Our top three tips for building a successful trading strategy

Picking up from where we left in our previous article, today we are going to share with you our top recommendations for the development of a trading strategy to address the current market conditions.

The relative calm on the global capital markets during the summer months – relative because the coronavirus uncertainty continues to weigh down on multiple financial instruments, often causing massive fluctuations – offers traders the opportunity to rethink, and perhaps to improve upon their strategies. The time is right for traders to fine-tune their methods for profitmaking in the context of today's market environment.

Trending vs Ranging. The continuously looming uncertainty from the coronavirus crisis causes anxiety amongst traders, which, in turn, results in more random and seemingly illogical price action. That is why determining superior levels of support and resistance for any given asset is as important as ever.

Distinguishing between SRLs (support and resistance levels) with minor importance and considerable importance allows the trader to discern possible turning points for the underlying financial instrument. Furthermore, it helps him or her to establish whether the market is trending or ranging.

The easiest way to spot the most important SRLs is to examine the asset in question on a daily chart. Look for multi-day peaks and bottoms on the price action (swing highs and swing lows). The behaviour of the price action around these prominent SRLs usually signals the next most likely direction for the market.

Determining whether the market is trending or ranging, depending on the behaviour of the price action around such SRLs, represents the next necessary consideration traders' strategies need to reflect upon.

If a given asset is trending, then the trader could decide whether he or she wants to join an existing trend, or if it would be better to wait for a reversal. In other words, the trader can narrow down his or her available options to a decision between trend continuation strategies and contrarian trading strategies. Working top to bottom by narrowing one's alternatives makes for more consistent trading.

Conversely, if the market is ranging the trader needs to determine whether the horizontal price action is behaving logically, or if it's been driven by random fluctuations. Afterwards, he or she can decide whether to buy/sell once the price action nears one of the existing range's boundaries or to sit and wait for a breakout play leading to the establishment of a new trend.

One of the easiest ways to determine whether the market is trending or ranging after all of the important SRLs have been established, is by implementing the Average Directional Index (ADX) on the daily chart. In short, the ADX measures the strength of a trend. Once the index crosses above the 25-point benchmark, the market is said to be trending. Therefore, the further the ADX climbs above this 25-point mark, the stronger that the underlying trend gets. Accordingly, the more the ADX falls below this level, the more robust that the underlying range gets. You can find more information about this indicator form our trading book.

Choosing the right indicators. Now that the underlying condition of the price action has been established, the trader needs to select suitable indicators to properly measure the prevailing market sentiment.

If the market is trending the trader would have to monitor the underlying momentum of the price action. This is valid for both trend continuation strategies and contrarian trading strategies. The Moving Average Convergence/Divergence (MACD) is one of the most popular tools for measuring the price's momentum.

When used in conjunction with other moving averages (for instance a 30-day and 50-day MAs), the MACD can highlight the distinctive price waves that comprise a broader trend. Hence, traders seeking to join an existing trend can place buying/selling orders at swing lows/swing highs, which can be determined using the MACD, the SRLs, and other MAs.

Contrarian traders, in turn, can use the same instruments to look for oddities in the behaviour of the price action. For instance, waning momentum of the underlying price action close to a major SRL could potentially indicate exhaustion of the overall trend. Consequently, contrarian traders could then look for more pieces of evidence signalling a potential trend reversal.

If the market is ostensibly ranging, traders could use the Stochastic Relative Strength Indicator (RSI) to determine when the market is 'Overbought' and when it's 'Oversold'. The price action tends to bounce between the boundaries of significant ranges –prominent SRLs usually encompass these. Hence, the price action can be anticipated to jump from the lower edge of one such range and to bounce back down from its upper edge.

The RSI illustrates the changing equilibrium between the buying and selling pressures on the market. If the indicator is in its 'Oversold' extreme while the underlying price action is nearing an existing range's lower boundary, then there would be a high probability for the emergence of a new upswing. Conversely, if the RSI is threading in its 'Overbought' extreme while the price action is nearing the range's upper boundary, then the market might be due for a new dropdown.

Applying proper risk management. Arguably the most challenging aspect of perfecting in any given strategy, advanced risk management cannot be explained in just a few simple steps. Nevertheless, there are some basic guidelines traders can follow in order to cut their losses and allow their profits to grow.

First of all, do not forget to place stop-loss orders. As was mentioned earlier, the levels of support and resistance represent historic obstacles for the price action, and as such, they are frequently tested. Whether the price action manages to break them depends on the particular instance; however, traders need to remember to place their stop-loss orders subject to the position of the nearest SRL to the entry price level of the primary order.

Whether the stop-loss is placed above or below the nearest SRL depends on the trader's own risk aversion. What is important to be remembered is that the market will fluctuate and sometimes stop-losses will be triggered even if the market eventually goes in the trader's original direction. This should not discourage the trader from using stop-loss orders in the future, as they represent the easiest and most effective way of achieving consistency of trading.

Another essential thing to remember is exposure. As a general principle, it is not prudent to place trading orders whose potential profits are exceeded by the potential loss. In other words, trade only when you expect to gain more from the trade than what you are willing to risk.