Trading Method Definition

Trading Method Definition

A trading method is a specific process and theory for approaching the financial markets in an established way to make money. A trading method brings orderliness of thought and behavior for planning and implementing a trader’s action for the philosophy behind entries and exits. 

Examples of trading methods are trend following, reversion to the mean, and momentum trading.

In contrast to a larger overarching trading method there are also trading plans, trading strategies, and trading systems.

Trading Strategies

A trading strategy is the process used to enter and exit positions in a market based on quantified signals on when to buy and when to sell. A trading strategy will have a trading plan to express a methodology that defines a trader’s return goals, risk tolerance, and time frame. A successful strategy should have an edge expressed in how trades are entered and managed to maximize gains and minimize losses. 

Creating a trading strategy from beginning to end requires several steps to complete the process.

Trading Systems

A trading system is creating a larger framework for the way that your watchlist, position sizing, and signals work together as part of a bigger process to create profitability for interconnecting parts of your trading . A trading system is a set of principles and procedures for how your trading will be done; it is an organized framework or executing your method and strategy.

A trading system includes:

  • Watchlist
  • Position sizing parameters
  • Risk management
  • Trade management processes
  • Signals
  • Volatility filters
  • Maximum risk parameters
  • Chart trend identification metrics

Trading Plans

Before you can trade you must first have a trading plan. A trading plan is written while the market is closed to tell you what to do when the market is open. A trading plan tells you how to specifically execute your trading system in real time with real money. A trading plan forces discipline and consistency onto your trading by allowing you to create a framework of execution to help manage your emotions and impulses when they are activated by price action, volatility, profits, and losses.

The Components of a trading plan:

1. Entering a trade: You must know clearly at what price you plan to enter your trade. Will it be a break through resistance, a bounce off support, or a specific price, or based on indicators? It needs to be quantified.

2. Exiting a trade: At what price level will you know your trade is unlikely to work out? Loss of support, a price level, a trailing stop, or a stop loss? Know where you are getting out before you get in.

3. Stop placement: You must either have a mental stop, a stop loss entered, or a time stop.

4. Position sizing: You determine how much you are willing to risk on any one trade before you decide how many shares to trade. How much you can risk will determine how much you can buy, based on the equities price and volatility.

5. Money management parameters: Never risk more than 1% of your total capital on any one trade. (2% maximum for aggressive traders who can handle bigger drawdowns). This 1% refers to the amount of total capital you would lose if  your stop loss is triggered based on your position sizing not the position size of your trade of the amount of price movement.

6. What to trade: Trade things you are comfortable with. Swing trading range bound stocks, trend trading growth stocks, or trend following commodities or currencies. Trade what you know.

7. Trading time frames: Are you a day trader, position trader, swing trader, or long term trend follower? If you are a long term trend follower, don’t get shaken out of a position in the first day by taking profits or getting scared. Know your holding period and adjust your plan accordingly.

8. Backtesting: Do not trade any method until you reviewed charts over a few years to see how you would have done. Alternatively, utilize backtesting software to analyze historical data for your system. There are also systems like CAN SLIM, The Turtles Trading System, and many Trend Following Systems. You need to begin trading knowing you have an edge.

9. Performance review: Keep a detailed record of your wins and losses. You need to be sure that your method is working in real trading. Review this after every 20 trades. Also, if you had any issues with discipline, then make notes, learn from your mistakes, and the make necessary adjustments.

10. Risk vs. Reward: Enter high probability trades where you are risking $100 to make $300, or trade a system that wins big in the long term through trend following.

Regardless of how you trade, every trader must have a trading plan.