Table Of Content

Recap
What Is A Trading Strategy
Higher Prices, Higher Quality
Find The Middlepath
The Absolue Bare Minimum Ingredients
Other Considerations
Example Strategy
Rule No. 1
Picking A Broker
C - Choosing Instruments
O - Opening Rule
R - Rule For Closing
E - Exposure Level (Position Size)
First C.O.R.E. Draft
Preview

Recap

After building out the first pillar for solid risk management in trading, talking about crucial backtesting steps and pitfalls to avoid, and going over the most basic futures trading considerations, we're almost ready to start the real journey.

Before we can do that though there are some other very important things we need to talk about first.

This week we're going to take a closer look at the Anatomy Of A Trading Strategy

What Is A Trading Strategy

A trading Strategy is like a recipe for baking a cake. It can be done numerous ways and each way has its own benefits and drawbacks.

Buying Cake From Supermarket:
The price we have to pay and the difficulty in baking the cake is low. We just need to warm up the oven. This is fine on the one hand but we have very little flexibility over the outcome and its quality can be considered also quite low.

It's basically the same as buying a pre-made algorithm or signal service for trading.

Buying From A Restaurant:
The price is somewhat higher and comes out at medium which luckily also increased the quality to medium. Our flexibility is still low, all we can do is ask the waiter to add some extras. The difficulty increased to medium too but this doesn't really concern us because we're not the ones baking the cake.

This is aking to adopting a pre-made strategy from a financial advisor.

Ordering From A World Class Chef:
The price is medium to high which again also increases the cakes quality. Higher quality usually also increases the difficulty but again we're not really concerned with that because the chef is baking it for us. That's what we're paying the higher price for. The flexibility increased to high because we can tell the chef exactly what we want.

It's the same as fitting a pre-made strategy from a world class investor to your needs.

Higher Price, Higher Quality

There's a clear pattern to observe: The more we pay, the better the quality. While we're not concerned about the difficulty yet because we're not baking the cake ourselves, it's still important to note because it affects a number of options we have yet to talk about:

Buying a Pre-Mixed Cake Box And Make It Yourself
The price is usually low but since we're now the ones baking it we have to work with an increased difficulty of medium to high. This is the first time the difficulty really affects us. The trade-off here is that we still only pay a low price. We also gained a high degree of flexibility and might be able to produce a quality of medium to high ourselves with lots of effort.

This anology describes the process of learning about the ingredients of a successful trading strategy and then developing it yourself over time.

Study To Become A Chef And Learn All Components Of Cake-Making: Probably the highest price you can pay. Learning everything there is usually increases the difficulty to high. There's a reason for all the certificates, degrees and diplomas out there one can obtain in a given market. Even if it's 'just' being a chef. Becoming a master at any profession usually is nothing to look down on. None of the paths to mastery are particularly easy without prior knowledge and require lots of effort and time-commitment. After learning everything you have a great deal of flexibility and will be able to produce high quality products.

Find The Middlepath

Market dynamics are ever changing. What has worked 100 years ago might not work today. Buying signals or fixed strategies will simply not do if you intend on being successful long-term.

Depending on your current life and background, becoming a world class chef might be far too time-consuming.

From my own experience the best way to get started is method 4: buying a pre-mixed cake box and make it yourself. You got full control and transparency over the workflow. You have a high degree of flexibility and learning this way allows you to create your own recipe everytime.

Let's start the learning process by looking at the structure of such a recipe:

The Absolute Bare Minimum Ingredients

There are lots of things you can include in a trading Strategy but the most important ones you must not leave out no matter what are the C.O.R.E. ones:

Chosen Instrument:

Which instrument(s) you want to trade. The capital you have severly affects your instrument and strategy choice. Lots of strategies employ a Dollar-Neutral or Delta-Neutral kind of style. They are taking both directions, long and short, on instruments simultaneously, reducing their risk to one-directional price movements. A great example would be pair-trading mean reversion strategie where the trader relies on the spread between two cointegrated pairs to converge again after it widened a statistically significant amount. Due to its two-sided nature, it usually requires more capital than directional strategies like Trend Following.

Let's assume $100,000 as the benchmark for high or low capital. Often brokers require at least that amount for the use of Portfolio Margin which enables two-sided strategies. In the crypto world things look a bit different: brokers like Deribit or Delta require only a portion of that ($500) to be able to use portfolio margin. If that is a good thing or not is a topic we're going to go into later.

Different instruments also have different instrument risk (volatility) so brokers require different margins for them. Small Caps might require as much as 50% margin requirements due to their relatively high risk.

Depending on where you're living local regulations can also limit what instruments and asset classes you're able to trade. Things like different tax structures across the globe only complicate things further.

Opening Rule

The opening rule of your trading Strategy defines when to enter a trade and whether you need to buy or sell. There are tons of indicators out there that are used for opening rules and which one you choose is up to you. Your opening rule can rely on one or a combination of multiple of these indicators.

Over time specific indicators have proven to work for different types of strategies.

Whatever you choose, it should be kept as simple as possible. Simple observations like "it was profitable in a backtest" are not enough.

You should be able to articulate the source of returns of your rules and why they make sense.

Signal research is a complex topic but there are a hand full of signals that have known rationales behind them and are proven to work till this day.

We will have a look at some of them later when constructing an example strategy.

Redemption Plan / Rule For Closing

The closing rule specifies when to exit an already opened trade. It can be a stop loss, a profit target, a time based exit or just your opening rule in reverse.

Different types of strategies work better with or without stops.

Exposure Level / Position Size

This describes how big your notional exposure will be when opening a trade and is usually calculated in units of shares or amount of contracts. Your position size should be closely tied to your risk management system and regularly re-adjusted accordingly. For example when you're risk-scaling based on volatility and volatility increases, you usually need to decrease your position to not take on excessive risk and increase your risk of ruin chances.

You can find the template for this framework here. If you want to change the sheet, you need to make a copy of it into your own drive.

Other considerations

All of the above pose the absolute bare minimum each trading Strategy should have. Each of the points should be treated as sacred: you must not deviate from them ever. You only have a trade when all of the boxes for your opening rule tick. The position you open should be the exact size your strategy demands it to be. Closing your trade is only allowed if your closing rule comes into effect.

After creating the strategy, you're not allowed to change it on the fly because of you're emotions. When in a big or longer drawdown, you might feel the urge to "cut your losses". Backtesting and analysing typical historical drawdowns make it easier to not fall for this trap but only go so far. After all the only thing that's stopping you is you. Discipline is a must!

If things go bad and you need to re-evaluate your strategy to see if eveything is within bounds, that's fine and you might even find some errors this way. But if you're constantly changing things because of emotions, you're doing something wrong. The point of the strategy is to provide a systematic structure and ther's nothing systematic about constantly changing things flipping back and forth.

Trading Timeframe:
To test your strategy and run it you need to have price data. Depending on the frequency of your trading timeframe, that data can be very expensive.

Higher timeframe data like already adjusted EOD prices for stocks can be gathered for free while lower frequencies or data for other instrument types can be much more expensive.

It's usually better for low capital accounts to focus all of their margin on trading so they should stay away from strategies that rely on faster than daily price data feeds.

Working Hours:
The higher your trading timeframe, the less time is needed to maintain your positions. People that have dayjobs trading in their freetime should stick to the daily timeframe. Automation helps out a lot here, so the better you are at automating, the more leeway you get.

Your Programming Skills
Again, your ability to automate elements of your trading system greatly influences the timeframe you should choose. If everything is fully automated and you need to check in on it very rarely even on the lower timeframes, you just need to put in some work up front to be able to run your "quick" system on the side without much time-effort.

Brokers:
The choice of your broker is vital and should be very dilligent. The most important thing to note here is that it's far safer to stick with big exchanges that are regulated and regularly audited by external parties. But it doesn't stop there. Even after careful broker consideration you still need to factor in how the products offered are handled. Things like spread bets, CFDs and FOREX are traded through brokers instead of exchanges. Futures on the other hand are traded using direct to market access which reduces your risk. In a direct to market transaction your counterparty is the exchange itself, not the broker.

A good rule of thumb is to strike a balance between credibility, products offered and trading costs (commission).

Example Strategy

As you can see a lot of factors influence your trading strategy without even looking at price data yet. But enough with theoretical stuff for now. Let's put these bulletpoints to work!

For this example we're going to assume a part-time hobbyist trader. He tried his best discretionarily trading crypto currencies on a shady offshore exchange and was - for the most part - breakeven, sometimes a little more down than up. But then something very bad happened: the exchange went out of business without notice and left him no ability to withdraw the money he deposited, which was most of his savings.

He did not give up on trading after going through this experience though. He wants to continue and this time be more dilligent about his brokerchoice. He has about $10,000 left.

Rule No. 1

Only trade with money you can afford to lose!

This time it were shady actors that made the trader go broke but it could've also been bad risk management or other things. You have to accept the fact that there's always some kind of possibility to somehow lose it all. If you manage your risk well, it's not really that big of a deal but it's better to assume that it might be for now.

He has a day job and not that much coding experience. He's considering the daily timeframe but also feels the urge to go a bit quicker. Unfortunately his account is very small so he needs to rely on free data for now. Currently only the daily timeframe makes sense.

Picking a Broker

Our trader didn't go through a proper broker research phase yet but decided to stay with big, well known exchanges. He doesn't want to pay high commissions while also having easy access to APIs because he's not that good of a programmer. He's not quite sure about the products offered yet but he also definitely wants to trade a fair amount of crypto.

His main considerations for now are:
Interactive Brokers
Binance (biggest crypto exchange)
Deribit (biggest crypto derivatives exchange)

C - Choosing Instruments

He's not sure about which instruments exactly to trade. He didn't sign up for the brokers yet to calculate their margin requirements but he wants to both go long and short. He wants to stay on the "safer" side and is fine with margin trading, futures trading or spot utilizing direct-to-market access.

Since his capitall is small he's limited in options but he'll consider any of the most liquid and "established" equity indexes, stocks, cryptos, bonds, metals, and commodity futures.

O - Opening Rule

He knows that trend following is a well established source of returns and their rationale. The idea is to buy instruments that are trending upwards because they tend to continue to go upwards until a shift in momentum takes place. When this shift takes place he wants to be out of his position and play it to the other side (short).

Moving Average Crossovers are a great filter to smooth out momentum structures to see their shifts clearly. He doesn't have that much time so he's opting for a standart middle to longer-term mix of moving average intervals: MA(8) vs MA(32). He's going to go long if the slower moving average (8) crosses above the slower moving average (32) and go short if the opposite happens, reversing his position if he's currently positioned on the other side.

R - Rule For Closing

He doesn't want to overcomplicate things and will simply stick to his Moving Averages as described in the Opening Rule section. He plans on adding in more rules but since he didn't build anything yet, does not feel the need to rush things. As soon as he has a robust implementation going, he's going to incrementally add onto it.

E - Exposure Level (Position Size)

Due to broker limitations, he needs to trade at least 1 contract and will be risking around 20% of his capital using an annualized standard deviation of returns (volatility) as adjustment tool.

First C.O.R.E. Draft

This is the CORE of his retail trading business:

Preview

Next week we're going to start diving deeper into each of these steps having a look at brokers and what to consider while choosing one, what exact instruments make sense to trade and how to implement or even extend the opening and closing rules.

Until then, happy trading!