7 steps mantra to create successful trading strategies

If you happen to google stock trading strategies, you will be bombarded with results with highly fanciful names: Iron condor, butterflies, lizards, sunrises, dragons, you name it! These are nothing more than attractively packaged titles to make trading strategies sound formidable, notable and attractive. But the crux of a successful strategy lies not in the name, but in its formulation, execution discipline and regular monitoring. It is worthwhile to study all the commonly used strategies to get an understanding of how they are constructed and executed, and we recommend our readers to do this exercise. However, most of the readily available tips and strategies have a serious limitation. All these strategies are generalized, and as we know, risk-taking ability differs from investor to investor. This is where it pays to create your own strategy: a tailor-made suit that fits you best. This article will explain the Tequity investing 7 step mantra to create successful trading strategies. The following 7 steps are prescribed to have a successful proprietary trading strategy:

1. Define the instrument: To start with, begin with strictly defining your instrument of choice. Equities, commodities, currencies, etc. Furthermore, define whether you will be trading in the underlying instrument directly or whether via futures, options or a combination of those.

2. Define Universe: Once your asset of choice and financial instrument of choice are finalized, it is imperative to define the boundaries of your selection criteria. For example, instrument is commodity futures, your universe could be crude, gold, copper, and silver. Nothing more, nothing less. Alternatively, if your area is equity stock options, your universe can be highly liquid NIFTY stock options, or perhaps, BFSI sector companies or illiquid mid-cap options. The choice is yours. Restricting the universe is imperative to reduce chaos and limit choices. IT greatly helps to bring objectivity in decision making. While a machine can pick from hundreds of available candidates, a human mind cannot. Having a narrowed down universe helps keep regular track of your underlying. Your familiarity with the underlying will help you to identify patterns that otherwise would not be possible. That being said, we recommend you answer the following questions when defining your universe:

Does my instrument of choice and universe have:

  • Easy access to historical data

  • Liquidity constraints

  • Clarity of Understanding the arithmetic of the underlying instrument

  • Authenticity and reliability of real time data

  • Sources to track news and events relating to your underlying

3. Defining Entry Triggers: Once your universe is defined, it is time to step further and get to the execution end of things. This is where experience and individual discretion come into play. We will explain entry triggers via one of Tequity Investing’s specific trading strategies for better understanding: Our instrument of choice is highly liquid options of equity stocks and indices. We have 3 trigger conditions

  • Trigger 1: 15 days < Time to expiry < 7 days. That is to say, that the time to expiry of the underlying’s option is between 7 days and 15 days

  • Trigger 2: If absolute IV of shortlisted option is greater than 50, eliminate

  • Trigger 3: (IVs of Far month option) / (IV of near month option of the same strike)

This is to say, we check the ratio of the implied volatility of next month and this month's options for the same strike prices. If the value of this ratio fits our ‘target range’(our trade secret), we consider executing the trade.

Internally, we call our strategy, a calendar volatility arbitrage. But for you dear reader, we will give it the fancy title of ‘Sleeping Tiger’ ☺

Do note that by defining our trigger, we achieve many important milestones. First, we adhere to a fixed repeatable discipline. Second, it helps us greatly narrow down to maybe 3-5 possible alternatives. A successful strategy among other things has to be repeatable, and also highly specific. If your triggers give you too many alternatives, consider adding another trigger level to further filter out the noise. This is how a trade comes into our ‘consideration set’.

4. Define Risk Metrics: After defining the entry trigger parameters and narrowing down your alternatives to achieve your consideration set, the time comes to quantitatively define risk metrics. For this process, the following questions must be answered

  • What is the maximum loss of this strategy

  • What is the maximum loss you are willing to take before exiting the strategy

  • What is the maximum profit achievable with your strategy

  • What is the realistic or probabilistic profit

  • What is the probability of success of the strategy

  • What is the ratio of expected profit to acceptable loss

  • What is the holding period of the strategy

  • What is the capital required to execute strategy

  • What is the expected return on capital

Remember that all of the above have to be quantified with precision. The Tequity Investing way of doing this using a graphical representation of the strategy to ascertain risk parameters.

Let’s take a simple example of a short strangle trade on Maruti trade(note that this example is different from the Sleeping Tiger strategy discussed above). The following are input criteria.

Date: 4th Oct 2019

Spot Price: 6646

Short 7000 OCT CE for 123.85 premium received

Short 6200 OCT PE for 81.95 premium received

(If you don’t understand options, don’t be bogged down by the above terminology. Continue reading on)

For this strategy, we have created a Payoff Chart using Opstra DefineEdge

The payout chart shows the predicted outcome as on 31st Oct 2019. On the X-axis is the share price (current price on 4th Oct is 6645.95). On the Y-axis is the profit/loss. So at each corresponding value of share price on 31st October, we have an idea of our expected profit/loss. In this particular example, if the share moves sharply on either side there is a chance of making a loss. However, if the share price stays in a range between 6000 and 7200, there is profit to be made. By means of this payoff chart, we are able to define the risk questionnaire as under:

  • What is the maximum loss of this strategy - Infinite

  • What is the maximum loss you are willing to take before exiting the strategy: Max loss 10,000 (this is defined by the trader’s discretion)

  • What is the maximum profit achievable with your strategy: INR 15435

  • What is the realistic or probabilistic profit: 68% probability that profit will be between 0 and 15,435(note the -1σ and +1σ range in the payoff chart. That range indicates that there is a 68% chance that the share price will be within that range by 31st Oct. How this is calculated is the subject of a different article which we will not cover here). We will consider probabilistic profit as INR 10,000 for this case. Note that acceptable profit and acceptable loss are both 10,000 INR.

  • What is the probability of success of the strategy: 68%

  • What is the ratio of expected profit to acceptable loss: 1:1

  • What is the holding period of the strategy: Maximum 25 days OR until profit target OR until stop loss is achieved

  • What is the capital required to execute strategy: INR 1.67 lakhs

  • What is the expected return on capital: Assuming INR 10,000 profit, the expected return is 6% in 25 days. Annualizing this, the expected return is 87% per annum

With the above example, we have shown how strictly we need to define our risk and return expectations even before executing the trade. This exercise is done for all the alternatives that have been filtered from the ‘Define Entry Triggers’ step. The best alternative is chosen. If two or more strategies still look equally rewarding, the discretion lies with the intuition and experience of the trader as to which strategy/strategies to execute. Please note that risk and return are completely a function of individual interests and ability. The above example is a real-life illustration, but in no way is it a guarantee of generating 87% annual returns.

Consistency of a trading strategy is more important than rates of return while evaluating a trading strategy.

5. Define Exit Triggers: If the risk and return are properly defined in stage 4, this is just a synthetic step. A strategy typically must be exited when the target profit, target stop loss, or target holding period is reached. However, one may choose to add additional exit parameters to further insulate themselves from losses. These parameters could include RSI level, different moving average levels, 52Week High/Low, Supertrend lines, major news announcements, etc. These points are discretionary and will vary from trader to trader.

6. Validate: This is often the most neglected aspect of trade strategy formation, but perhaps the most important. A good strategy must have the capability to weather many storms and deliver predictable outcomes regardless of market conditions over a period of time. We propose the following activities to our readers:

  1. Back-test: Before your approach can even be called a strategy, it must be able to succeed in a rigorous backtest. Data from at least the last 1 year should be handy with you, and you must perform backtesting of your strategies diligently. You can use engines such as Opstra to run these tests. Once you get your results, you will be able to add or modify to your entry, exit and risk criteria, so that you have a well-defined strategy statement

  2. Maintain a trade journal: Once your trade strategy is backtested, deploy it, but with caution. Note that a successful backtest is by no means an assurance of success. Start with small capital, or perhaps paper trade for a few months. Every trade you complete must have a journal entry corresponding to it. Note down what went right, what went wrong and what can be improved.

  3. Fine Tune: Once you have enough evidence of your strategy from your backtest and journal entries, fine-tune the strategy. This may elicit changes in all 6 steps of strategy formation. Fine-tuning is a continuous process.

Making money through trading is a boring and dull job, just like most other jobs. It requires immense patience. Excitement doesn't go very well with trading. If you are always excited about your trading strategy, most probably you are a newbie and your trading strategy needs to be evaluated thoroughly.

7. Recycle: In our experience of trading in the market with our strategies, we have noticed that successful trading strategies have an expiration date. We attribute this to changing market behavior and investor intelligence. This means that successful strategizing is a continuous process and the best out there are constantly working on new approaches, while systematically deploying currently successful strategies. It’s hard work, but it sure does pay!

For curious readers, our Sleeping Tiger Strategy is one of our most successful ones. We have a success rate of over 80% with our trades, and since we have deployed the Sleeping Tiger, our annualized returns from the same are a whopping 48%! Get in touch with us if you’d like to know more, and get updates about this.

In Summary, the Tequity Investing 7 steps to create a successful trading strategy are as under:

  1. Define Instrument

  2. Define Universe

  3. Define Entry Triggers

  4. Define Risk Metrics

  5. Define Exit Triggers

  6. Validate

  7. Recycle

©Tequity Investing

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