Traders generally fall into one of two broad categories: Discretionary and systematic. While both groups develop and follow their own trading strategies, the systematic trader typically automates an objective set of trading rules that define exact conditions under which trades will be entered, managed and exited. This also allows him to backtest, optimize and forward-test a strategy before putting it to work in a live market. Through each step of the process, the trader can review a strategy performance report, a compilation of metrics that are based on statistical aspects of the system’s performance. The automation aspect also is a plus for traders looking for more consistent results.
While discretionary traders often use a combination of knowledge and intuition to find trading opportunities, systematic traders develop strategies based on quantifiable specifications. Here, with a focus on systematic trading, we will outline in detail the process of creating a trading strategy that can be measured, tested, optimized and auto-traded.
Indicator vs. strategy
Before we begin, note the distinction between technical indicators and strategies. A technical indicator is a mathematical calculation used to evaluate past and current price and volume activity. Whether available in the public domain (for example moving averages) or developed to perform a specific function, indicators help traders identify market conditions and make predictions about future price movements. However, indicators alone do not generate buy and sell signals.
In contrast, a strategy is a set of objective, absolute rules that defines how and when a trader will pounce. A strategy is composed of three basic parts:
Entry conditions that tell us how to enter a trade. Typically, entry conditions are based on a combination of trade filters, which identify the setup conditions, and trade triggers, the actual condition that prompts a trader to act. Both trade filters and triggers often are based on technical indicators.
Exit conditions that tell us how to get out of a trade. Trade management rules include exits such as profit targets, stop losses and trailing stops, and can be based on dollar values, time, number of price bars, etc.
Position sizing that tells us how much to trade. Position sizing can be based on a fixed number of shares/contracts, a fixed dollar amount or a percentage of capital.
While an indicator is used to evaluate market conditions, a strategy is the playbook that determines how the indicator will be interpreted and applied.