Plenty of people are comfortable with the slow and steady growth that happens when they invest. But there’s another class of market participants who want more opportunity and more excitement.
That’s where trading comes in.
Although trading comes with a higher level of risk, it can also lead to substantial profits. Whether you’re trading stocks, contracts for difference (CFDs), forex, or any other asset, it’s possible to generate a profit regardless of market conditions.
In all reality, the differentiator between profits and losses boils down to your trading strategy and how closely you stick to it. But how do you go about choosing a trading strategy to employ?
to Choose a Trading Strategy
Your trading strategy should address your goals, risk tolerance, and skill set. It’s also important to test your strategy before risking your hard-earned money and monitor your performance as you go. Follow the steps below to get started choosing a trading strategy that works for you.
1. Identify Your Trading Goals
Several trading opportunities will pop up from day to day, but it’s important that the ones you take advantage of align with your goals. Your trading goals should challenge you but also be achievable.
For example, as a novice trader, it’s not likely that you’ll earn a 100% monthly return. Instead, set your goal to a 15% monthly return. The goal is achievable but will also be challenging.
By setting a solid goal in place, you’ll have something to shoot for as you trade throughout the month.
2. Identify Your Risk Tolerance
Although there are many different trading strategies, all traders have the same goal — to exploit volatility in the stock market to make money. Unfortunately, volatility isn’t directional; prices fall as quickly as they rise.
Thus, traders always accept at least a small amount of risk. So it’s important to practice solid risk management.
You’ll need to know your risk tolerance in order to stay ahead in the market. If you’re a risk-averse investor, trading may not be for you. On the other hand, if you’re willing to accept moderate to high levels of risk, you may be the perfect candidate.
Your risk tolerance plays a role in the trading strategy you choose. For example, if you have a healthy appetite for risk, you’ll likely be interested in fast-paced day trading strategies. On the other hand, if you only have a moderate risk tolerance, swing trading may be the best strategy for you.
Risk tolerance also informs your trading tactics, such as where you set your stop-loss orders. Stop-losses limit downside potential on trades by triggering an exit when a certain price or percentage loss is met. However, they can also limit your returns by executing premature trades.
If you have a moderate appetite for risk, you should set your stop-loss closer to the current price of the asset. A trigger price farther from the asset price is best for those with a healthy appetite for risk.
3. Be Honest About Your Skills & Needs
Your experience level plays a major role in the trading strategies you should employ.
For example, if you’re a beginner, you shouldn’t start with a scalping strategy. Scalping requires intense technical analysis in a fast-paced trading environment, so it’s a strategy best reserved for experienced players.
Your level of expertise isn’t the only factor at play here. Some other factors you’ll want to consider include:
- Time. The most intense trading strategies require traders to be active for several hours throughout each trading session. Some strategies won’t come with such a time commitment. When choosing your strategy, consider the amount of time you have to devote to trading every day.
- Money. Some trading strategies require you to make multiple trades per day. Doing so will inevitably lead your broker to label you as a pattern day trader. When you have this label, you must have at least $25,000 in liquidity in your trading account at all times. If you don’t have at least $30,000 or so to trade — enough to keep $25,000 on the sidelines while you trade — you’ll want to focus on strategies that only require three or fewer trades per week to avoid this issue.
- Emotions. Human beings are emotional creatures by nature. Some of us are able to control those emotions, while others of us cry every time we watch a Lifetime movie. Bringing emotions into the trading process is a mistake that can devastate returns, and your ability to control your emotions should play a role in the strategy you choose to follow. You should only choose a fast-paced trading strategy if you have complete control over your emotions and can stomach both the ups and the downs.
4. Choose a Trading Strategy
A trading strategy is like a trading plan or roadmap. It tells you what types of assets to watch, when to enter positions, and when to exit them. A simple online search will yield several trading strategy options, but they’ll all fall into one of the following categories.
Keep everything above in mind when comparing these strategies for your unique situation.
Day traders purchase an asset and sell it on the same calendar day. The idea is to take advantage of intraday price movements to generate significant short-term profits. Day traders are known for making large trades, often on margins that provide leverage. This is because small price movements on large, leveraged positions can lead to significant returns.
Day traders never hold a position overnight, and for good reason. Once the trading session closes, the after-hours and premarket sessions will determine where the stock opens the next day. Unfortunately, institutional investors have the most control in these sessions.
By the time the next official trading session rolls around, there may be a big gap between the previous closing price and the current opening price. Day trading strategies require traders to close all positions by the closing bell. This way, they’re never victims of the gap.
Scalping, momentum trading, and short selling are all popular strategies often combined with day trading. You’ll find further details on each of these strategies below.
Day trading is a good fit if:
- You’re Experienced. Day trading requires a deep understanding of technical analysis. Day trading gains can be significant but the losses can be catastrophic if you don’t know what you’re doing.
- You’re Able to Keep Your Emotions in Check. Day trading is a fast-paced process where you can earn and lose money quickly. It’s important to keep your emotions in check as you trade.
- You Have Plenty of Time. Many day traders work the entire time the market is open and research at night to find targets for the next day.
- You Have at Least $25,000. Day trading requires you to make multiple trades daily, which will result in you being labeled as a pattern day trader. Pattern day traders are required to keep a minimum balance of $25,000 in their brokerage accounts at all times.
The swing trading strategy is a slower-paced strategy with a time frame ranging from a day to a few months. The strategy is based on the idea that it’s possible to predict price swings in the market using technical analysis.
Swing traders don’t attempt to buy in at the bottom and sell at the top. Instead, these traders are interested in buying in after a trend has been established and selling at the first sign of weakness in the price action, ultimately reducing reversal risk.
Although swing traders do use technical analysis, it’s often coupled with fundamental analysis to determine why the stock is headed in the direction it’s headed and how long the swing is likely to last.
Swing trading is a good fit for you if:
- You’re a New Trader. Swing trading is great if you’re a beginner because it’s a slower-paced style of trading. This gives you the option to take the time to properly analyze trends in charts and fundamental data.
- You’re an Expert. It’s also a strong bet if you’re an expert trader with moderate risk tolerance. Even as an expert, you may not be comfortable with other fast-paced, highly speculative trading strategies.
- You Don’t Have $25,000 to Start With. You can generate meaningful returns as a swing trader with one to three trades per week, so you don’t have to be labeled a pattern day trader to use this strategy.
- Your Time Is Limited. Swing trading isn’t as time-intensive as other faster-paced styles of trading. You will need to devote at least an hour or two to the process per day, however.
- You’re Emotional. Swing trading is a calculated process that requires you to analyze data over time. So there’s less chance of an emotion-driven, knee-jerk reaction that could result in significant losses. If you’re prone to emotions running high when markets turn on a dime, the slower-unfolding mechanics of swing trading may be perfect for you.
Scalping is the fastest-paced trading strategy. Scalpers aren’t interested in making big gains with each trade they make. In fact, they’re happy with the smallest gain possible on each trade, as long as the trade ends in a profit.
The goal of scalping is to make several trades every day and exit the trades as soon as they become profitable. Scalpers have a short-term outlook, and their trades can be held for anywhere from a few minutes to a few days.
The concept is simple. Scalpers take advantage of several small price fluctuations that generate tiny profits. At the end of the trading day, several tiny profits add up to meaningful returns. Scalping also protects the trader from reversal risk because they exit their trades as soon as they become profitable.
Scalping is a good fit if:
- You Have at Least Some Trading Experience. Scalpers rely on technical analysis and work in a fast-paced environment, so you should have some experience before using this strategy. However, you don’t have to be the most experienced trader because the exit signals are as simple as they come: If the trade’s profitable, it’s time to get out!
- You Have a Moderate Appetite for Risk. All trading activities come with risk. However, you can significantly limit risk with this strategy by faithfully setting your stop-loss orders and strictly following the strategy of exiting as soon as the trade becomes profitable.
- You Have Plenty of Time to Trade. As a scalper, you’ll need to make several trades per day and may be required to trade through the entire trading session to generate meaningful returns.
- You Have More Than $25,000. Scalping requires several trades daily. You’ll definitely be labeled as a pattern day trader and be required to maintain a $25,000 minimum balance.
Momentum traders use technical analysis tools called momentum oscillators to gauge the direction and veracity of a trend. These traders are only interested in diving into a trade when the asset is clearly trending in a single direction and there’s strong momentum behind the trend.
The idea is that momentum will slow before a trend reversal. By diving in when momentum is strong and making an exit as momentum slows, you’ll be able to profit.
Momentum trading is a good fit if:
- You Have Limited Experience. Momentum oscillators may seem complicated at first, but their signals are very clear, so they’re a perfect tool for you if you’re just getting your feet wet.
- You Have a Moderate Risk Tolerance. All trading comes with risk, but historically, strong momentum has led to trend continuations. If you keep your stop-losses in check and pay close attention to the momentum oscillators you use to trade, you’ll be able to limit your risk.
- You Have Some Time. You’ll need to devote plenty of time to this strategy because you’ll need to keep close tabs on momentum. If you walk away from the screen and momentum slows or changes, you could be in line for losses.
- You Don’t Have $25,000 to Start With. You can generate meaningful returns with just a few trades per week as a momentum trader. You don’t have to be labeled a pattern day trader. However, that label may come down the line as your account grows and you decide to trade more frequently.
The stock market isn’t always about tapping into upward movement. Short sellers bank on the downward movement.
Short selling is the process of borrowing shares of a stock you believe is going to fall and immediately selling them into the open market. When the stock price falls, you repurchase the shares at a discount and return them. In the end, your profits come from the spread between the original price at which you sold the shares and the new price at which you repurchased them.
Short selling is a good fit if:
- You Have Plenty of Experience. Short selling is a high-risk, highly speculative trading strategy. It should only be used by the most experienced traders.
- You Have a High Risk Tolerance. Having a short position in a stock can produce losses in a hurry if its price jumps higher. Short squeezes happen often. In these events, a price that was expected to fall starts to rise. When it does, short sellers abandon their positions, leading to high-volume buying and quick gains in the asset price. If you’re not one of the first shorts to exit, you could be left with devastating losses.
- You Have Plenty of Time. Short sellers devote a significant amount of time to research. It’s common for short sellers to spend eight or more hours per day in front of their computer screens.
- You Have Plenty of Money. You won’t be labeled a pattern day trader as a short seller, but it’s important for you to have a cushion to fall on if you get stuck in a short squeeze.
5. Test Your Trading Strategy
Once you’ve locked onto a trading strategy that fits your needs, you’ve got one more step before you start to trade. It’s time to test your strategy.
There’s a long list of brokers and trading platforms that offer free trading simulators. You’ll be able to use fake money to test your strategy in real-time when you take advantage of these simulators.
If you test your strategy and it generates meaningful returns on paper, you’re ready to trade in the real world. If the test results in losses, you need to make adjustments but you won’t lose any money!
6. Monitor Your Performance & Adjust as Needed
Use a trading journal to track your performance, and take the time to review your journal on a weekly basis. As you compile data on your trades, trends will begin to emerge, giving you the opportunity to adjust your strategy and become a more profitable trader.
7. Stick With Your Trading Style
You may be tempted to shift your trading style from time to time. But you shouldn’t fix something that’s not broken. Only adjust your trading style when there’s a clear need to do so. Hopping from one trading strategy to another or deviating from the rules of your chosen strategy is how traders wind up making costly mistakes.
Your trading strategy is like a treasure map. If you follow everything it tells you to do, you’ll be a successful trader. However, it’s not always easy to follow a strategy, especially when it’s uncomfortable from a risk perspective or your emotions get involved.
That’s why it’s important to consider your unique traits as a trader when picking a strategy.
Consider your goals, risk tolerance, and level of experience, and always take the time to test your strategy in a simulated environment before risking real money in the real world.