HOW DO YOU DEVELOP A TRADING STRATEGY?
It’s good to generate your own trading ideas. These don’t have to be completely original, but the more original an idea, the less likely it is to be already mainstream, which means it won’t yet be priced in to the market. To develop a trading strategy your ideas can come from anywhere. There is the “bottom-up” approach which can be thought of as looking at small, everyday stuff. For instance, look around at your high street and note how it is changing: why might this be and how could it change in the future? What about your own behaviour as a consumer? Which shops to you go to most and why? Have you changed your own buying habits recently and if so, why? What about your friends and family? These are all questions which can help you build an understanding of the retail sector and develop trading ideas. Additionally you could have your own area of expertise, either through your work, studies or even a hobby. Is your field of expertise changing, and if so how is that affecting you? Are there new software products you have to buy? In what ways are they better than the old ones? Are there new technologies such as 3D printing which may be helpful in your work, yet also disruptive? Think about these issues and try to think laterally. Don’t just follow one train of thought through to what appears to be its logical conclusion, but expand into other related areas. Then you can try to put this all together and look for investing opportunities. To develop a trading strategy you could also take a “top down” approach. For instance, you may believe that eventually all cars will run on electricity, or that in future solar power will play a major role in supplying our energy needs. Researching further you learn about the latest developments in battery technology and this in turn connects directly to a commodity like lithium. From here it is relatively simple to identify companies who could benefit from future developments. Suddenly you will find ways to try to capitalise on your trading idea. This means that you’ve got a good chance of getting in near the beginning of a trend. If your idea is any good then the market will respond and momentum will build. Now you don’t want to get in too early either. Buying, or selling something too early can be the same as being wrong. If the market takes too long to come round to your view then you run the risk of suffering losses if prices move against you. In an ideal world you want to get in as a trend is beginning and as momentum is starting to build. The important thing is that you’ve got your own reasons for doing the trade which is much better than taking trading tips from third parties. After all, we can’t know what another person’s full trading plan is, or if they’ve even got one. This means that we have no idea what their tolerance to risk is, let alone how it may compare to ours. It’s tempting when you’re told that this is “a sure-fire thing” but what is your plan if it starts to go wrong?
Develop a trading strategy that suits you. Your own ideas helps to build self-confidence and gives you the tools to trade again and again. This will help you to be a successful trader. Coming up with a good idea is just the first step in the process of how you develop a strategy. Now it’s time to carry out some analysis to see if your idea can be turned into a profitable trade.
There are two parts to this: fundamental and technical analysis.
Fundamental analysis is where we look in detail at the factors which influence the pricing of a particular financial instrument. These can be many and varied, and will depend on the asset class that you’re considering. For example, if you’re looking at stocks you will need to carry out some company analysis. This would include a study of what the company does, where does it operate, who runs it and how financially stable is it? A big multinational may be stable because it is diversified. But this may also mean that growth in one particular area may be offset by a slowdown in another division. In contrast, a company that concentrates on just a few products may experience stellar growth but then not be protected if something goes wrong in a specific area. For instance, in the oil industry a giant multinational involved in exploration, production and refining such as BP has depth and is capable of surviving damaging events. BP is still in business despite the disaster in the Gulf of Mexico. Smaller oil explorers can bring stunning results if they are successful, but can easily go out of business following a single disappointment if their money runs out. You will want to look at such things as the company’s management, along with financial statements such as the balance sheets and profit & loss accounts. Some companies are popular with investors because they pay out a healthy dividend. But what happens if the dividend outlook deteriorates? This can have a dramatic effect on the company’s stock price. Also, where does the company operate geographically? This may not be an issue for a tech start-up in Silicon Valley, but it is a major consideration for many miners and oil exploration companies. Fundamental analysis should be the starting point for any trade, whether it is on an individual equity, a stock index, commodity or bond. Then it’s time to look at the charts to identify the best entry and exit points. This is technical analysis and we’ll consider this in another guide.