Strategies vs. Trades

You have just opened an Upstox account, you’ve funded it, done some initial market research, and you are ready to place your first trade. You see that a certain large cap stock is trading flat for the last few trading sessions while the market is trended upward in price. You also notice that this company is set to announce earnings this week. You are a customer of this company and you think some of their recently released products are fantastic. After some thought, you’ve made your decision – this stock will be your first buy order and your hope is that the company will announce news that these new products have sold better than expected. If all goes well, the market will take notice and others will buy the stock as well thus driving up the price. Today is Monday and the announcement is Wednesday evening. By Friday, you should know whether or not this trade was a winner.

Looking at this, you may think that this is simply “a stock trade”. While it technically is a stock trade, what is described is a trading strategy. You had a hypothesis about a particular security; in this case, in was formed on fundamental analysis rather than technical analysis, or chart patterns. The strategy was also time-bound to the earnings announcement plus or minus a few days. Since you are familiar with this stock, you could execute this strategy in a similar way each quarter resulting in four trades per year. You could also expand this strategy to include this stock plus competitors because you may be familiar with their products as well.

A trading strategy is the systematic implementation of a market hypothesis. It is defined by several characteristics including: asset class, trigger, frequency, and duration.

• Asset Class: Common tradeable asset classes include stocks, index (or stock) futures, options, ETFs, and commodities. Some strategies are tradeable across multiple asset classes while some can only be traded in one. For example, if you believe that a company will get acquired in the near future, which would drive the stock price higher, you could buy the stock, future, or option. Each asset class will have its own risk-reward profile that should be assessed to help decide which one you will use. In addition, the asset class you use will determine how much capital and margin is required.
• Trigger: A ‘trigger’ is what determines the criteria for your trade entry and exit. What must be true for you to trade? This could come from technical analysis like the crossover of two moving averages or the relative strength index of a stock crossing a certain threshold. It could also be results of a company’s fundamental ratio, like their P/E, hitting a 52-week low or a quantitative metric, like the implied volatility of an index option reaching a certain level. Events, such as the annual Union Budget or an RBI rate change, could also be the motivation behind entering the trade.
• Frequency: The strategy frequency is how often will you be able to execute a trade. Some trading strategies, particularly event-driven ones, will have lower frequency – perhaps a few times per year. Some technically driven, scalping strategies could result in hundreds of trades per day.
• Duration: The duration is how long your typical trades are held. Some strategies involve “swing” trades where you hold a position for several days or a few weeks. Other strategies are intraday and require you to enter and exit on the same day. There are also high frequency strategies that are only profitable if you are able to enter and exit within a minute or two.

When you first start out, you will likely only use one strategy but over time, you should expand to a portfolio of strategies. This is because not every strategy works under all conditions – the more strategies that you are able to effectively run, the better of a chance you will have at long-term trading success. Each strategy you use will likely have at least one differing characteristic. Perhaps all are options trades that are triggered based on a technical chart pattern but perhaps one strategy has an intraday duration while another has a 2 to 3-day duration. Because of this, there will be different durations in your two strategies which will lead to different key risk-reward metrics.

In the next several lessons, we will discuss what these key risk-reward metrics are and how you can use them to effectively plan your trades. While we will go in-depth later, these are the metrics:

• Max Gain: How much could you possibly make with this trade in a best-case scenario?
• Max Loss: How much could you possibly lose with this trade in a worst-case scenario?
• Average Profit: How profitable will you be on average?
• Average Profit | Win: Given that the trade was successful, how much will you usually profit?
• Average Profit | Loss: Given that the trade didn’t work out, how much will your losses usually be?
• Win / Loss Ratio: If you run a strategy or similar trades continually, how many of the trades are winners and how many of the trades are losers?
• Breakeven Point: How much does the price of the stock, index, commodity, etc. need to move in order for you to start becoming profitable?
• Probability of Profit: What is the likelihood that you will reach breakeven, or better, on the trade?

As a take-home exercise, I’d like you to think about the trading strategy you are planning to use or perhaps already using. Can you succinctly define your target asset class, trigger, average frequency, and trade duration? If you can, that is a great start. If not, continue trying to define it and keep these characteristics in mind and we begin to explore the key risk-reward metrics. By the end of this course, you should feel comfortable in being able to define both your trading strategy and the risk-reward metrics associated with it.