How To Create Your Own Trading Strategies
Learn how to create your own trading strategies. Learn what variables to consider, how to come up with entry criteria, how to determine where to take profits and losses, how to manage risk, and how to assess your strategy for viability.
Creating a trading strategy may seem like a daunting task, but it’s actually quite fun. Creating your own strategies forces you to delve into the charts and really notice small things that may put the edge in your favor. You can, and should, go through this same detailed process with someone else’s strategies as well. My trading courses provide a roadmap for how I navigate the markets. Others can use my roadmap, but they still need to know how to read the roadmap…and that only comes from looking at lots of charts, practicing the strategies, and understanding why things are done in a certain fashion. And we only understand why things are done in a certain fashion if we look at lots of charts with an open and inquisitive attitude.
In university, I discovered that I performed a lot better if I didn’t memorize. Instead, I spent time trying to understanding the underlying principles of what I was learning. For example, let’s say you are taking a math class and there is a big formula you’re learning about. Most people memorize and formula and then hope they can solve for the missing variable when asked.
A far better approach is to understand what all the symbols in the formula mean, how they work together, what it provides us with, and how it can be manipulated in other ways. If you really understand what the formula is telling you, and you can put it into words, you don’t need to memorize the formula because you will always be able to recreate it at any time with your understanding. You will also be able to adapt it to different circumstances (which tests often require you to do), whereas the person who simply memorizes likely won’t be able to to do this as well. The point is, immerse yourself in the process and really understand why a strategy is telling you to buy sell at certain times, and you will be far better off than simply trying to blindly follow rules you don’t understand. This applies whether you are using someone else’s strategy or creating your own.
If you come across a strategy that you like and that “sits well with you,” then incorporate that strategy into your trading plan. I encourage all traders to “personalize” any strategies they use, though. I created all my own strategies, so I believe in them. You may like part of my strategy, but may think certain aspects of it should be altered. By all means do! Take what you like from strategies and leave the rest. Test out better ways of doing things. By making it your own and doing your own research you will start believing in your method. And having confidence in your method is a requirement for successful trading because the market is going to constantly make you second-guess yourself to prompt poor decisions. If you aren’t confident enough to stick with your method, you will fall into these traps. You only gain confidence by putting in lots of effort and seeing that your strategy works.
I have been trading full-time since 2005, and I am still so excited about it that I have to share what I am finding and learning. I spend many hours each week just flipping through charts, noting where I could have done something different to increase profits or reduce risk. Often, these insights don’t reveal much, because over many trades I see that I am doing the right thing by sticking to my current plan. But occasionally there is a revelation, and a new strategy is born. I notice something I didn’t see before, even after all these years. Markets are so dynamic that there are countless ways to make money…which also means there are countless ways to lose it as well.
Creating a trading strategy that makes money is truly a joyous event. Let’s look at how you can start to build your own trading strategies, or find ways to make strategies you are currently using better.
How to Create Strategies
For the purposes of this article, we will focus on finding day trading and swing trading strategies. I typically rely solely on price charts for these styles of trading. Therefore, I tend to start my strategy creation journey by looking at charts. The first question therefore is: What charts do I look at?
- If day trading. Start out by picking one stock, forex pair, or futures contract you will trade. Once you find a strategy that works in one asset, you will likely be able to adapt it to other markets. For forex traders, stick to the EURUSD or GBPUSD. For futures traders, the S&P 500 Emini (ES) is a good one to start with. The S&P 500 ETF (SPY) is good for stock traders starting out, or check out the Day Trading Stock Picks page for other ideas.
- If swing trading, trading what is hot is a good place to start. Every week or two look at the top performing stocks (can use Finviz to do this). These are the stocks offering the most potential, so we want to analyze their charts and see how we can exploit the movement. You can also choose to find charts based on some other criteria.
The next step is to look at lots of charts. For day trading, this means looking through the last several months of 1-minute, 5-minute, or any other style of intraday charts. For swing trading, it means looking at how all the top performing stocks have moved over the last year (or whatever group you decide you want to take trades in).
Within those charts, we are looking for any major areas where profit could have been made. I typically start by looking at bigger price moves on the chart. I then consider what was happening on the chart that could have tipped me off to get into that trade. How could I have taken advantage of the big move(s)?
We then look at other charts (or days, if looking for day trading strategies) and see if we can find other moves that look similar (we will!). We are looking for similar conditions, across many charts/days, that resulted in the price making a significant move we could have capitalized on.
Our major question now becomes, what precipitated the move? We need to look for ways the market alerted us that a bigger move, in a particular direction, was forthcoming.
Here is a sampling of the questions you want to ask yourself in order to start building your strategy.
Is there a chart pattern, a candlestick pattern, a news event, or do moves tend to occur at a certain time of day?
Did the move start before a certain session (NY, London, Tokyo, etc), near the close, mid-day? Is there any relation to an opening or closing market? (See: Forex Market Hours and Hourly Tendencies).
What is the longer-term trend? What is the short-term trend? Is the short-term trend ending and the price is starting to move back in the long-term direction?
How fast and how far are the recent price waves compared to prior price waves?
Looking At How to Enter
How could I have gotten into the trade (market order, limit order, stop order, stop limit order)? Which order type works best for what I am trying to accomplish?
Looking at my answers from above, how could I take advantage of this opportunity in real-time? Was it even possible to get in at a decent price (consider price gaps and volume)?
Does the pattern I am watching give an entry signal such as a breakout of resistance/support/pattern? Does the price tend to wiggle around a certain dollar amount, or for a number of days (on average), before it takes off?
Are there any technical indicators that could aid in filtering out bad signal or confirming good ones?
Does the asset generally stay within a certain price area for the day?
Consider catalysts, like a regular news event, and how it could be exploited for profit. See Non-Farm Payroll (NFP) Forex Strategies.
Considering the Exit
Getting in is one thing. But we also need to think about who we will get out. The exit is very important and deserves as much consideration as the entry.
What market conditions, chart patterns, or price moves are present once the trend/move (that we entered into) has topped or bottomed and is starting to reverse?
How far does the price tend to run before it pulls back? Do I want to get out before the first major pullback, or is it worthwhile to hold through it?
If my entry criteria disappear, can I use that as an exit?
How can I stay in the move to capture the bulk of it, but also not give up too much profit when it reverses?
Not all trades you enter will work out. For the ones that don’t, consider where to place a stop loss so that the risk is capped and won’t significantly hurt the account.
Are there any indicators that aid in this?
Would a trailing stop have allowed me to capture a large profit? If so, what should my trailing stop be?
Would a fixed number profit target work? For example, if risking $100, could a profit target be placed at a profit target yielding $200, $300, etc.?
Does the asset generally stay within a certain percentage move for the day? All assets have average movements per day, so could this be used in determining when to exit? Think Average True Range, daily range, or other volatility statistics.
Money management helps us determine if a trade is worth taking, how much we are willing to risk, and whether the potential reward warrants taking the risk in the first place.
Based on the entry point and stop loss, what is the risk in dollars based on the position size? The amount lost if the price hits the stop loss should not be more than 2% of total account equity, and should ideally be less than 1%.
What is the potential profit? This is based on the target, or what the typical trailing stop loss produces based on the charts you looked at.
Based on the above two answers, is the trade worth taking? If the risk is too large, or I am getting into moves too late, I need to adjust. If I am giving up too much profit when prices reverse, I need to adjust.
For day trading, profits should be at least 1.5x risk. For swing trading, profits should be 2x risk. Your average, over the many trades you look at, should be above these figures.
Do the conditions you identified to trigger a trade occur at other times, and not just before large moves? For example, are you going to get a lot of false signals? Whenever your entry criteria occur, you need to count that as a trade. If the entry criteria result in too many trades (mostly losing ones) you need to refine your conditions.
Can you cut down on false signals by only trading a certain time of day, adding indicators, or filtering out certain patterns? Could you only trade in the dominant trend direction? Or only after the price has made a strong reversal?
If you would have lost a lot of money implementing a strategy, that tells you something worthwhile! Doing the opposite of what you set out to do may be a path to profits. I actually love false breakouts and use them to my advantage all the time. If a strategy is losing you money, someone else is making money! Think about what that group of traders is doing!
In short, you want to analyze your charts looking for opportunities. Examine those opportunities and construct how you could turn those opportunities into real money, without exposing yourself to excessive risk.
Testing the Strategy
Once you have an idea that seems to work on the charts you have been looking at, test it more rigorously. See if the strategy works on recent movements (new charts/different days), looking for at least 50 or more “trade signals.” See if the strategy is still capable of producing a profit.
Check for profitability by adding up the wins and losses and getting a net result. Also factor in commission costs. If the strategy continues to work, start trading it in real-time in a demo account (see 5 Step Plan For Forex Trading Success). If you produce a profit in the demo account (using that strategy) over a few months, then consider trading the strategy with real capital. During demo trading, and even once you start live trading, track your trading statistics to gain insight into what is working well and what could be improved.