Originally Posted On: https://enlightenedstocktrading.com/trading-strategy/

Unlocking Your Profitable Trading Strategy: 5 Trading Strategies You Must Know

What Is a Trading Strategy?

Successful traders have a solid trading strategy that guides their trading decisions. In this article we will discuss several different trading strategies, as well as explain how your trading strategy differs from trading systems and algos. Despite the fact that trading strategy, trading system and trading algo are often used interchangeably, they are actually quite different things.

One of the more confusing aspects of trading terminology is that many different terms are used interchangeably when, in fact, they are quite different. Before we go any further I want to draw a distinction between the following terms that are discussed in this article:

• Trading Strategy
• Trading Timeframe
• Trading System
• Trading Algo
• Trading Plan

I find it helpful to think about each of these concepts distinctly because it makes learning how to trade much simpler and less confusing.

 

The trading strategy is the overarching concept or style of trading that we are employing. The most common trading strategies are listed and explained below, however “trend following” is a trading strategy, so is “mean reversion” or “seasonality trading”. There are certain approaches that work when trading stocks, I think of these concepts as the “trading strategy”.

Many traders confuse the strategy with the trading timeframe. If you say you are a “day trader”, this tells me what timeframe you are trading on (you are buying and selling within one trading day or session) and the period of time you typically hold your trades, but it does not tell me what trading strategy you are using. Similarly, many traders will describe themselves as “swing traders”. This is also a timeframe rather than a strategy, as you can follow trends / capitalise on mean reversion / use seasonality in a swing trading timeframe.

Next comes the trading system which is the specific rules that you will be using to capitalise on your chosen trading strategy within your chosen timeframe. The system generates the trading signals that you follow, thereby ensuring you make objective trading decisions. Trading systems are powerful because they remove the emotion and subjectivity from my decisions and allows you to backtest your approach to the markets to ensure it is profitable.

In recent years the term trading algo has gained a lot of popularity. A trading algo is basically an automated trading system that has been automated. These are also just called automated trading systems. If you hear someone talking about an ‘automated trading strategy’ they are really talking about a system or algo that has been automated because the strategy is the higher level concept or style as discussed above.

Finally we have the trading plan which is far broader than the trading strategy or system. A trading plan is a comprehensive framework that outlines a trader’s strategies, timeframe, systems, risk management rules, and financial goals. It functions as a detailed guide that helps you maintain discipline and make informed decisions in varying market conditions. Essential for ensuring consistent and systematic trading, it defines how to enter and exit trades, manage investments, and respond to different market scenarios effectively. Essentially, a trading plan is about preparing for various situations, minimising emotional decision-making, and aiming for consistent profitability in trading activities.

Trading Strategies Every Trader Should Know

Lets have a look at the 5 types of trading strategies that every trader should know. Once you understand these strategies you will be in a powerful position to select the right one for your portfolio. Each of these approaches can be made into 100% objective trading systems using popular indicators and backtested to ensure consistent profits over time.

The 5 trading strategies every retail trader should know are:

1. Trend Following
2. Mean Reversion
3. Rotational Momentum
4. Seasonality
5. Pattern Trading

There are other strategies not covered here, such as range trading, news trading strategies, arbitrage opportunities and pairs trading, however the 5 listed are ones that retail traders should start with and understand first because they do not require as much specialist knowledge and are easier to implement.

Every one of these strategies can be performed purely using technical analysis indicators. You do not require any specialised technical analysis tools other than your backtesting software such as Amibroker or Realtest. Fundamental analysis can be used as an overlay, however I avoid this because it is impossible to backtest the impact of the fundamental factors.

I work with quantitative traders and all of my trading is 100% systematic, so my trading mantra is:

TRADE WHAT YOU TEST AND TEST WHAT YOU TRADE

Let’s review these 5 popular trading strategies in turn.

Trend Following Trading Strategy

Trend following is a trading strategy that involves identifying and capitalizing on market trends for profit, utilizing systematic rules to enter and exit trades. Using this approach, trend traders  exploit substantial moves in markets across various asset classes with disciplined risk management and without the need for continuous market monitoring.

The key components include recognizing a trend is in place, entering at a low-risk point, using a stop loss to exit if the trend reverses early and using a wide trailing exit that gives the trade lots of room to move so that you can ride the trend to generate large winning trades. Under the banner of trend following strategies I would also include breakout trading strategies.

Trend followers aim to generate substantial returns by taking many trades at low risk knowing that a small number of them will turn into large trends that generate substantial profits. Read the full article here for detailed insights on trend following.

 

I frequently suggest that beginner traders adopt a trend trading strategy because it has a low time commitment so is easy to fit into your life, and it is very forgiving, provided you cut your losses and don’t close your winning trades to early. One of the best ways for retail traders to ensure they get long-term success is to adopt trend trading as a cornerstone of their portfolio. You have a much higher chance of long-term success using trend following strategies than many others as long as you have the patience to wait for the entry and exit signals.

Mean Reversion Trading Strategy

Mean reversion trading capitalizes on the financial markets’ tendency to move towards their average over time. This strategy looks for extreme movements away from the average, expecting prices to revert back, providing opportunities for profit.

Mean reversion traders are typically looking for short-term trading opportunities, relying on statistical probabilities rather than long term market trends. The focus is on entering trades during overextended price movements and exiting shortly after the market corrects itself, with the aim of capturing the swift return to equilibrium.

 

Rotational Momentum Trading Strategy

Rotational trading is a dynamic trading strategy that involves periodically reallocating investments among a set of assets based on specific performance metrics. This method leverages the cyclical nature of markets, rotating capital into sectors or stocks that are currently showing strength and out of those that are underperforming. By doing so, traders aim to capture the momentum of rising assets while avoiding or minimising exposure to downturns. The strategy requires a disciplined approach to monitor and analyse market indicators regularly, ensuring timely adjustments to the portfolio.

We use quantitative rules or models to identify these signals, which are often based on relative strength or other momentum-based measures. This strategy is particularly appealing for those looking to actively manage their portfolios while minimising portfolio churn, as it combines elements of tactical asset allocation with the principles of trend following, potentially enhancing returns over a passive investment approach.

 

Seasonality Trading Strategy

Seasonality trading strategy focuses on the historical patterns and tendencies of markets to move in certain predictable ways during specific times of the year. For example, the “Sell in May and go away” strategy suggests that the stock market typically underperforms during the summer months from May to September compared to the more robust months from October to April. Traders employing this strategy might reduce or eliminate their market exposure during these less favourable months to protect against potential losses and underperformance. The idea is that by understanding these patterns, traders can time their market participation to capitalise on periods of statistically proven strength while avoiding those of traditional weakness.

The Santa Claus Rally is another example of a seasonality strategy where historical trends show that stock markets tend to perform well in the final days of December into the early New Year.

 

This phenomenon is observed globally, not just in individual countries, suggesting that traders might benefit from a diversified approach during this period. By analysing past performance, including during various market conditions like bull or bear markets, traders can better understand the potential risks and rewards associated with trading these seasonal trends. Strategies can range from simple equal-weighted portfolios focusing on the rally to more sophisticated approaches that include trend filters and momentum risk profiles to enhance returns and reduce risks.

For more insights on seasonality trading strategies, check out Enlightened Stock Trading’s detailed explanations and historical analyses of monthly stock market seasonality and the Santa Claus Rally.

Pattern Recognition Trading Strategy

Chart pattern trading is a strategy that involves identifying recognizable formations on stock charts, typically using technical analysis, that signal a stock’s future price movement. Common patterns include ‘head and shoulders’, ‘double tops and bottoms’, ‘triangles’, and ‘flags’. These patterns are grounded in the psychology of market participants, reflecting the underlying sentiment. The idea is that certain shapes formed by the price action can signal continuation or reversal of trends, providing traders with potential entry and exit points.

However, a key challenge with chart patterns is their subjectivity—patterns that seem clear in historical charts can be ambiguous in real time, making it difficult to identify and trade them effectively at the “right-hand edge of the chart,” where future price action is unknown.

To overcome the subjective nature of chart pattern recognition and validate these patterns’ potential profitability, traders should turn to backtesting tools with pattern recognition capabilities like Wealth-Lab. Backtesting allows traders to apply their pattern-based strategies to historical data, calculating the strategy’s edge or expectancy — the average amount you can expect to win (or lose) per unit of risk. By backtesting, you can more objectively measure the effectiveness of chart patterns and refine their strategies based on statistical evidence rather than visual interpretation alone.

An example is illustrated below with Wealth-Lab identifying a double bottom chart pattern as an entry in a backtested trading system.

 

When using Wealth-Lab or any backtesting platform, it’s crucial for traders to accurately code the criteria for the pattern and ensure that the backtesting environment closely replicates live market conditions. This involves accounting for slippage, commission costs, and the liquidity of the asset. With rigorous backtesting, traders can gain confidence in their chart pattern trading strategies, making them a viable component of a diversified trading approach.

Time Frames For Trading Strategies

The time frame or time horizon for your system is quite distinct from the trading strategy you use. Traders describe themselves as ‘scalpers’, ‘day traders’, ‘swing traders’, ‘Position Traders’ or ‘Buy and Hold Investors’. These are all descriptions of the period of time you hold your positions when trading. Let’s look at each of these in turn.

 

Scalping

One of the quickest strategies, scalping involves making dozens or hundreds of trades in a single day to “scalp” a small profit from each trade. Scalpers aim to gain from small market movements, taking advantage of a ticker tape that never stands still during the market day.

Day Trading

Day trading involves buying and selling securities within the same trading day. Day traders capitalize on small price movements in highly liquid stocks or currencies. The key characteristic of day trading is that all positions are closed before the market closes for the trading day.

Swing Trading

Swing traders typically hold positions for several days to several weeks. This trading style aims to capture short—to medium-term gains in a stock (or any financial instrument) over a few days to several weeks. Due to the short-term nature of the trades, swing traders primarily use technical analysis, but they may also use fundamental analysis or a combination of both to make their trading decisions.

Position Trading

Sometimes considered a form of medium-term investing, position trading involves holding a position for several weeks, months, or even years. Position traders use longer-term charts — anywhere from daily to monthly to determine the trend of the current market direction. A common position trading strategy is long term trend following. The main advantages of position trading include the low frequency of activity, low transaction costs and ease of fitting your trading into your daily life.

Buy and Hold

Beyond position trading, the term “Buy and Hold” is commonly used to describe a longer-term trading or investment strategy. This approach involves purchasing stocks and holding them for an extended period, often years or even decades, regardless of short-term market fluctuations. The strategy is based on the belief that long-term returns can be more predictable as markets tend to increase in value over time.

Here’s a breakdown of the buy-and-hold strategy:

1. Long-term Investment Focus: Unlike day trading or swing trading, buy and hold is not about capitalizing on short-term market movements. Instead, it focuses on the potential for long-term growth and compounding returns.
2. Lower Transaction Costs: Because it involves fewer transactions, a buy-and-hold strategy can significantly reduce costs related to commissions and taxes that can erode investment returns.
3. Risk Mitigation Through Diversification: Investors often diversify their buy and hold portfolios across various asset classes and geographic regions to mitigate risk and stabilize returns over the long term.
4. Patience and Temperament: This strategy requires patience and temperament to withstand market volatility without reacting impulsively. It is suited for investors who are less concerned about short-term fluctuations and more focused on long-term growth.

Buy and hold is often associated with investing rather than trading, reflecting its passive, long-term nature and its common use among those seeking to build wealth gradually without actively trading markets.

The Difference Between a Trading Strategy and a Trading System or Algo

The difference between a trading strategy and a trading system, or algorithm, can be thought of in terms of concept versus application. A trading strategy is a conceptual framework that outlines the trader’s approach to the markets. It’s a high-level plan that defines the criteria for making trades, such as entry and exit points, and may include broad objectives and guidelines for risk management. A strategy might be based on principles like trend following or mean reversion and can be described and discussed without reference to any specific technology or platform.

A trading system, or algorithm, is the tangible embodiment of a trading strategy. It translates the ideas and rules of a strategy into precise, actionable steps that can be implemented in real-time trading. While a strategy might suggest buying stocks during a market uptrend, the system will define the exact conditions for what constitutes an uptrend, how much to buy, and when to sell. An algorithm, in particular, implies automation, meaning the trading rules are coded into software that can execute trades on behalf of the trader, often without the need for manual intervention.

Therefore, while a strategy provides the “why” and “what” of trading, the system offers the “how” and “when.” The system is more detailed, often includes specific parameters and technical indicators, and requires backtesting to validate its effectiveness. In practice, the strategy is the idea behind your trading decisions, and the system is the tool you use to put those decisions into action.

Choosing the Best Trading Strategy For You

To succeed in the stock market, you must be clear on the stock trading strategy the best fits you and your trading goals.

The strategy is the concept that underpins your stock trading system – this is what gives you the edge in the markets. Some common examples include:

Many trading strategies can make money, but because of your own psychology, beliefs, and preferences, many of these may not work for you. You must have a valid trading strategy to guide your decisions; otherwise, you will lose money in the stock market.

Most newcomers to the stock market (or any other financial market, for that matter) feel impatient and just want to start using a profitable stock trading system. After all, “I just want to learn to trade and make big money”, right? But this is symptomatic of why most people fail miserably at trading…most people want the quick answers that make the megabucks. Without an understanding of how your stock trading strategy fits your psychology you are unlikely to trade profitably…because it doesn’t fit YOU!

This is not because the strategy doesn’t work. It is because when you try to consistently act against your beliefs and self-image, it causes psychological discomfort (pain). The result of this psychological pain is generally self-sabotage, but at the very least, it will cause stress and costly trading mistakes.

Most new traders are not willing to think about their own psychology and preferences before launching into trading. The path to successful trading and making big money is illustrated below:

 

You may need help implementing these steps, especially finding good trading systems and learning to backtest and build confidence in them. If that is the case then The Trader Success System is the right next step for you. The Trader Success System is the last trading course you will ever need. Perfect for traders with an ‘engineering brain’ who like to take control and back up their decisions with facts and analysis rather than subjective unproven decision-making.