3/6/2019 A Systematic Approach to Developing Trading Strategies
A Systematic Approach to Developing
Trading Strategies
Team Auquan Follow
Aug 30, 2017 · 3 min read
In Part 1 and Part 2 of our Beginner’s Guide to developing trading
system, we talked about the necessary skills and how to approach a
trading system. We said that an Automated Trading System consists of
several elements. You need to decide which markets you want to trade,
identify and code a trading logic, account for trading costs and
optimize via backtesting (but not over t).
Here, we speci cally talk about the process of identifying the trading
logic and developing a strategy. The strategy will be the meat of your
trading system.
The end goal of a trading strategy is to give you a nal trading action -
buy or sell a certain quantity of a trade-able asset. However there is
structured process that leads to this end goal. Ideally your trading
strategy should decide the following:
• DIRECTION: identify if an asset is cheap or expensive or fair value
• ENTRY TRADE: given that an asset is cheap/expensive, decide if it
wants to buy/sell that asset
• EXIT TRADE: given that an asset is fair priced and if we hold a
position in that asset(bought or sold it earlier), decide if it wants to
exit that position
• PRICE RANGE: decide the price (or price range) that it wants to
make this trade at
• QUANTITY: Amount of capital(how many shares of a stock for
example) that it wants to trade
This give you the nal trading action, for example: buy X number of
shares of comapny Y at below Z price, that you an send to your broker.
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3/6/2019 A Systematic Approach to Developing Trading Strategies
While thinking about designing a trading strategy, I nd the following
owchart helpful
How to develop a trading strategy?
Let’s analyze what’s happening here in detail:
1. We have real time price data for multiple securities(this could
come from a broker or a data vendor or a co-located server)
feeding into our system
2. DIRECTION — This data feed get analyzed by our prediction
model, which uses current as well as historical data to predict a
fair value for the securities using a pre-learned logic. The actual
prediction can vary based on how you have built your model. For
example, instead of predicting the fair value, you could predict the
probability that price will go up(or down)
3. ENTRY/EXIT TRADE — The previous prediction feeds into trading
signal logic, which decides if we want to make a trade. This is
very important. Even if an asset is cheap, you may not want to
necessarily buy it. For example, the fair value of a stock may be Rs
100 and it is currently trading at Rs 99 (you expect price to go
back to Rs 100), but the variation in stock prices (standard
deviation) recently may be Rs 10 and you may want to wait for a
better entry point. Or the cost to trade might be Re 1, leaving you
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3/6/2019 A Systematic Approach to Developing Trading Strategies
with no pro t if you buy at Rs 99. Or you may already be at your
maximum position limit. This part of the logic identi es which
trades to make and what price to trade at (PRICE RANGE)
4. QUANTITY: Now you know what trade to make, you have to
decide how much funds to allocate to that trade. The logic here
will vary greatly from strategy to strategy. Normally, you don’t
want to enter (or exit) into a trade all at once. You may want to
enter a trade in small chunks to avoid losses from a bad decision or
to trade at the best price or to avoid impacting the market too
much. In the previous example, you may buy small quantity of
stock at 99, then wait till price goes to 98 and buy some more and
so on. The amount of position you already hold and available
funds to trade also a ect this logic. If you are trading multiple
assets, you will have to decide how much to allocate to each asset
as well.
5. Finally we have the complete order that we are ready to execute in
the market.
The aim of this post was to walk you through the systematic approach
of developing a trading strategy. In the next few tutorials we will talk
about some basic strategies such as mean reversion and momentum
that will help you with step 2 and 3 — identifying the Direction, Trade
and Price. For some hands-on experience, try developing your own
strategies using our toolbox.
Happy Trading!
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