An Anatomy of Trading Strategies

There are limitless systems for trading stocks, but all systems require similar strategies. Whether a trader is scalping for small but quick profits, trading short-term or taking a long-term approach, every trading system needs to incorporate several characteristics to be successful. Without these strategies in place, a trading system will under-perform, or, worse, it will lose a tremendous amount of money.

Determine Appropriate Trading Style
1. A trading system needs to be appropriate for the trader's personality. If a trader likes trading for quick short-term profits then a scalping system would be appropriate. If this trader implements a strategy that holds stocks for days or weeks, he will become impatient and will most likely deviate from the strategy causing the system to under-perform. Likewise, if a trader's style leans toward accumulating slow and steady profits, he will be miserable trading a strategy that has him entering and exiting positions quickly throughout the day.

Verify System with Back Testing
2. Before implementing a trading system the trader must verify if the system has the potential to be profitable. This is accomplished by back-testing the system. Back-testing uses the buy and sell rules of the trading system to run a historical simulation to determine the potential of the trading system. The results of the back-test allow the trader to verify if he has a plausible trading system. Back-testing also gives a trader the opportunity to adjust the system to make it more effective.
Most brokerage firms offer their clients robust back-testing systems. These online systems are easy to use and provide a wealth of data that allows the trader to analyze his trading system.

Limit Losses
3. Even the best trading systems encounter losing trades and periods of under performance. It is imperative that all trading strategies incorporate safeguards to limit losses. For example, a trading strategy can have a rule that sells a stock automatically if it declines by a certain percentage. It is best to make these rules automatic, so that it takes the emotion out of selling a losing trade.

Protect Profits
4. Protecting your profits is just as important as limiting your loses while trading. All trading systems need to sell rules that lock in profits. This can be accomplished by setting a stop-loss after a stock has made a gain. For example, a rule can be set for a stock that has appreciated by more than 5 percent. The rule would state that it is necessary to sell the stock if it declines by 2 percent. This will lock in a gain of about 3 percent if the stock falls; however, it will allow you to hold the stock and make more profit if the stock continues to rise.

Review Performance
5. It is vital to periodically review a trading system after it has been implemented. Reviewing all of your trades can be a time consuming process, but it will allow you to pinpoint aspects of the system that can be adjusted to produce more profit. Reviewing your trades will also let you see how you can limit losses in the future. As market conditions change over time, most trading systems benefit from tweaking the trading rules.