What is it that makes a great strategy? How do you know if you have the best trading strategy?
Of course you need a great system, a great strategy. You don’t just plunk your money down and trade any old thing. So you find a system, a strategy – maybe you created it yourself, maybe you took ideas from someone else, maybe you bought one. How do you know if it is any good, or even great?
I’ve made a video for you where I cover everything you should consider when evaluating your strategy:
These are all the things you should cover when you consider a trading scheme, system, or strategy:
Let’s look at these one by one.
Best Trading Strategy: Clear Rules
Your strategy must have
- Entry rules
- Profit taking rules
- Risk Control
This seems obvious, but I have to tell you, I’ve had a number of people discuss their trading scheme with me who really have no clear idea about exactly how they enter a trade, for example. They just wave their hand at a chart and say, I’d get in here.
You need very carefully thought out entry and exit rules. Always use stops! Even if you have some calculation that will take you out of a losing trade, be sure to place a stop well below the possible calculated loss exit, to insure against surprise down moves.
And, your rules should be simple. They should be easy to follow, easy to determine if they are really working. Some folks get all caught up in very complicated intricate calculations, with the feeling that the more conditions you have to satisfy to enter a trade, the more likely it is to be a winner. But, then figuring out if the market actually has all those conditions gets to be very time consuming and confusing. If you want to program an automated strategy to use these conditions, the more complicated the conditions are, the harder it is to determine if the strategy really is executing the rules correctly, or if it has a bug or error. Simple Trading Rules!
Best Trading Strategy: Ease of Use
You want your strategy to be easy to use. If you use TradeStation (or another platform that has automated strategies) you can write or have written for you an automated strategy that follows your trading rules. You might or might not want to acutally automate it. You might want to use it for backtesting your rules, and as suggestions for trades as you move forward. Or, you might want to just automate it, and let it place all your orders.
If you don’t use a programmed strategy, you want to be sure you don’t have to spend too much time calculating whether to enter a trade or not, what instrument or stock you want to trade, and when to enter the trade. Some people create spreadsheets with fields that help them determine whether to take a trade. Make it easy to use!
And lastly, you want to be able to backtest your strategy. If you have an automated strategy, you can backtest it on as much back data as you can get, and see how it would have done in the past. Of course this does not guarantee it will do well in forward trading! But I bet you would not start trading a strategy that did badly in backtesting, and that is one of the best uses of backtesting there is.
Best Trading Strategy: Accurate
To be sure your strategy is accurate, you must include in the calculations, both commissions and slippage. This is so important, I can’t stress it enough.
If you are doing long-term trading – buy and hold – it is down in the noise level, not that important.
But if you are holding a trade only 5 minutes, or only a few hours, or a few days, commissions and slippage can loom large in the profitability of your strategy. I go over this in detail in the video above, but I’ll cover a few points here.
If you are taking 2 points profit on the ES emini, for example, that is a gain of $100 per contract. But if you pay $5 commission and fees, and get one tick of slippage on either end of your trade, you end up with only $70 per contract on that trade. When you then look at your Profit Factor, or your Average Trade Profit, given all your losing trades and winning trades, you may find that you have gone from a winning strategy to a losing strategy.
Commission and Slippage Example
For a simple example, let’s look at the equity curve over 3 weeks. Here is a nice strategy that takes trades in the morning on the ES emini. As you can see, this snapshot shows it taking a short position with 4 contracts, and exiting with a profit.
This is what the profit equity curve looks like over the three weeks of data on the chart, not including any commissions, fees, or slippage:
Pretty nice, huh? Let’s start trading this strategy! WAIT! Not so fast…
This is what the profit equity curve looks like with standard commission and 1 tick of slippage on either side of the trade (1 tick slippage on entry, 1 tick slippage on exit):
Oops. Commission and slippage ate up all our profit and more.
Be sure you account for them.
Possible Trades, not Impossible!
You must also be sure that your backtesting shows possible trades, not impossible ones. I’m not going to go into much detail here, other than to say: I had a client show me a strategy he had developed for TradeStation which in backtesting made a kazillion bucks. But, trading forward it just refused to take the same type of trades at all. His problem was that his strategy entered and exited almost all the trades in the same bar. Thus, because the calculation of what the price does inside a bar is problematical, these were not realistic trades.
Which brings me to the last point under accuracy: make sure forward trading is “just” like backtesting. It won’t be exactly like it because of slippage vagueries and other issues (again I won’t go into all the details here).
Do this to test if your strategy is accurate
Automate your strategy in simulated mode (so you don’t lose any real money). If you are day trading, let it trade for several hours. Be sure you show your actual trades, not just the strategy trades (contact me to find out how to do this, if you are not sure). Let’s say you trade from 9:00 to 12:00.
Then, turn your strategy off, then on again. Now, the trades from 9:00 to 12:00 are backtested trades! They are now in the past, calculated on past data. Since you are showing the actual trades and the strategy trades on your chart, you can see if they are the same except for slippage. If they are pretty close, you are good. If they are quite different, you have an accuracy problem.
Best Trading Strategy: Robust
A great trading strategy is robust – this means that without optimizing for each chart, you can put it on multiple symbols, multiple bar times, and it does well. You want a robust strategy, not one that must be niggled into working for just this stock or futures symbol, and for just this granularity of chart time.
For example, the strategy we use when we buy stocks or futures and report in the Oracle on Wilshire, does well over 10 or more years on many stocks, many commodities, and many funds, on daily charts and weekly charts. Here are a few of the equity curve lines for some of them, without fiddling with the strategy, just placing the strategy on the chart.
Oracle Daily ES emini trading 2 contracts 7 Years
Oracle Daily Facebook Since Inception
Oracle Daily DX Dollar Index 7 Years
Oracle Daily VSAT 7 Years
Oracle Weekly VSAT 10 Years
The Oracle is a robust strategy, and you should be looking for robustness in your strategy.
Best Trading Strategy: Makes Money Over Time
To check that your strategy makes money over time, I want to reiterate that you must account for realistic commission and slippage in your backtesting.
There are also a number of measures you can check to determine if your strategy is making money over time and doing well for you. These include
- Percentage winning trades
- Average trade profit
- Profit factor
- RINA index
- Max drawdown
I’m going to briefly cover these – be sure you check all of them when you are evaluating your strategy.
Percentage winning trades
It’s always nice to have a high percentage of winning trades, but it is not necessary. It depends on how big your winning trades are and how big your losing trades are. If you have very big wins, and tiny losses, you can go with a smaller percentage of winning trades. However, what if you didn’t actually manage to get into that trade that turned into the big winner? That changes your percentage of winning trades to even less. So, higher percentage is generally better.
For the Oracle strategy running on the ES emini that I showed the equity curve for above… Oh, well, let me show it again here:
For this strategy on the ES, the Percentage Winning Trades is 60%:
Average trade profit
You need to know what your average trade net profit is. Be sure you are including commissions and slippage in your calculations. You average trade net profit needs to be big enough that if your slippage estimates are off in the wrong direction, or you miss a trade, or some other adverse event occurs, you have room enough to still be profitable. Here is the Average Trade Net Profit for the Oracle on the ES:
The profit factor is defined as the gross profit divided by the gross loss (including commissions and slippage) for the entire trading period. This performance metric relates the amount of profit per unit of risk, with values greater than one indicating a profitable system.
Here is the Profit Factor for the Oracle on the ES. This a Profit Factor well over 1, indicating a profitable system:
The RINA index combines Total Net Profit, time in the market, and drawdown calculations into a single reward/risk ratio. The larger the number, the more efficient and risk adverse the strategy.
Look for a RINA index over 200 to show a profitable system. This is a good overall metric to determine if you have the best trading strategy. However, it does not take into account a single big winning trade that may skew the results, so be sure to check the other measures as well.
Here is the RINA index for the Oracle on the ES. This RINA index is not over 200, showing that it is not as profitable as we would like:
We’d like to have small drawdown, compared to overall profit, peak to peak or trade to trade. Be sure to look at this metric as well as all the others.
Here is the max drawdown for the Oracle on the ES:
Best Trading Strategy: ROI
ROI is the gain of an investment minus the cost of the investment, all divided by the cost of the investment.
ROI = (Gains – Cost)/Cost
For example, if you buy 20 shares of Joe’s Pizza for $10 a share, your investment cost is $200. If you sell those shares for $250, then your ROI is ($250 – $200)/$200 for a total of 0.25 or 25% ROI.
You must include your commissions and slippage in your cost.
One way to increase your ROI is to use leverage. Note that leveraged investing or trading exposes you to higher risk.
From a very simplistic point of view, what trading a leveraged instrument means is, you can control a large quantity of something with a much smaller deposit into your trading account. One way this can happen is your broker “loans” you the money to buy or short futures, forex, or other instruments.
As an example, let’s say you have $10,000 in your trading account you could trade shares of a stock with, and a futures account where you have $10,000 that you can trade the ES emini. Of course you have much more in your account, because you don’t want to place your entire account on a single trade – so we asume the $10k is what you can afford to place on a trade. (I’ll talk about money management in a different post).
Let’s say the stock you want to buy is trading at $100. You buy 100 shares. If your stock goes up a dollar, it is now at $101. It has gone up 1 percent. You sell, and you make $1 x 100 shares = $100. You made $100 on a $10,000 investment.
Let’s say the ES is trading at 2000. Depending on the margin requirements of your broker, you could buy, say, 3 ES contracts with your $10k. If the ES goes up a point, you make $50 per point. To compare with the stock trade, we say it goes up 1%, and you get out at 2020. You sell, and you make 20 x $50 x 3 contracts = $3000. You made $3000 on a $10,000 investment.
This is a very simple discussion of leverage – there are lots of resources to learn more, and you should make the effort to do it.
You can easily increase your leverage by trading futures, options, leveraged ETFs, and Forex, to mention a few.
Best Trading Strategy: It Fits Your Goals and Your Personality
How much time do have to pay attention to your trading? Do you want to be a full time trader? Do you have a full time job, so you can only spend an hour or more a day determining your trades? Do you just want to be a long time investor? Do you want to have someone else suggest trades and you just go take those trades?
Be sure what you decide to do about your trading fits your time constraints.
It takes money to make money, and that’s the truth. If you have $5000 and want to make a living day trading, guess what? It probably won’t happen. You need to be well enough capitalized to be able to 1. Take the trades you want to take, and 2. Be able to absorb the losses that will inevitably come your way.
Do you want to make a living day trading? Do you want to get filthy rich trading? Do you want to dabble a bit? Do you want the ego satisfaction of finding winning trades?
Be sure you know what your goals are. Then, don’t fool yourself. Find out if your goals are possible given your time and money constraints. If you are not sure, ask!
Your strategy is only the best trading strategy if it fits your personality. Do you like the adrenaline rush of quick little scalping trades? Do you need calm consideration before taking a trade, and plenty of time to decide if it is time to get out? Then day trading is not for you! Do you need the boost to your self-esteem that finding your own trades brings you? Do you just want someone else to make the decisions for you? Do you just like dabbling in stocks?
Best Trading Strategy: The Mind Map
Here’s a diagram of all the features that make up the best trading strategy, outlining everything I’ve covered in this post. You can download it to your own computer, if you like. Just right click on it and choose “save image as…”. Then, when you open it in an image viewer, it will be large enough that you’ll be able to read everything.
Hope this helped!