Trading is a risky business. But with some research and planning, it is possible to turn it profitable. One of the ways to create a profitable trading business is by building a trading model. A trading model is a clearly defined, systematic, rule-based structure for managing trading activities. If you are interested in understanding the basic concept of trading models, their benefits, and knowing how to build your own trading model, read on.
The Benefits of a Trading Model
Before we dive into the above-mentioned details, let’s understand the benefits of having a rule-based trading model.
- As models are based on a set of proven rules, they help remove human emotions from decision-making.
- You can back-test models on historical data and verify their worth before taking any concrete decisions involving money.
- Model-based backtesting also facilitates the verification of associated costs. This helps a trader to see real profit potential. For instance, a $2 profit might be highly lucrative until you consider the brokerage charge of $2.50.
- Models can be automated in such a way that they can send you mobile alerts, pop-up messages, and useful charts. It means you don’t have to manually monitor everything constantly. With a model, you can easily track several stocks for a 50-day moving average (DMA) crossing over a 15-day moving average. Without automation and modelling, manual tracking of even a single stock DMA is a tough ask.
Build Your Own Trading Model
You don’t need expert trading knowledge to build a trading model. Nevertheless, you’ll need an understanding of how and why prices move, where are the profit opportunities, and how to capitalise on those opportunities. If you are a novice, you can start by familiarising yourself with a few technical indicators. They offer significant insights into trading patterns. Understanding technical indicators are also helpful in conceptualising trends and in making customised strategies and alterations to models.
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A Simple Trading Model Strategy
Some traders act based on the principle of a trend reversal, that is, what goes down will come back up (and vice versa). We will build a model using trend reversal as a strategy. Let’s get going with the following seven steps:
1. Conceptualise the Model
The first step is to study the historical stock movements to identify predictive trends and to create a concept based on that. You can use extensive data analysis or base your concept on chance observations. As we are using the trend reversal strategy to build the model, the initial concept will be if a stock falls by X percent compared to the previous day’s closing price, the trend is expected to reverse in the next few days.
Then, you will use past data and ask questions to fine-tune the concept. Ask yourselves if the concept is true or whether it will apply to all stocks or only a selected few. What is the expected trend reversal period? What is your down level to enter a trade? What is your goal level?
As you can see, the initial concept has several unknowns. You’ll need a few deciding points or numbers to begin, even if they are based on assumptions. The numbers are generally based on the trader’s experience and assumptions. For this, a basic understanding of technical indicators is critical.
2. Identify opportunities
Once the initial concept is clear, the next step is to identify the right opportunities or stocks to trade. It requires validating the concept against historical data. You can download historical data of the regularly traded stocks from exchange websites or financial portals. You can calculate the percentage change from the last day’s closing with the help of spreadsheet formulas. By filtering out the results matching the chosen criteria, and by observing the pattern for subsequent days, you can identify opportunities.
However, it is likely that you will not be able to get a piece of conclusive evidence from this analysis. In such a scenario, you’ll have to further check your concept across more data points and stocks. You can run the test of the daily prices across multiple stocks for over five years to find which stocks provide positive trend reversals within a specified time. If the quantity of positive results is better than negative ones, you can proceed with your concept. If not, you might have to tweak the concept and retest it or discard it completely and start over.
3. Develop the Trading Model
Once the opportunities are identified, the next step is to fine-tune the trading model and introduce necessary variations based on the assessment results of the concept. You must continuously verify large datasets and watch out for more variations. Check if the strategy outcome improves on specific weekdays or does the outcome improve for high-volatility stocks with beta values above 4?
You can verify these customisations even if the original concept does not show positive results. You must explore multiple patterns and perhaps use computer programming to identify profitable trends. The algorithms and computer programs can analyse the data to improve the positive outcomes from your strategy to increase profitability.
Make sure you don’t get drowned in data analysis. Some traders get stuck with endless data analysis with slight variations in parameters. Remember that there is no perfect model and so you have to stop analyzing and take decisions every once in a while.
4. Conduct a Practicality Study
At this stage, your model is looking great and shows a positive profit for a majority of trades. However, you need to carry out a practicality study at this stage, based on the following points:
- Does the brokerage cost-per-trade leave enough room for profit?
- Does the trading model account for capital limits?
- What is the frequency of trade? Does the model show too frequent trades above your capital available, or too few trades thereby keeping profits very low?
- Does the hypothetical outcome meet the necessary regulations? Does it require short selling or long-dated trading options that are banned, or the holding of simultaneous buy and sell positions that aren’t allowed?
5. Go Live or Stop and Move to a New Model
At this stage, you must decide after considering the results of the above testing, analysis, and adjustment. If everything is ok, you can go live by investing real money using the trading model. If not, you must abandon the model and start over from step one.
You must remember that it is important to keep on tracking, analyzing, and evaluating the result once you go live with real money. This is especially important in the beginning.
6. Prepare yourself for Failures and Restarts
Trading success is not a guarantee. You must be prepared to fail and start over every time you trade. In fact, trading needs continuous attention and improvements to the strategy employed. So, even when your trading model has consistently earned you profits over the years, market developments can change at any time and ruin it for you. You must be prepared for failures and losses. Even when you fail, you must be open to further customisations and improvements. You should not hesitate to trash the model and move on to a new one if you fail and lose money or if you cannot find any more customisations.
7. Devise risk management strategies by considering what-if scenarios
As a trader, you must always be prepared to take and manage risks. Always be aware that things may not go your way and that you might fail. Although it might not be possible for you to include risk management in selected trading models, always have a backup plan if things don’t go the way you expected. For instance, ask questions like - what if the stock you bought went down 3%, and did not show trend reversal for the next month? Should you get rid of that stock at a limited loss or keep holding on to that position?
Ask yourself as many what-if questions as possible and come up with answers for them too. Soon, you will have a great idea of how to go about in any given scenario, whether expected or unexpected. You can never be over-prepared.
There are hundreds of established trading concepts that are growing daily with the customisations of new traders. You must have discipline, ample knowledge, perseverance, and a certain degree of risk assessment capability to successfully build a trading model. You must guard yourself against one of the biggest pitfalls – your emotional attachment to a self-developed trading strategy. Blind faith in any model, no matter how successful they were in the past, can lead to mounting losses.
Model-based trading is all about emotional detachment. You must get rid of the model and go for another one if it fails. Most of the time it makes sense to limit your loss and time delay than lose it entirely. Never hesitate to ditch the model if it isn’t working. As you know, trading is about profitability, and loss aversion must be built into the rule-based trading models so that they help you earn greater profits.
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