An essential part of any serious endeavor is having a clear and comprehensive rationale for the task at hand. Trading should be no different.
A trading strategy states what you want to accomplish and why. It is the result of a thoughtful review of your abilities, skills, resources, and expectations. The strategy serves as a compass, helping you then develop your trading plan.
As noted, a trading strategy defines the "what" and the "why" that is driving your trading. Trade Plan, which is a separate Trader Path, is the "how" of trading. It outlines the steps you will take when evaluating, executing, and managing your individual trades. We suggest that you first review the Trading Strategy path and think about how it relates to you. Do you have a strategy? Can you articulate why you want to trade or why you are trading? What is success and how will you know that you have achieved it? With a sound trading strategy in place, see how a disciplined trade plan can help you trade in ways that will achieve your trade strategy.
While simply having a trading strategy does not guarantee success, developing one can make you more aware of your own motivations, allowing you to better manage your trading expectations and approach to individual trades.
So how do you develop a trading strategy? There is no single approach; it is as individual as you. We believe all approaches should begin with a review of what you want to accomplish, your existing skills and abilities, and other considerations. The second step is developing clear, measurable, and actionable goals.
Trading strategy considerations
Carefully consider the following as you think about why you want to trade.
- Motivation: What exactly do you want to accomplish? Think about why you want to trade. Do you want to take greater control of your finances? Are you looking to generate income to supplement living expenses? Do you want to help fund a child or grandchild's education? Defining more clearly what you want to accomplish can help influence trading decisions.
- Experience: What skills and talent do you bring to trading? Are you a small business owner who has had to manage monthly budgets? Maybe you come from an analytical background? Do you like gathering and assessing information and developing a point of view from it? Think about your strengths and how they can help you achieve your goals.
- Risk Tolerance: Are you risk averse or risk loving? How might your orientation impact your ability to meet your objectives? What level of risk are you willing to assume to potentially earn your targeted returns? How might assuming more risk play into other parts of your life?
- Challenges: What stands in your way? Time is often cited as a reason for not pursuing interests, trading included. Other reasons include a lack of resources, a lack of knowledge, or competing priorities. Spend some time thinking about what may keep you from building and putting into place your strategy. You will be better equipped to address these challenges if they are known.
Building a useful strategy
Once you can articulate "why" you want to trade and key issues that may influence or impact your approach to trading, a good next step is to build a strategy. Write it down to encourage yourself to think it through and cover all aspects of your thought process. Additionally, it provides a compass for when you begin evaluating trade opportunities and something to compare actual results against.
The example below is provided to illustrate a trading-related goal.
"Generate additional income while also looking for the value of the stock price to increase. Achieve this by creating a short list of stocks (five maximum) that pay a minimum four percent annual dividend and are good candidates for capital appreciation in the next year. Place trades on two of the identified stocks prior to their next earnings announcement."
There are many approaches that can be used to build a strategy. The sample above uses the "SMART" approach. Choose one that best serves your needs.
The SMART approach is a tool to developing a measurable goal. It establishes a timetable to reach the goal and specifically identifies intent. Importantly, it also asks you to consider how realistic achieving the goal will be.
Specific—The goal is clear, precise and well-defined: a short list of opportunities.
Measurable—There must be a way to confirm that the goal has been accomplished. In this case, you will have an output (the list) whose contents can be compared against the criteria you set up.
Actionable—The goal is something that you can act upon. Placing trades, based on your goals, are appropriate actions.
Realistic—The goal is realistic for you. It fits you as a trader and what you want to achieve with trading. In our example, a number of trades are identified. This number should be based on your trading capital and objectives.
Time-bound—The goal will be accomplished or completed in a specific timeframe. Pick a timeframe that allows you to reach your goal. In our example, a date prior to an upcoming earnings announcement makes sense if your goal is to generate income.
Asset growth and income objectives are common goals for traders. You may have more than one trading goal. If you fall into this camp, you may want to consider longer-term financial goals first and then use these to validate other goals as they should be aligned.
Work your strategy
By setting a strategy "in stone," you will not only have a tool that will help you identify potentially appropriate trades, you will have something that you can use to evaluate your actions. Upon analysis, you may determine that your strategy needs modification. You may determine that your strategy still holds, but the actions you are taking to meet it aren't delivering results. In both cases, you are learning based on experience and then applying that learning to future actions.
Trading is full of challenges and decisions and you'll never stop learning. Remembering why you started in the first place remains important. Some people lose sight of why they began trading or what they were hoping to achieve. By building a thoughtful trading strategy, you will instill trading discipline and have a tool to evaluate your behavior.