Developing a Trading Strategy
I would just like to remind you that the purpose of this CFDs guide is not to give you a complete strategy to trade. It is to tell you how CFD trading works, how to open and manage your trading account.
However, you absolutely MUST fully appreciate the importance of using a sound trading strategy.
Any trader who is experienced will say a strategy should include:
- Entry criteria
- Trade time frame
- Money management
- Risk control
- Stop loss planning and of course,
- An exit point
Let’s just get an overview of these things:
There are so many ways to determine a possible entry point it is impossible to count them. You can use moving averages, trend lines, chart patterns, candlestick patterns, support/resistance levels, a wealth of technical indicators and much, much more. Then, when you start to consider using these things together, the different permutations are endless.
And that’s apart from any fundamental analysis (profits, dividends, P/E ratios etc) you might care to incorporate.
So many people believe that a reliable entry is the only thing that is important but strangely, this is can be one of the LEAST important aspects of a good strategy. You can actually make a good profit with considerably less that 50% winning trades provided the rest of your strategy, including money management, is sound.
You need to decide if you want to be a Buy and Hold investor or a shorter-term trader. Day Traders will have time frames in minutes or even seconds. They use Real Time (RT) charts that show the exact price that is present on the Stock Exchange floor. Real Time charting software is quite a bit more expensive than EoD and really only of value if you are going to sit in front of the screens to do your trading. Day traders will usually close all trades by the end of the day and start with a blank sheet again the next day. They look for very small point gains on each trade but use large positions and open and close several (often many) trades per day.
Swing traders will look for short price swings or short trends and will use End Of Day (EoD) charts for analysis. A trade might last a few days to a few weeks.
Some traders prefer longer-term positions that last weeks or months. Your trading strategy might dictate your time frame or you can build a strategy to suit the time frame that you prefer.
The time you can devote to your trading will also dictate your time frame.
The shorter the time frame you use, the more time you will have to devote to your trading AND the more difficult it can be to make money.
Money Management and Risk Control
Essentially, you must look at how much you are prepared to trade with, how much you are prepared to risk on each individual trade and the size of your trades. The objective is to preserve capital if trading does not go well because once you are out of capital you simply can’t trade any more. Much of this subject has been covered earlier in this book but a point worth remembering is that if your maximum risk is a percentage of capital then if your capital decreases, so will your risk in money. This is a very good way of preserving your capital. Also, if you are opening more than one trade at a time, remember your overall risk across all positions.
Probably the hardest part of building a trading strategy is knowing where to place your stop loss and it is always a compromise. Some traders do not use stop losses at all. My firm belief is that you absolutely must or you will have little control over your maximum trade risk. Where to put your stop loss must be an integral part of your strategy and once you decide, you must stick to it. The danger of not placing a stop is that you are always tempted to let the loss run for a while longer to see if it turns around. This is a sure sign that you are now trading on emotion and not with a sound strategy. Usually a recipe for disaster because your emotions (fear and greed) are just about the worst traders in the world – more about that later.
There are a few basic methods of deciding when to close a trade.
You can exit at a calculated target price by using various technical tools including Fibonacci retracements or projections, projections from chart patterns, support or resistance levels and many others.
Determining reasonably accurate target prices can require some fairly advanced technical knowledge and is beyond the scope and purpose of this guide. If you have never heard of Fibonacci I suggest you ask for a book on technical analysis for your birthday!
As an alternative, you can decide that you are happy to take profit if the price goes in your favour by a certain number of points or a percentage of price. I know one trader who always closes a trade when he has made £100. I’m not sure that this is a good idea but at least it is a closing strategy.
Or you can use a trailing stop (that you move up as the trade progresses) and just stay in the trade until you are stopped out. All of these methods have their merits and downfalls.
So those are the basic ingredients of a strategy. They are all important BUT, they are not the only things that make up a GOOD trading strategy. There are two other vital ingredients:
- Your trading personality
- The ‘personality’ of the market you are trading