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Trading Strategies - Module 3

Welcome to this unit on Trading Strategies. In this module we will be explaining the core components of a trading strategy and how you can begin to incorporate analysis techniques into a step by step process or strategy.

Key Learning Outcomes:

- You will understand the definition of a trading strategy as well as why traders use one when trading the financial markets.

- To identify two popular entry techniques used in a trading strategy and how to implement them when trading the financial markets.

- To understand the five core components of a trading strategy and how you can begin to combine these components in order to create a trading strategy based on technical analysis.

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Trading Strategies

Having a clearly defined trading strategy is an important factor to consider when first beginning to trade the financial markets.

The purpose of a trading strategy is to combine various analysis techniques with key money management principles into step by step actions or processes.

Two Entry Techniques

There are two popular entry techniques used by financial traders in a clearly defined trading strategy, regardless of the financial instrument or timeframe. This includes the entry on breakout and the entry on pullback.

A breakout technique is used to enter a trade when price breaks through a clearly defined Support or Resistance level, profiting from a surge of either buyers or sellers. In the example below we can clearly identify a strong support level as shown by the black line.

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When using the entry on breakout technique, we would look to enter the trade with momentum just below the identified support level. When price breaks the support level, we are looking to capitalise on that initial surge of sellers as shown below. Notice the large volume of sellers that have entered the market as identified by the large full bodied red candles.

In some cases we may not have been able to capitalise on this initial surge, so instead we could use the entry on pullback technique. A pullback technique is used to enter a trade when price pulls back or retraces towards a previously broken support or resistance level.

We could therefore look to place an entry level just below the previously broken support level, which may now act as resistance, as shown above.

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In this example we can see how price has pulled back towards the previously broken support level, which has then acted as resistance. Financial traders could look to enter the trade on the pullback in order to profit from the continued move lower, as shown below.

The same breakout and pullback concept can be applied in reverse.

In this example we can see that price is consolidating in the form of a triangle pattern and a clear trendline resistance level can be identified.

Financial traders may therefore place an entry level just above this resistance level looking to profit from an anticipated surge of buyers.

We can then see the reaction as price breaks the trendline resistance level as a large volume of buyers have entered the market.

By using the entry on breakout technique, financial traders could capitalise on this initial surge of buyers.

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If we were to use the pullback technique on the same example, we may look to place an entry level just above the previously broken resistance level. We can then see how price has pulled back towards that same region before continuing higher.

Both entry techniques discussed can be used to capitalise when price reacts at support or resistance levels. By using the breakout technique, financial traders are looking to capitalise on that initial surge in either buyers or sellers as price breaks a support or resistance level. By using the pullback technique, financial traders will look to enter the trade when price pulls back towards a previously established support or resistance level, before profiting on the continued move with the trend.

Five Core Components

There are five core components to consider in a clearly defined trading strategy:

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Alert:

An alert provides us with a clear visual indication that a potential new trend or trading opportunity is developing. In the example below, a potential alert to a new trend developing may be the cross over of two moving averages.

This type of alert gives us a distinct visual indication, which we can then look for across various currency pairs and financial instruments.

Assessment:

The assessment process ensures that we are trading with the main trend, or establishes if a previous trend has come to an end. In the example below we can see that we had a previously downtrending market, however, there is a failure to break lower with a clear support level.

Therefore our alert of an uptrending market, combined with a failure to break lower, might be considered as confirmation that a new uptrend may be developing.

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Entry, Stop Loss & Target:

The next stage of a trading strategy is to establish at what level we would look to enter the trade, where our stop loss should go, and finally our target level. More information on entry, stop loss and target levels can be found in the Money Management section. Using our previous example, we could use the Fibonacci indicator to help us determine potential support levels from which price may react and enter using the pullback technique.

We may look to enter a long position as price pulls back towards the 38.2% Fib level, as shown in blue. In this example, our stop loss level is positioned below the 61.8% Fib level and below the moving averages, shown in red. Finally our initial target region could be the previous high as shown in green.

Execution:

The execution stage involves placing the trade, possibly through an online broker using an order ticket as shown below.

In the order ticket we would input our entry, stop loss and target levels in the relevant highlighted boxes as shown.

More information on these levels as well as order tickets can be found in the Money Management and Platforms & Accounts sections.

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Trade Management:

Trade management is the process of using techniques to reduce risk or even secure profit during an open trade.

In this example, our trade has been entered as price has pulled back to a support level around the 38.2% Fib level. Price has then continued higher resulting in the trade being in profit as buyers are in control. At this stage we may then look to move our stop loss to breakeven, meaning all risk is removed from the trade.

To do this we would manually amend our order ticket by changing our stop loss level to the same as our entry level. At this stage in the trade there would be no further risk on the trade. More information on how to move a stop loss to breakeven, as well as risk management, can be found in the Money Management and Platforms & Accounts sections.

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As price continues to rise in our favour, we could look to amend our stop loss and target levels, in order to then secure a profit on an open trade. If price were to then pull back and trigger our stop loss, we would have secured the difference between our entry level and our newly established stop loss level.

We can then see that price has continued to rise in our favour as the currency pair increases in value. When price hits our target level, our trade will automatically be closed by our broker for a profit.

Each of the five components discussed can be used and implemented in a trading strategy as they can help to build a framework that traders can reference and use on any currency pair.

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Trading Strategies- Summary

- A trading strategy is a process-driven plan combining various analysis methods and money management techniques into step by step guidelines.

- There are two popular entry techniques used in a trading strategy. This includes the entry on breakout and the entry on pullback.

- A breakout technique is used to enter a trade with momentum when price breaks through a clearly defined support or resistance level.

- A pullback technique involves entering a trade when price starts to pull back or retrace towards a previously broken support or resistance level.

- There are five core components of a trading strategy including an alert, an assessment process, identifying our entry, stop loss and target levels, execution of a trade and finally, trade management.