In finance, a trading strategy is a fixed plan that is designed to achieve a profitable return by going long or short in markets. The main reasons that a properly researched trading strategy helps are its verifiability, quantifiability, consistency, and objectivity. The development and application of a trading strategy follows eight steps: (1) Formulation, (2) Specification in computer-testable form, (3) Preliminary testing, (4) Optimization, (5) Evaluation of performance and robustness, (6) Trading of the strategy, (7) Monitoring of trading performance, (8) Refinement and evolution.
Trading strategies can be broadly divided into the mean-reversion and momentum groups. Trading strategies are usually verified by backtesting where the process should follow the scientific method. In the words of E. P. Chan, in the book Algorithmic Trading:
We should start with a hypothesis about an arbitrage opportunity, maybe based on our own intuition about the market or from some published research. We then confirm or refute this hypothesis by a backtest. If the results of the backtest aren't good enough, we can modify our hypothesis and repeat the process.
Types of trading strategies
The term trading strategy can in brief be used by any fixed plan of trading a financial instrument, but the general use of the term is within computer assisted trading, where a trading strategy is implemented as computer program for Automated Trading.
The Trading strategy is developed by the following methods:
- Automated Trading; by programming or by visual development.
- Discretionary trading; by pen and paper learning by the faults during trading.
A trading strategy can be executed by a trader (Discretionary Trading) or automated (Automated Trading). Discretionary Trading requires a great deal of skill and discipline. It is tempting for the trader to deviate from the strategy, which usually reduces its performance.
An automated trading strategy wraps trading formulas into automated order and execution systems. Advanced computer modeling techniques, combined with electronic access to world market data and information, enable traders using a trading strategy to have a unique market vantage point. A trading strategy can automate all or part of your investment portfolio. Computer trading models can be adjusted for either conservative or aggressive trading styles.