“Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat.”
Trading strategies are the source of all success when it comes to investing. As in the famous quote above from the “Art of War”, a manual devoted to training to generals for war, strategy and tactics go hand in hand when it comes to developing a winning strategy whether war or investing. One of the beautiful parts about trading strategies is that they can be adapted to fit nearly any time horizon or market conditions. Whether a market is bullish or bearish, or not trending, by carefully designing and implementing your strategy, you can deliver winning results no matter the prevailing conditions.
Two Common Analysis Platforms
Investment strategies can be deployed for multiple purposes. While the ideal condition is to engage in a particular strategy to generate positive returns, strategies can also be used to prevent losses, commonly known as hedging, or reduce risk in an effort to minimize potential losses or take money off the table in during potential gains. For the most part, strategies are built on two common platforms: technical analysis and fundamental analysis. Fundamental analysis requires a highly mathematical approach towards determining the “intrinsic value,” or true value of an asset. Once decided if an instrument is overvalued or undervalued based upon all available data, an investor determines whether an asset is a buy or a sell.
While fundamental analysis can be viewed as a crucial analysis form that should not be ignored, it requires years of training in finance, valuation, modeling to fully grasp the bigger picture and determine intrinsic value. By comparison, technical analysis is more forthright and visual. Unlike fundamental analysis which depends largely on complex calculations, technical analysis is a valuable tool for understanding price action and how it is evolving over time with the graphical depiction of changing prices. Although it is more of an art than science when compared to fundamental analysis, it provides a great baseline for building a trading strategy and setting the risk/reward conditions of any trade.
Time Frames For Strategies
Before getting started with picking strategy, the key is to determine your trading time horizon and levels of trading activity. Depending on whether you are holding trades open for a short period of time or longer period of time, the type of strategy and trades may differ widely. For periods of time that can range from seconds to hours, most traders will try and employ a day trading or scalping strategy. These are trades designed to be closed same day and pick up smaller gains with a high volume of trading activities. While rewards in this strategy might be smaller because they don’t take advantage of longer-term trends, when multiplied by a high frequency, these small returns can quickly add up.
For more medium-term time horizon, swing trading more readily defines strategies for traders who are willing to hold positions opens for day, weeks, or even months. Often built on a combination of technical and fundamental analysis, swing trading seeks to identify changing market conditions that are often early indications of a changing trend or heightened momentum. While great for trading markets that are trending, assets exhibiting horizontal trends are typically avoided by this strategy. Finally, the last type of time-based trading strategies is position trading, which involves taking a position for a longer period of time. It is most commonly associated with a buy-and-hold strategy and more hands off approach to trading in an effort to capitalize on longer-term trends by ignoring the shorter-term market noise.
Types of Strategies
Although there are many different versions and varieties available, it is crucial to pick the strategy that best fits your time horizon and risk tolerance. Each strategy category is set to take advantage of different market conditions to deliver the best results. The key is determining which conditions you are searching for and how to best incorporate the appropriate strategy into your investment habits. The five major categories of strategies that stand out as the most popular amongst investors are the following: trend following strategies, momentum strategies, breakout strategies, contrarian strategies, and continuation strategies.
Trend Following Strategies – Following the old adage that “the trend is your friend” is a very commonly applied technique by traders looking to follow and not fight market momentum. The key to employing a trend following strategy is first and foremost a strong understanding of the trend. After identifying whether a market is trending higher or lower, the key is to apply a trend line that connects either the highs or lows depending on whether a downward trend or upward trend. Once determined, the key is to wait for the price action to hit the trend line at which point a position is established in the direction of the prevailing trend. The risk in this case is that a trend reverses, which is why it is essential to use the trend line as a place to set entry and exit points for this particular strategy.
Momentum Strategies – Usually the result of news or a fundamental catalyst, momentum strategies usually involve a burst of volatility, volume, and price action which combine to form directional momentum. Although momentum strategies are a little more challenging because they typically depend on a fundamental catalyst and excellent time, if caught early, momentum can provide excellent reward conditions, but due to their shorter-term nature, also carry higher risks especially when momentum is accompanied by higher than average volatility. In the case of momentum, if late to a trade, it generally makes the most sense to ignore an opportunity, because just like the “early bird catches the worm,” traders who are early are best able to capitalize on momentum that may just last seconds or minutes.
Breakout Strategies – As the name would imply, a breakout trade implies than an instrument has broken a major level or exited from a range or period of price consolidation. Breakouts are often accompanied by the most volatile trading conditions and while they can provide excellent reward conditions, risks are also elevated with this type of strategy. More importantly, the timing of a breakout and identification can be a little more complex that other trading strategies. Like momentum strategies, it is good to get involved early with breakout strategies, however, getting confirmation from above average volume and volatility is helpful in assessing that the breakout is real and not a fake move that is intended to shake out traders from positions.
Contrarian Strategies – For those investors who prefer to swim upstream or go against the crowd, there are contrarian trading strategies which seek to capitalize on trading opportunities that may be opposing the prevailing sentiment. An example would be an asset that is trending higher, riding high on positive sentiment, and looking for an opportunity to establish a bearish position believing that the tide may be turning, an asset is overvalued, or that prevailing optimism is unwarranted. This typically involves trading counter to momentum, believing that those investors chasing after a momentum move will cause prices to overshoot their true value, providing an opportunity for contrarian traders to add balance and help find the equilibrium price.
Continuation Strategies – After taking a pause in a directional trend, an asset oftentimes finds its price correcting or consolidating depending on conditions. These types of formations and price action can signal a continuation of the prevailing trend depending on the setup. While this can be viewed as an extension of trend following or breakout strategies, continuation often appears after a significant pullback in prices before determining the next move. In the case that a trend reverses, a continuation strategy would not necessarily be applied and would instead be swapped out with a new trend following position or momentum strategy depending on the case.
Commonly Applied Strategies
Although the list is long and strategies can be modified to fit different approaches to trading, this overview of some highly popular strategies amongst investors is a good place to start when assessing which strategy is best to meet your goals.
Trend Trading – Although discussed above, the key to trend trading involves determining the direction of the trend and using the trend line as a place to enter and exit potential opportunities. When setting up the conditions for a trade, generally, a position should be entered on a touch, but not a breach of the trend line. If a trend line is broken, it suggests that not position should be stablished. In the event that a position has been already opened, a broken trend line is a place to exit an opportunity.
Reversal Strategy – Popular amongst contrarians, a reversal strategy relies on identification of a trend and waiting for the trend to be broken. Once broken, a reversal position is established with the expectation that the trend has changed and that by entering early, a trader will be able to capitalize on new directional momentum. Similar to a trend following strategies, the entry and exit points are determined by the trend line. Once broken a position is established, if crossed back and a trend is continued, it is a sign to exit.
Pinocchio Strategy – Similar to the reversal strategy discussed above, the Pinocchio strategy involves taking advantage of early signs of a reversal in a trend, although is not dependent on trend lines, but rather, specific candlestick formations. Usually, as the name implies, a Pinocchio candlestick has very long tail in one direction and a short body that indicates that prices opened and closed at nearly the same price during a period. A position should be established opposite to the direction of the long tail once the reversal has been confirmed by a candlestick in the direction in the direction of the reversal. However, if after confirmation the trend reverses once more in the direction of the Pinocchio, it is a strong indication to exit.
MACD Strategy – Defined as more of a momentum strategy, the MACD indicator helps to identify shifting momentum and provides signals based on oscillating exponential moving averages. When the MACD line is crossed over by the signal line when trending below the zero line of the oscillator, it is a bullish signal whereas a crossover above the zero line provides a bearish signal. Besides helping identify changing momentum, these signals provide excellent support for strategies by providing helpful timing for both entering and exiting trades.
Bollinger Bands Strategy – These useful bands give good information about the state of volatility for a particular asset and whether the trading range is expanding or narrowing over time. Considered more of a contrarian strategy, Bollinger bands help to define when an asset is overbought or oversold, helping users to time bearish or bullish positions if the Bollinger bands indicate an asset is overvalued or undervalued. Besides helping to establish entry points for trades, when broken, Bollinger bands help to define exit points in both the optimistic and pessimistic scenarios.
Tools Used for Strategies
Strategies are most useful when they are accompanied by helpful technical analysis tools that give more information about the state of price action and momentum. These helpful tools and indicators can make all the difference when analyzing how an asset is behaving over time and identifying turning points in the price action.
Candlestick Charts – Candlestick charts are especially useful because they give a real time view of investor sentiment. The fight between buyers and sellers is readily on display by the range defined by the candlestick and furthermore, smaller or wider bodies give useful evidence of momentum accelerating or slowing depending on conditions. In some cases, such as the Pinocchio strategy, candlesticks form the basis for spotting reversals, making them very beneficial for analyzing price action and setting risk/reward.
Support and Resistance – These important horizontal levels are especially important for identifying pockets of buying and selling pressure that may prevent an asset’s price from overcoming or crossing a specific level. Support, as the name implies, is a level an instrument has difficulty falling below whereas resistance is a level an instrument has difficulty rising above. These levels are very important tools for a trading strategy because they can help identify levels to enter and exit trades more effectively without having to encounter the greater volatility that usually accompanies support and resistance levels.
Fibonacci Levels – A natural extension of support and resistance, Fibonacci levels add a bit of math to the identification of support and resistance. Besides taking away the more subjective approach towards identifying important levels by setting them automatically based on the Fibonacci sequence, it simplifies the process by just requiring a user to identify a high and low. Once implemented, the Fibonacci levels are helpful in identifying levels that an instrument may encounter increased support or resistance. Therefore, these levels can be used to set entry and exit points depending on how they are combined with a strategy.
Moving Averages – A moving average takes the closing prices from a number of prior periods and helps smooth them out by averaging them, helping to give a visual representation of how the price action has changed over time. Besides helping to confirm trends and in certain cases reversals, moving averages can also act as support and resistance levels depending on whether they are trading above or below the price action. The most useful attribute is using two moving averages together to produce bullish and bearish signals when there is a crossover. Depending on the trade time horizon, these moving averages should be adjusted to reflect the timeline to give better signaling.
Relative Strength Index – Also commonly referred to as the RSI, the relative strength index is a useful indicator for determining when momentum may be overdone for a trading asset. The indicator is based on two important levels including the 30.0 and 70.0 level. If above the 70.0, the RSI implies an asset is overbought (overvalued) whereas if below 30.0, the indicator suggests an asset is oversold (undervalued). Besides providing indicators of when to establish positions, the RSI can also be used to time exits when used in conjunction with a strategy.
When determining the right strategy to maximize your trading results, it is important to consider multiple factors. The first most important aspect to determine is your trading time horizon and whether or not you are placing trades over a short, medium, or long-term time period. If interested in a buy or sell-and-hold strategy, a longer term time horizon may be more suitable versus a short-term time horizon for scalping positions. Once established, the next step is to decide your precise risk tolerance. If you have a lower tolerance for risk, trend following strategies might be more beneficial than breakout strategies which are higher risk, higher reward opportunities. Finally, after a strategy is adopted, it is important to incorporate useful tools that will help identify entry and exit points for a trade in keeping with the risk and reward set at the trade outset.