Types of Trading Strategies: Components, Methods, and More

Excerpt

There exist various types of Trading strategies, and as we are aware, trading strategies are an essential part of live trading. When properly researched and executed, a trading strategy helps traders in achieving desired outcomes from executing trade orders.

When the strategy execution is fully automated, this type of trading strategy is called an algorithmic trading strategy. By applying the right trading strategy, a trader can execute trades with more accuracy and confidence. In this article, you will learn the different types of  trading strategies.

Going further, this article explains:

  • What is a trading strategy?
  • Components of a trading strategy
  • Types of trading strategies
  • ML-based trading strategies
  • Portfolio of strategies

What is a trading strategy?

A trading strategy is a detailed plan to analyse the market conditions and make trading decisions. A strategy consists of best practices to estimate the price movements and rules to enter and exit a trade.


Components of a trading strategy

The following are components of a trading strategy:

  • Methods of creating trading strategies
  • Trade universe
  • Entry and exit logic
  • Risk management

Methods of creating trading strategies

There are three main methods used to design a trading strategy:

  1. Technical analysis
  2. Fundamental analysis
  3. Quantitative analysis

Adding to the above is:

4.  Machine learning for designing the trading strategies

Machine learning is a contemporary practice and is a type of artificial intelligence. Now, let us discuss the introduction of each method:

Technical analysis

Technical analysis is a method to identify trading opportunities by studying the trends and patterns in the price charts. Technical analysis assumes that all information related to the stock, such as news, fundamental factors, sentiment, etc., is already included in its current price. So, it focuses on current trends in price, volumes, and estimates the future movements of the price.

Fundamental analysis

Fundamental analysis is a method to estimate the intrinsic value of a stock. It is done by studying the industry the stock belongs to, the economy, and the fundamental factors of the company. The intrinsic value is considered to be the true value of a stock. An asset is deemed to be undervalued or overvalued by comparing the intrinsic value to the current price. The undervalued stocks will be bought and the overvalued stocks will be sold.

Quantitative analysis

In trading, quantitative analysis is a method of predicting stock prices with the help of mathematical models and statistical techniques. The quantitative analysts assess the price and direction of the stock to find trading opportunities.

Machine learning for designing the trading strategies

Machine learning, as the name suggests, is the ability of a machine to learn, even without programming it explicitly. Machine learning is based on algorithms to detect patterns in data and adjust the program’s actions accordingly. Machine learning system detects a trading pattern, learns it, and executes the trade automatically every time.

Trade Universe

The trade universe includes products and markets where you apply the trading strategy. There is a wide range of products to trade, such as futures, options, equities. These products facilitate trading in markets like currency, commodities, stocks, cryptocurrency, etc. Every trading product and market comes with its own risks and trade dynamics.

Entry and exit logic

Entry and exit logic are a set of conditions that should be met to buy/sell the stock. The entry and exit price levels are defined by the analysis method of the trading strategy.

Risk Management

Risk management is a crucial component of a trading strategy. Capital allocation and stop-loss are the main elements of risk management. Capital allocation indicates the amount of capital allocated to each trade. Stop loss is used to limit the risk of the trade. Once a trading strategy is designed, it is backtested to understand its performance.

Types of trading strategies

Trading strategies can be broadly classified into five types which are:

  • Trend trading strategies
  • Mean-Reverting strategies
  • Breakout trading strategies
  • Carry trade strategies
  • Event-based trading strategies

Trend trading strategies

The trend trading strategies generate entry and exit conditions according to the trend of the stock. According to the trending trading strategy, an asset is bought during its uptrend and is shorted during the downtrend, assuming the price to continue in the direction of the trend. And, the trade is exited once the trend reverses.

Using technical analysis, a trend trading strategy is designed based on indicators like moving average crossovers, relative strength index (RSI), and average directional index (ADX).

Visit QuantInsti to read about Moving Average Crossover: https://blog.quantinsti.com/types-of-trading-strategies/

Disclaimer: All investments and trading in the stock market involve risk. Any decision to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.

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