Concepts in Trading Strategies – Alpha Generation
Before trying to find or design a good trading strategy, one should understand the intrinsic concepts. The following 8 concepts can help as a quick start guide for designing trading strategies.
Understanding Market Segment
People new to charting may feel automated trading is all about price data, and tend to overlook understanding the market segment in which they trade. However, the fact is that whichever instrument you trade is largely influenced by its related market segment. For example, individual stocks are influenced by their respective industry group, broader stock market, and the economic cycle in which they are in. In comparison, Copper futures will be influenced by metal sector and currency market.
Similarly if you want to trade intraday you need to understand the microstructure of the instruments you are trading. For example, derivatives exhibit peculiar characteristics (and resultant price behavior) based on their underlying.
Time Frames and Periods
Time frame is a ‘snapshot’ of prices at regular time intervals. For example, in the hourly time frame we see the high, low, open and close prices for EACH hour. Time frames of magnitude more than the Daily are referred to as intraday. See the chart, the large price drop towards the end occurs usually more on minute time frames then daily time frames. Similarly time periods in indicators play a very important part in stock analysis.
Everything quantitative that we talk about is in reference to a specific time frame. If we say a stock is uptrending it does not makes sense unless it is specified whether it is uptrending in intraday or for the past month.
In chart based trading, it can be very helpful to watch a time frame immediately bigger (to see the broad picture) and one time frame immediately smaller (for good trade execution).
Trend is the most important part of Technical Analysis. As proved by consistently profitable traders, prices do not follow a random walk. Price movements exhibit trending tendency. Trends can be three types: up, down and sideways.
How to mark a trend? Let us take the example of an uptrend to demonstrate it. To mark an uptrend, consider three price troughs (price bottoms). If they are rising, we can assume that the market is in uptrend. To mark an uptrend consider the price troughs, to mark a downtrend consider the price peaks, and to mark sideways consider both peaks and troughs. A Moving Average of length 20 is also good to mark visualize immediate trend. Trends exist both in prices and volumes and they tend to correlate. (Refer Trend lines drawn and MA(40) in the chart)
The golden rule is to never initiate a trade against the current trend.
Volatility is a measure of risk. It can help you decide where to place the stoploss.
Finding a Support and Resistance level is the next most important concept after trend. These may also be called buying/selling zone, accumulation/distribution level or supply/demand lines.
The support/ressistance levels are marked by taking the confluence of past highs and lows. The most recent highs/lows are more important price reference points than older highs/lows. The more highs/lows a trend line can connect, the more important the level tends to be. A support/resistance line does not necessarily has to be horizontal; for example, the common Moving Average lines can be used as support or resistance.
When price breaks through previous support, the next time it rises, the same support acts as resistance. So past support can act as resistance and vice versa.
Here is you first trading strategy trading strategy! Buy in a uptrend when prices retraces to a support level (retracement happens in the immediate lower time frame).
Momentum or Internal Relative Strength
The level at which a stock trading relative to its past trading range is important for timing of the trade. Even in an uptrend a stock may move down in the shorter time frame or may stagnate at a price level. Oscillators are useful in gauging the momentum.
When prices are extended in a particular direction, they tend to revert to their mean. The mean here is just a hypothetical value at which all buyers and sellers would like to see the market. The mean is always moving, and the simplest replacement of mean can be a short-term moving average. Refer to the circles marked in the chart when prices were extended to either direction.
So here is your second trading strategy! Buy in a uptrend when prices are extended downwards (oversold) and returning to the mean.
Mean reversion in prices tends to correlate with mean reversion in volumes.
Relative Strength indicates exactly how stronger an instrument is trading relative to its market segment. For intraday time frames it can be used for breakout strategies. For daily/weekly time frames an entire branch of Technical Analysis has spun off called Intermarket Analysis (which may be said to include Sector Rotation or Business Cycle investing).