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 difference between short trading and long-term investing is in the opposite approach and principles. Going short trading would mean to research and pick stocks for future fast trading activity on one's accounts with a rather speculative attitude.[1] [2] While going into long-term investing would mean contrasting activity to short one. Low turnover, principles of time-tested investment approaches, returns with risk-adjusted actions, and diversification are the key features of investing in a long-term manner.[3]
For every trading strategy one needs to define assets to trade, entry/exit points and money management rules. Bad money management can make a potentially profitable strategy unprofitable.[4]
Trading strategies are based on fundamental or technical analysis, or both. They are usually verified by backtesting, where the process should follow the scientific method, and by forward testing (a.k.a. 'paper trading') where they are tested in a simulated trading environment.[5]
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.
Technical strategies can be broadly divided into the mean-reversion and momentum groups.[6]
All these trading strategies are basically speculative. In the moral context speculative activities are considered negatively and to be avoided by each individual.[8] [9] Who conversely should maintain a long-term horizon avoiding any types of short term speculation.
The trading strategy is developed by the following methods:
The development and application of a trading strategy preferably follows eight steps:[10] (1) Formulation, (2) Specification in computer-testable form, (3) Preliminary testing, (4) Optimization, (5) Evaluation of performance and robustness,[11] (6) Trading of the strategy, (7) Monitoring of trading performance, (8) Refinement and evolution.
Usually the performance of a trading strategy is measured on the risk-adjusted basis. Probably the best-known risk-adjusted performance measure is the Sharpe ratio. However, in practice one usually compares the expected return against the volatility of returns or the maximum drawdown. Normally, higher expected return implies higher volatility and drawdown. The choice of the risk-reward trade-off strongly depends on trader's risk preferences. Often the performance is measured against a benchmark, the most common one is an Exchange-traded fund on a stock index. In the long term a strategy that acts according to Kelly criterion beats any other strategy. However, Kelly's approach was heavily criticized by Paul Samuelson.[12]
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 while the price variation is favorable or aggressive trading styles e.g. Scalping is considered a form of trading in financial markets with a very short-term approach that is why it is associated with aggressive style.[13] [14]
Trading activity boost and development is connected with the era of internet inception. First online related trading activity and rapid growth of electronic commerce started in 1997–98.[15]