Posted by A lot of things go into a good trading strategy. It’s not simply “a good idea,” but really, the orchestration of many different disciplines towards a common goal.
What is a trade?
A trade can happen in the form of both investing and speculating. A trade is just a transaction, or an exchange. A successful trade is actually at least 2 separate trades – one to get into the position, and one to get out of it, which is sometimes referred to as a roundtrip.
Components of a trading strategy
So what are the components of a trading strategy? In broad terms, a good trading strategy should always have these 3 main components:
Base thesis
Why are we even considering this trade?
What is the catalyst, or driver for this trade to perform well?
Examples:
- Inflation trade, e.g., we believe inflation is going up/down over the next N months/years.
- Macro trade, e.g., we believe this country/industry/sector will go up/down over the next N months/years because of reasons.
Execution
How would we translate the base thesis, from a purely analytical state, to one or more trades? Following are something to consider:
- Time horizon – How long are we holding the position in each roundtrip?
- Instrument – What asset are we going to trade to express the base thesis?
- Price – At what price are we looking to trade?
- Trading – Are we going to edge into the position slowly? Or buy everything at once?
Examples:
- Base thesis: We believe that inflation will go up slightly in the next 2-3 years.
- Time horizon: 2-3 years.
- Instruments:
- Short/medium term Treasuries.
- Long stocks of businesses with fixed input costs and variable output prices.
- Price: At the market based on trading strategy.
- Trading: From a basket of the instruments with some ration, rebalance every 3 months.
Risk management
How would we know that our base thesis and execution strategy was wrong?
And if one (or both) was wrong, what are we going to do to salvage the situation?
Example:
- We’ll know our inflation thesis is wrong if inflation does not go up at least 0.1% on a year over year basis every month for the next 6 months.
- If our thesis is wrong, immediately close out the short Treasuries leg of the position, keep the long stock leg as long as it is still performing at or near broad market performance, and slowly close it out over 2-3 quarters.
- We’ll know our execution strategy is wrong if inflation does go up as described, but out position does not appreciate faster than broad market performance over a 1 month moving window, sampled daily.
- If our execution is wrong, immediately close out all positions and rethink.
The reason why a good trading strategy plans out the base thesis, execution strategy and risk management way before even entering a trade, is so that these decisions can be made with a level head. Laying out your strategies, and putting them to paper while you still have a clear head helps to eliminate emotional biases that creep in in the heat of the moment. This gives you a chance to at least think clearly about the issues, and decide what your risk tolerances are.
Author
