A trading model is a well-defined, rule-based system for controlling trading activity. In this post, we will present the fundamental notion of trading models, explain their advantages, and show you how to create your own trading model.
The Benefits of Building a Trading Model
Using a rule-based trading model offers many benefits:
- Models are built on a set of tested rules. This aids in the removal of human emotions from decision-making.
- Models may be readily backtested on historical data to determine their value before investing actual money.
- Model-based backtesting helps the trader to verify related expenses, allowing him to view profit possibility more realistically. A possible $2 return may seem appealing, but a $2.50 brokerage fee alters the calculation.
- Models may be programmed to provide smartphone notifications, pop-up messages, and charts. This may reduce the need for manual monitoring and intervention. A trader may simply follow 10 stocks for 50-day moving average (DMA) crossing over 15-day moving average (DMA) using a model. Manually monitoring even one stock DMA without such technology might be tough.
How to Build Your Own Trading Model
You do not need significant trading skills to create a trading model. However, you must comprehend how and why prices fluctuate (for example, as a result of global events), where profit possibilities exist, and how to realistically capitalize on such chances. Beginners and intermediate traders might begin by learning about a few technical indicators. These provide useful insights on trading trends. Understanding technical indicators can also assist traders in conceptualizing trends and developing unique strategies and model modifications. This essay will concentrate on trading using technical indicators.
Example of a Simple Trading Model Strategy
Some traders believe that what goes down must come back up, based on the trend reversal theory (and vice versa).We will create a trading model based on the premise of trend reversal. We will travel through a number of stages to construct a trading model and assess its profitability in the sections below.
Flowchart for Building a Trading Model
1. Conceptualize the Trading Model
The trader analyses previous stock movements to uncover predicted tendencies and develop a concept in this stage. The notion might be the outcome of considerable data study or a wild guess based on random observations.
The approach for this post is based on trend reversal. The basic idea is that if a stock falls X percent from its previous day’s closing price, the trend will reverse within a few days.
Examine previous data and ask questions to improve the concept: Is the notion correct? Will this notion simply apply to a few high-volatility equities, or will it apply to all stocks? What is the predicted length of the trend reversal (one day, one week, or one month)? What should be the down level for entering a trade? What is the desired profit level?
An first notion is frequently riddled with unknowns. To begin, a trader need a few decision points or figures. These might be based on certain assumptions. This technique, for example, might be used to moderately volatile equities with abetavalues between 2 and 3. If the stock falls by 3%, buy it and wait 15 days for a trend reversal for a 4% gain. These figures are based on the assumptions and experience of the trader. Again, a fundamental comprehension of technical indications is required.
2. Identify the Opportunities
Identify the best chances or stocks to trade in this stage. This entails comparing the notion to historical evidence. In the example, we purchase on a 3% drop. Begin by selecting highvolatility stocks for the analysis. Historical data for regularly traded equities may be downloaded from exchange websites or financial portals such as Yahoo! Finance. Calculate the percentage change from the previous day’s closing price using spreadsheet formulae, then filter out the results that satisfy the criteria and monitor the trend for following days. An example spreadsheet is shown below.
In this case, the stock’s closing price falls by less than 3% on two consecutive days (Feb.4 and Feb.7).A careful examination of the next days will tell whether or not the trend reversal is noticeable. On February 5, the price increased by 4.59%. By February 8, the change was 1.96%, which was less than projected.
Are the findings conclusive? No. One observation meets the concept’s expectation (a change of 4% or more), whereas the other does not.
Next, we must validate our thesis using additional data points and stocks. Run the test on at least five years of daily pricing for various stocks. Determine which stocks have positive trend reversals within a certain time frame. Continue with the notion if the number of good outcomes outnumbers the number of bad results. If not, modify the notion and retest it, or abandon the concept entirely and return to step 1.
3.Develop the Trading Model
Based on the idea evaluation findings, we fine-tune the trading model and incorporate appropriate adjustments at this stage. We will continue to validate across huge datasets and look for other variants. Does considering certain weekdays increase the strategy’s outcome? For example, does a 3% drop in the stock price on a Friday result in a 5% or greater rise the following week? Is the result improved if we choose high-volatility equities with beta values greater than 4?
We can test these modifications regardless of whether the original notion yields favorable results. You may continue to experiment with other patterns. You may also utilize computer programming at this point to find lucrative patterns by allowing algorithms and computer programs to examine the data. Overall, the goal is to enhance the good results of our plan, which will lead to increased profitability.
Some traders become stuck at this step, evaluating enormous datasets with little modifications in parameters indefinitely. There is no such thing as a flawless trading model. Remember to draw a line in the sand when it comes to testing and making a choice.
4.Perform a Practicality Study
Our model is presently in terrific shape. The majority of deals result in a profit (for example, 70% wins of $2 and 30% loses of $1). We infer that for every ten deals, we may win $11 (7 * $2 – 3 * $1).
This step requires a feasibility analysis, which might be based on the following criteria:
- Is there enough potential for profit in the brokerage cost-per-trade?
- To generate a profit, I may need to make up to 20 transactions of $500 each, but my available cash is just $8,000. Does my trading model take capital constraints into account?
- How often can I trade? Is the model displaying too many transactions above my available capital, or too few trades, resulting in extremely poor profits?
- Does the theoretical conclusion correspond to the required regulations? Is it necessary to engage in short-selling or long-dated options transactions, which may be prohibited, or to maintain simultaneous purchase and sell positions, which may also be prohibited?
5.Go Live or Abandon and Move to a New Model
Make a choice based on the outcomes of the preceding testing, analysis, and modification. Go live by putting real money in the trading model, or quit the model and restart from the beginning.
Remember that once you start using real money, you must continue to monitor, analyze, and evaluate the results, particularly in the beginning.
6.Be Prepared for Failures and Restarts
Trading requires ongoing attention and strategy refinement. Even if your trading strategy has regularly produced profits for years, market events might occur at any moment. Be prepared to experience failures and losses. Be open to further changes and enhancements. If you lose money and can’t find any more modifications, be prepared to destroy the model and start again.
7. Ensure Risk Management by Building in What-If Scenarios
Risk management may not be viable to incorporate in selected trading models based on chosen methods, but it is prudent to have a backup plan in place if things do not look to be as predicted. What if you purchase a stock that fell 3% but did not exhibit a trend reversal during the following month? Should you sell the stock at a little loss or stay on to the position? What should you do in the event of a business action, such as a rights dispute?
The Bottom Line
Hundreds of proven trading ideas exist and are developing everyday as new traders customize them. A trader must have discipline, knowledge, tenacity, and a realistic risk assessment in order to properly create a trading model. One of the most significant difficulties is from the trader’s emotional commitment to a self-developed trading method. Such complete confidence in the model might result in significant losses. Emotional detachment is essential in model-based trading. If the model is failing, abandon it and create a new one, even if it comes at a small loss and time delay. Trading is all about making money, and loss aversion is integrated into rulebased trading models.
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