Much has been said about having a trading strategy and sticking to the plan, but what exactly do you need to build a profitable strategy?
If you keep a detailed trading journal (and you should!), you probably have a pretty good idea of which indicators and setups tend to work in your favor.
This can be as simple as textbook breaks and retests, involving a combination of Fibonacci, support and resistance, moving averages, and stochastics in a vector market.
Defining building blocks like these not only makes your strategy more profitable, but also helps you maintain the discipline to trust and follow the plan.
1. Market environment
Understanding the market environment is one of the most important considerations when taking trades. This is why it is an essential building block for a profitable trading strategy.
Simply put, it means measuring whether asset prices are trending or range bound. You want to be able to use the right kind of indicators and drawing tools for the current environment.
In a trending market, asset prices move in a certain direction for an extended period of time. During these situations, it makes sense to use the likes of moving averages, Fibonacci, and trend lines in your strategy.
In a range bound market, asset prices usually bounce off strong support and resistance levels. A trading strategy that includes pivot points, Bollinger Bands, or oscillators can work best in this case.
Note that a combination of these technical indicators can be applicable to both range bound and trending markets depending on how you apply them, so it is really important that you know what kind of environment you are trading in!
2. Momentum
Momentum is often associated with physics, referring to the product of an object’s mass and its velocity. In trading, momentum looks at how quickly an asset’s price can change over a certain period of time.
This can be determined either by using complex mathematical formulas in the form of technical indicators or simply by observing the price action.
For example, a sharper and larger rally in the previous four hours than the price action in the same time period in the past is said to have stronger bullish momentum.
Looking at momentum can help you predict the next direction of price movement and how fast or slow that move will occur. It can also help you gauge whether a reversal or breakout from a reversal will occur, as well as the speed of a potential correction within a trend.
3. Inflection points
These generally refer to support and resistance levels that can guide you in setting entry and exit rules for your trading strategy.
Reversal points can include Fibonacci levels, pivot points, areas of interest based on historical price action or psychological numbers, dynamic levels based on technical indicators, or a combination of these.
4. Size
Another important building block is volume, which tracks the level of market interest in a particular asset. Changes in volume can help determine the best times to enter trades and when to exit.
Volume often appears as lines or bars below the main price chart. The higher the trading activity of an asset, the higher the volume.
Lower volume or shorter bars are usually seen during periods of consolidation while higher volume or longer bars generally accompany breakouts or sustained moves.
5. Timing
Finally, timing looks at specific periods during which a security will typically retrace or consolidate from a previous move. An example of this is during the end of trading sessions or overlaps for certain currency pairs.
By knowing these typical correction or consolidation periods, you can be able to time your entries well, catch better prices to buy or sell at, and avoid being faked out by price spikes that aren’t likely to last.
Of course, these building blocks are not set in stone, and you should be able to make some adjustments based on testing or new information that you think could improve your results.