Developing A Trading Strategy by Frank McGuff
Trading strategies have several required characteristics, ranging from the ability to provide clear, unambiguous signals to the ability to validate each trade against the strategy. Developing and validating trading strategies is an absolute necessity in becoming a successful trader. Here, then, are some suggestions for designing a trading strategy.
An effective trading strategy will, first, be automatic; second, it will incorporate risk management; third, it will define what actions are to be taken in the near future; and finally, it will provide specific evidence to evaluate the merits of the trade. To start, we must look at the signals generated by a trading strategy. Essentially, there are two types: positive (indicating a trade should be made) and negative (indicating no trade should be made). Each signal may also be true or false (right or wrong); a true positive signal correctly indicates a trade should be made, while a false positive signal erroneously indicates a trade should be made.
Conversely, a true negative correctly indicates that no trade should be made, while a false negative erroneously indicates that no trade should be made (that is, a trade should have been made). The profits from the true positives must overcome the losses from the false positives and false negatives. Positive signals are the result of a basic trading strategy. They tell us when and how a trade should be executed, while negative signals are the result of market action that does not generate a signal.