Trading Strategy Methods and Types
There’s a saying that if you fail to plan, you’re planning to fail. Another way to express this is: if you don’t know where you’re going, any road will get you there. These expressions are particularly true in investing. Your portfolio represents something of significance to you: a comfortable, secure (and perhaps early) retirement, a means to help your children get started, estate planning, and the ability to live the life you’ve always wanted. Ensuring you are maximizing its value requires careful planning.
Investors can generally be grouped into two camps: active or passive investors. Passive investors tend to buy and hold. While they may make a few trades every quarter to rebalance their portfolio, they are not active traders. On the other end of the spectrum are active investors. They make frequent trades, perhaps even daily trades. They employ trading strategies and rely on quantifiable information and either fundamental or technical indicators to guide their investment decisions.
When it comes to using a trading strategy, one size does not fit all. An investor needs to factor in their investment objectives, their tolerance for risk, how much time they have, and tax implications. The purpose of this article is to briefly describe some of the most popular trading strategies that active investors use.
Why use a trading strategy?
Traders use different strategies to avoid bias and to ensure consistent results. One of the tenets of buying and selling stocks is to keep emotions out of it. Falling in love with a stock can cause you to keep a stock longer than you should after it has lost potential. On the other end, being governed by anxiety and fear about a stock that is falling may cause you to sell when the proper response would be to buy more shares at a discount. This is where a trading strategy can help.
What are some common trading strategies?
The following are a list of some of the more common trading strategies. Anyone of these could be an article in itself, but for the purposes of this article, we’re providing a brief overview to show you how some of these strategies are similar or different.
- Day Trading– as its name implies, day trading involves buying and selling shares of securities within a day. Day traders close their positions before the end of the trading day. The speed at which day traders buy and sell is what separates it from other trading strategies. Day trading is a risky strategy and requires commitment, discipline and rigid attention to money management controls.
Day trading is a tool that became available to individual investors with the advent of the internet and online trading. Day trading combines a number of trading strategies including trading on the news, range trading and momentum trading. Day traders will also pay attention to the average daily trading volume to help determine whether they will be able to quickly enter and exit a position.
Like swing traders or momentum traders, day traders will look for a stock or ETF to break above an area of price resistance or below a previous level of support. Day traders will typically put in buy orders above the new breakout point and stop-loss orders below the point of broken resistance. Another approach is to look for a stock or ETF that has been clearly trending in a positive direction and jumping in when it shows a pullback down to a previous support line.
- Momentum Trading– There is a saying in baseball that momentum is the next day's starting pitcher. This refers to the fact that when a team is hot or cold, they tend to stay that way, even if they have a significant talent disadvantage unless something happens to break their momentum. In investing, the concept of momentum is that when prices are moving in a direction, up or down, they will tend to continue in that direction unless some event occurs to break its momentum. While some investors tend to shy away from buying a stock that is reaching new highs or selling at a new low, momentum traders use technical analysis to determine which stocks have the potential to depart from trends. To be a successful momentum investor, you need to be able to carefully evaluate what sectors are likely to be actively traded and then analyze, and rank, individual equities to look for ones that have the best chance of continuing on trend. Unlike day traders, momentum traders will hold positions sometimes for weeks or months. To hedge against risk, they will frequently have buy or stop/loss orders in place to sell on the first indication of a trend reversing.
- Swing Trading – Swing traders try to profit from market swings (or trends) that last one day or perhaps several weeks. In this way, this kind of trading falls in between day trading and momentum trading, yet combines elements of both. The technical principles are the same. Like day traders, these investors are using technical analysis to identify stocks that are breaking past a resistance point, and like momentum investors, they are willing to hold the trade for some time. The difference is that quick wins are important to these investors and they will be willing to exit a trade sooner which may mean they miss a major move to the upside. Still, they may make more profitable trades than a day trader. Swing traders also need to ensure that they manage the higher commission costs that can come with more frequent trading. Many investors who are new to active trading will find swing trading to be an attractive option to help them understand how markets move and how to set up appropriate stop-loss techniques to minimize their risk.
- Range Trading – Range traders attempt to identify when a stock is either overbought or oversold based on a technical analysis of price trends. In a sense, range trading is perhaps the easiest of these trading systems to understand because it advocates a very clear strategy of “buying low and selling high”. Investors who follow this strategy are looking to see when a stock has risen to a level where it is likely to meet resistance (overbought) or fallen to a level where it is generating support (resistance). The idea is to be a contrarian and be willing to take a profit, even when a higher profit may be possible and perhaps taking a loss if a stock that you thought would go up continues to go down. Some of the technical analysis used for this kind of trading is to determine how long the stock has traded within a range, how far the price is from its high or low, and how much volume is being traded.
- Trading on the News – this is also known as World Event Trading (WET). A helpful analogy for this kind of trading is the butterfly effect. That is, events that happen in one area of the nation or world can cause significant trends in the market. That's the idea behind trading on the news. The Weather Channel has helped consumers learn when a hurricane may be threatening the Gulf states, which can change buying habits as consumers will rush to the gas pumps to make sure their cars are filled up before the inevitable price increase. In the same way, investors who trade on the news look at world events along with other technical indicators as a way of determining which stocks may be moving and in what direction based on events. The difference is, while investors who apply this model need to have a detailed knowledge of numbers and statistics, they do not use them as their sole factor in making trades.
Individual investors understand that a single tweet from the President can cause an individual stock or an entire sector to move up or down. WET investors understand how the policies advocated in the President’s State of the Union address can impact the market six months to a year down the road. Investors who practice WET are often thought to be trying to “time the market”. However, these investors understand that markets do not happen in a vacuum, they are always looking at world events as a way of positioning their portfolio to account for the “black swan” events that can often have devastating effects for other trading methods. And while the very nature of a black swan event is that it is not predictable, investors who have portfolios based on World Event Trading are more likely to be able to quickly capitalize on an event.
- Short Selling – Short selling is simply making an investment based on the belief that a stock or segment will decrease in value. The idea of short selling is to predict that a stock is going down and then execute a trade to profit from that event, even as other buyers are rushing in. It requires you to have a belief that a stock is going down while others believe that a stock will continue going up. Many movies and books have been written about the supposedly greedy investor who profits from short selling. However, at its core, short selling is simply a trading strategy, albeit a risky one. But to investors who have the capital to risk, it can be profitable and it can provide liquidity to the overall market.
Short selling is one example of what’s called margin trading. The basic concept is that you are not buying shares, you’re borrowing them from your broker, then immediately selling them. The money from the sale of the stock goes into a margin account (which essentially acts as collateral for the loan) that is held by the broker. The short seller then looks to buy new shares of the stock when it goes lower in order to pay back the broker with the intention of making a profit.
Example: An investor borrows 100 shares of a stock trading at $20/share. They sell it at that price and now have $2,000 (which they place in a margin account with the broker). If the stock goes to $15/share, they can buy (not borrow) 100 shares for just $1500, pay their broker back the shares, and pocket the $2,000 from the initial sale. In that case, they’ve made a profit of $500, or $5 per share. However, if the price of the stock rises to $25/share, the investor is facing a potential $5 loss per share if the margin is called.
- Pairs Trading – Pairs trading combines elements of range trading and short selling. The pairs trader is looking to find two (i.e. a pair) companies or funds that have similar characteristics, but whose prices are trending in different directions and at a statistically significant deviation from their history. The strategy is to buy the security that’s undervalued and short sell the security that’s overvalued. A fundamental tenet for the pairs trader is that the market will either seek equilibrium or will continue and increase the imbalance. When betting on equilibrium the investor knows that, all things being equal, two stocks that should be priced similarly will return to those states. This is convergence. Simply put, if company A’s stock is trading at $30 a share and company B’s stock is trading at $35 a share, the spread will become smaller. On the other hand, if the investor sees a reason that the spread between the company exists and may continue to grow (divergence), they will employ a pairs trading strategy to profit as the spread grows.
The bottom line on trading strategies
Trading stocks are not for the faint of heart. It requires discipline and, quite frankly, an ample supply of money to put at risk. Many successful investors will use one or more of these trading strategies to help protect their portfolio from a bias that can set in. In sports, a popular trend is to use analytics to gauge performance. And there’s no doubt that analytics are here to stay. But as many a fired baseball executive has come to realize, sometimes a .220 hitter is a .220 hitter. And the fact that certain statistical anomalies may exist does not mean that they will become a .260 hitter just because they’re on your team.
In the same way, an investor who relies on one trading strategy may start to see things in the data that support their point of view, but are not really there. That’s why just as investors can’t rely on past performance; they shouldn’t rely on one trading method for all their trading.
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