Developing Day Trading Strategy for Stocks

TRADING STRATEGY is the foundation of our stock trading success. This post is largely a practical application of the expert advise given in PART 2 of the international bestselling book The Complete Guide to Day Trading: A Practical Manual From a Professional Day Trading Coach.

Markus Heitkoetter, author of the book outlined the process of how to develop our own trading strategy in "seven simple, but very important, steps:"

• Step 1: Selecting a Market
• Step 2: Selecting a Timeframe
• Step 3: Selecting a Trading Style
• Step 4: Defining Entry Points
• Step 5: Defining Exit Points
• Step 6: Evaluating Your Trading Strategy
• Step 7: Improving Your Trading Strategy

Step	Action	Implementation
1	Selecting a Market	Marginal Stock Trader selected the stock market for his market of interest.
2	Selecting a Timeframe	For our stock trading activities, we selected the 10-day timeframe because of the limitations discussed in our previous post Day Trading Stocks at the Philippine Stock Exchange.
3	Selecting a Trading Style	The concepts we need to be familiar with before selecting a trading style were as follows: Fundamental Analysis Technical Analysis Day Trading Charts Bar Charts Candlestick Charts Line Charts Technical Indicators Trends Uptrend Downtrend Trading Range Support and Resistance Trendlines and Trend Channels Technical Indicators Technical analysis "The main question is whether you’ll use fundamental or technical analysis to decide which instrument to trade and when to enter and exit." says Markus Heitkoetter. Marginal Stock Trader shall use technical analysis. Trading strategies Following the suggestions from the book, we selected a primary trading strategy for trending markets, and a secondary trading strategy for sideways-moving markets. Primary trading strategy Our primary trading strategy is for trend-following – when prices are moving up, we buy, and when prices are going down, we sell. Marginal Stock Trader preferred the Simple Moving Averages for his primary trading approach because it works very well in trending markets. Other popular trend-following trading approaches were as follows: Crossover of Moving Averages Turtle Trading Moving Average Convergence-Divergence (MACD) Secondary trading strategy Our secondary trading strategy is trend-fading – when prices are trading at an extreme (e.g. upper band of a channel), we sell, and then we try to catch the small move while prices are shifting back into “normalcy.” The same applies for buying. Marginal Stock Investor chose the Relative Strength Index (RSI) for secondary trading approach because it works best in sideways-moving markets. Other popular trend-fading trading approaches: Williams %R - works best in sideways-moving markets Bollinger Bands and Channels - works best in sideways-moving markets Says Markus Heitkoetter: "Trading can be simple: you buy when the market is going up and you sell when the market is going down. That’s how money is made."
4	Defining Entry Points	Simple Moving Averages BUY signal is generated when the closing price moves above the moving average. Relative Strength Index BUY signal is generated when the RSI crosses the 30-line (oversold-zone) from below.
5	Defining Exit Points	Simple Moving Averages SELL signal is generated when the closing price dips below the moving average. Relative Strength Index SELL signal is generated when the RSI crosses the 70-line (overbought- zone) from above. Three exit rules There are three different exit rules we should apply: stop loss, profit exit and time-stop. 1. Stop loss rules to protect our capital. Once we have entered a trade, we immediately define a stop. This safeguards us from losing our entire account. Our stop loss rule shall be expressed in a fixed amount of 20 pesos for every board lot of ten shares of Ayala Corporation. Fixed peso amount strategy This is an easy, fast, and simple rule. Just specify a peso amount that we are willing to risk, subtract it from our entry price, and place a stop loss order. How to use this strategy Simply subtract the peso amount we specified from our entry price. Example: Let’s say we are trading the 100 shares of Ayala Corporation. We entered the market at 250 pesos per share and we want to risk 20 pesos for each board lot of ten shares. Let us also say we have BPI Trade for our online broker. Hence, we place our stop loss at 251 pesos per share. When to use this strategy This strategy is perfect for beginners like Marginal Stock Trader, since we don’t have to perform complex calculations. We simply add or subtract our stop loss to or from our entry price and that’s it. It works best if we’re trading only one stock or one market, and if the security doesn’t fluctuate too much. 2. Profit-taking exits to realize our gains. Once we’re in a profitable trade, the next challenge becomes when to take that profit. The "key to trading success," according to the book The Complete Guide to Day Trading is: "small profits, consistently." Our profit exit strategy shall be expressed in a fixed amount of 30 pesos for every board lot of ten shares of Ayala Corporation. Fixed peso amount strategy We mentioned in the first exit rule that this is the easiest way to exit a trade. Simply specify a peso amount that we would be happy with, add it to our entry point, and place a profit target order in the market. How to use this strategy Simply add the peso amount we specified to our entry price. Example: Let’s say we’re trading 100 shares of Ayala Corporation and enter at 250 pesos. Our profit target is 300, so we would exit the trade as soon as prices move up 6 pesos, to 256 pesos. When to use this strategy Again, this strategy works best if we are just trading one stock or one market, and if the security doesn’t fluctuate too much. 3. Time-stops to get us out of a trade and free our capital if the market is not moving at all. A time-stop gets us out of a trade if it’s not moving in any direction. If prices do not move at all, we get out. How to use this strategy We simply specify a “time-out,” after which we will exit the market. We exit the trade after the specified time, regardless of whether we reached our stop loss or profit target. Example: A good time-stop is three times the timeframe we’re using. Since we’re using 10-day charts, we get out of the trade if neither our profit nor our stop loss is hit after 30 days. When to use this strategy We can dramatically reduce our risk by applying a time-stop and exiting the market if it doesn’t move. We free our capital and then take the next trading opportunity.
6	Evaluating Your Trading Strategy	To be completed after 40 trades or at least a year. More likely, about 40 trades is possible by December 2009.
7	Improving Your Trading Strategy	To be completed as the need arises. Improving our trading strategy is an important concern for Marginal Stock Trader.