Trading Strategy II

In the previous lesson we learnt that a trading strategy is defined by:

• an entry, and
• an exit: a target price and a stop loss price.

In this lesson we will talk about each of these in detail.

How do we define an entry?

There might be a million ways to define an entry for a trading strategy. The most common ones are based on technical indicators like the EMA or VWAP, or on some statistical analysis.

One example of an entry definition:

• Price crossing above the 20-day moving average for the stock.

There are so many other entries that are possible. For example:

• For intraday: price closes above VWAP on a 5-minute timeframe.
• RSI touches 20 on a 5-minute timeframe.

While defining an entry we also need to define the direction of the trade. Will we buy the stock, or sell it? So while defining a strategy, the entry always carries the side of the trade as well.

The target price

The simplest way to define a target price is a percentage. For example: I will sell the stock once it reaches a price 5 percent higher than my buying price.

So let's say you bought a stock for $100. With the 5% logic, your target is $105. This is the simplest way, and the most practical in real life.

There are more statistically advanced methods, like defining the target based on ATR, because every stock moves differently and one fixed value is not the best fit for every stock. A target can also be defined using an indicator, like the 20 SMA. For example: I will exit my position when the price crosses and closes below the 20 SMA.

The stop loss

The stop loss is the price at which you accept that you are wrong in your evaluation of the market, and you exit your position.

Like the target, a stop loss can be defined as a fixed percentage, from ATR, or from an indicator like the SMA.

Trading Strategy Example 1

• Instrument: ES
• Timeframe: 60 minutes

Consider the RSI indicator. One famous strategy is to buy when ES falls into oversold territory, expecting a bounce.

So our entry and exit conditions would be:

• Entry: price at 7500, RSI below 30
• Target: 1 percent
• Stop loss: 0.5 percent

That means we will either make an exit at 7575, with a profit. Or make an exit at 7462.50, with a loss.

There are other ways to define a stop loss and target as well. Time-based: I will exit after 2 days, irrespective of profit or loss. Or a hybrid: time-based plus a percentage-based target and stop loss. These are more complex methods. Many brokers do not support them out of the box, and they are mostly used by algo traders. If this all sounds complicated, don't worry.

One more parameter which advanced traders use along with a stop loss is a trailing stop loss: a stop that moves up as the trade moves in your favour. That one deserves its own lesson, later.

For this course, we only need to understand the simple pieces:

1. An entry condition based on an indicator, like a 20 SMA crossing.
2. A percentage-based target and stop loss.