Let us say you are a highly motivated new trader and read several books, blogs and have found some things that works. The next critical step is to put together a complete working method.
This involves a step by step approach. It is an iterative process and once you master that you can put together several systems or variations of the setups. Once you understand the steps involved you can create your own system based on what a market wizard says in an interview or any other idea you come across.
Many time Stockbee members or readers of this blog traders share a concept with me and all I do is put together a working system by using interchangeable parts like entries, exits, entry set ups, exit set ups etc.
Think of these as lego blocks. Your task is to assemble them together in a functional coherent unit and make it work.
We need some valid way to select the universe of stocks we would be trading. We want to select the most profitable markets to trade. Because market is dynamic, we want to do this process dynamically as against using a static framework.
There are many ways to do these. Professional traders use dynamic vehicle selection strategies based on momentum , volatility, range contraction or range expansion.
Investors use attribute based model to select stocks. Value investors look for attributes like p/e, cash flow, book value, discount cash flow. Based on these attributes they select the stocks to invest in. Growth investors select vehicle based on earnings , sales, or margin growth or combination of factor. Momentum investors select vehicles based on momentum or lack of momentum.
You can choose vehicles based on attributes like market cap, size, trading volume, price, fund ownership, insider buying, year of IPO, country of origin, sector, short interest and so on.
Many of these attributes have been studied to death in last 50 years . There are many books published on these every year and most of the well known attributes that work are no secret.
We should only select attributes for vehicle selection which will give us most profitable opportunities.
There are potentially thousands of ways to select vehicles. Now this step is very critical because if we select more profitable markets to trade with then, we increase our probability of being profitable.
Vehicle selection is also a function of time scale you want to trade. If you are day traders, the attributes you would look for in a vehicle will be a combination of high trading volume, clear direction, large intra day range and enough volatility to make potential trading profits worth the risk and expense of trading. Or it can be stock with immediate news likely to lead to volatile moves during the day.
Swing traders look for vehicles likely to make explosive move in 3 to 10 days time frame. As a swing trader I look for explosive movers like WLH. That is my primary focus area for vehicle selection. WLH is up 15% in 3 days.
Selecting right vehicle is just one part of the equation. If you select right vehicle and enter it at wrong time you will have losses.
Once we select vehicle we select entry method. What kind of entry we want to make on this vehicle. Breakout, pullback, scaled, timed , etc are some of the entry choices we have.
Some traders use breakout based entries. They buy based on breakout of N days. Breakout based entries are very popular and there are hundreds of tactical variations of these used by traders and investors.
Some use non breakout methods like pullbacks to enter. Again several hundred variations of this are used by traders.
Again you can put together hundred way to enter a stock but the objective should be clear, to enter a properly selected vehicle at the start of a potentially profitable stage.
If you select right vehicle and right entry , your job is not over. You need to exit it at right time to be profitable.
Exit strategy has multiple considerations.
Your first exit is based on entry setup failure. This helps us protect our trading capital in event of the failure of entry signal.
Our second exit is based on meeting our intended profit objective or at level where the trade has achieved its objective.
There is a false belief among many traders that exit is most important part of trading.
Exits are also dependent on your trading time frame and style. A day trader by very definition enters and exits a position in a day. Swing traders enter at start of swing and exit at end of swing. Trend traders exit on trend change. Value investors exit on valuation reaching their objective. Growth investors exit at first sign of growth slowdown or at peak growth.
As a general observation, I have found that professional traders tend to exit into strength while ordinary investors exit on weakness and often are way late on exits.
Stops is important part of your trading mix and is used to enter, exit or manage risk.
Entry based on stops can help us enter a position at pre determined level . Same way exits based on stops can help you exit at predetermined levels or at certain profit levels.
Stops also allow us to control risk by avoiding catastrophic losses.
Once you have the above four elements of trading mix together, then you add risk selection to the mix.
Risk selection strategies are designed to manage risk of capital loss, to avoid catastrophic losses, to manage open position risk, to increase returns by use of leverage, or to decrease volatility of returns.
Your risk strategy determines how much you will risk per position. How many total positions you will have. What setup conditions will lead to you risking higher amounts or reducing risk.
For exactly same vehicle , entry and exit one trader can make 5 to 10 ties more profit on the trade if he risks bigger amount.
All these elements of trading mix are equally important and needs to be looked at in totality. When all elements are properly put together, you have a working profitable trading system. The process is iterative and testing and back testing, and trading them in real time over years can help you fine tune each element of the mix.
Most of the effort in such designing is one time and after that you need to fine tune it from time to time. If you understand this process you can develop your own profitable method based on many widely known setup ideas.
This is how most traders develop their trading methods. In the beginning they base their method based on someone else's ideas , but as they do more trading , they tinker around with several of the variables in vehicle selection , entries, exits, risk and in the process develop their own unique style.