reward and p/l bars to each other, the better the trade – so long as max risk is ¼ or lower


Continued personal development

The goal of such thorough analysis of my trading performance is to help me develop my trading strategy.  It allows you to identify areas of weakness and how they can be improved.  It also allows you to focus on what gives you higher probability.  Lastly, it helps you set goals and outline how to achieve them.

Traders should always be looking to improve – whether it be learning more about interest rates affecting the market, intermarket analysis, sector rotation, risk profiling etc.  There is always something to learn, however it is normally hard to identify what you need to learn about specifically.  This is where stats analysis is most useful.

Lately, I have developed the following goals or changes to rules based on my stats:

-Increase minimum risk reward ratio to 4.  46% of my losing trades had entry criteria between 3 and 4.
-Short term restrictions on positions open at any time and amount of trades taken on same day.  Average win% rate improved 20% month-on-month and 8% on average through better spreading of risk.
-Combined, these rules led to a cumulative Sharpe ratio increase to 1.5 from 1.13.
-ALWAYS trade trend direction.  Through contrarian trading in early Q1 I had 75% of my trades short with 46% of them being profitable.  In the same time period I had 25% trades to the longside with a 70% success rate.

My most recent goals are the following (May 2010)
-Get greater correlation between expectancy and average profit
-Maintain cumulative R in band between 1.25-1.75 for May
-Maintain win% rate above 40
-See a gain on percentage of trades that meet or exceed original target

One thought on “Trading Strategy

  1. Pingback: Strategies ~ Plan | The Trader's News

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