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Trading Strategy for Buying and Selling Stocks

While working the stock markets traders, investment firms and fund managers like to work with a trading strategy, which is a predefined set of rules for making trading decisions.

Traders, investment firms and fund managers use these trading strategies to help make wiser investment decisions and help eliminate the emotional aspect of trading. A trading strategy is governed by a set of rules that do not deviate. Emotional bias is eliminated because the systems operate within the parameters known by the trader. The parameters can be trusted based on historical analysis (backtesting) and real world market studies (forward testing), so that the trader can have confidence in the strategy and its operating characteristics.

Developing a Trading Strategy

When developing a trading strategy, many things must be considered: return, risk, volatility, timeframe, style, correlation with the markets, methods, etc. After developing a strategy, it can be backtested using computer programs. Although backtesting is no guarantee of future performance, it gives the trader confidence that the strategy has worked in the past. If the strategy is not over-optimized, data-mined, or based on random coincidences, it might have a good chance of working in the future.

Executing strategies

A trading strategy can be executed by a trader (manually) or automated (by computer). Manual 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.

Styles of Trading Strategies

  • Technical analysis - is a security analysis discipline for forecasting the future direction of prices through the study of past market data, primarily price and volume.
  • Fundamental analysis - focuses on the overall state of the economy, interest rates, production, earnings, and management. When analyzing a stock, futures contract, or currency using fundamental analysis there are two basic approaches one can use; bottom up analysis and top down analysis.
  • Quantitative trading - consists of thorough examination of vast databases searching for repeating patterns -- typically positive or negative correlations among liquid assets ("statistical arbitrage" or "pairs trading"), or price-movement patterns ("trend following" or "mean reversion").
  • Trend following - is an investment strategy that tries to take advantage of long-term moves that seem to play out in various markets. The system aims to work on the market trend mechanism and take benefit from both sides of the market enjoying the profits from the ups and downs of the stock or futures markets.
  • Mean reversion - is a mathematical methodology used for stock investing where the idea is that both a stock's high and low prices are temporary, and that a stock's price will tend to have an average price over time. Mean reversion involves first identifying the trading range for a stock, and then computing the average price using analytical techniques as it relates to assets, earnings, etc.
  • Volatility (finance) - is the standard deviation of the continuously compounded returns of a financial instrument within a specific time horizon. It is used to quantify the risk of the financial instrument over the specified time period. Volatility is normally expressed in annualized terms, and it may either be an absolute number ($5) or a fraction of the mean (5%).
  • TradingLevels - Brokerage firms review applications for options trading and assign the account a trading level ranging from level 1 to level five. Level 5 for beginning options traders and only allows a couple of conservative trading strategies. Level 5 is for very experienced option traders with large account balances.
Timeframes
  • Intraday - Intraday trading refers to opening and closing a position in a security in the same trading day. This can be buying and selling to capitalize on a potential rise in a security's value or shorting and covering the short to capitalize on a potential drop in value
  • Scalping (trading) - in this sense is the practice of purchasing a security for one's own account shortly before recommending that security for long-term investment and then immediately selling the security at a profit upon the rise in the market price following the recommendation.
  • Shaving - a round trip trade (a buy and sell) in as little as one second.
  • Momentum (finance) - is the empirically observed tendency for rising asset prices to raise further. For instance, it was shown that stocks with strong past performance continue to outperform stocks with poor past performance in the next period with an average excess return of about 1% per month
  • Day trading - is the practice of buying and selling financial instruments within the same trading day such that all positions are usually closed before the market close for the trading day. Traders that participate in day trading are called active traders or day traders.
  • Trend following - is an investment strategy that tries to take advantage of long-term moves that seem to play out in various markets
  • Gorilla Trading - Buying near the closing bell and selling the next morning (holding a position overnight)
  • Long term trading