How to Create a Technical Strategy: A Guide for Beginners.

How to Create a Technical Strategy: A Guide for Beginners

Performing analysis and combining indicator data to create a viable forex strategy often appears like a task suited only to the most experienced and professional traders. Beginners are intimidated sometimes by the mystical quality of the word strategy, and tend to associate the formulation of technical scenarios with the genius minds of Caesar, Napoleon, or Warren Buffet, for example. On the other hand, there is nothing that exceptional about the ability to design a strategy. Instead of timidity and worry about doing something wrong, it is much more productive and meaningful to be bold and try as many ideas and as possible as they present themselves to your mind. Since there is nothing right or wrong about a technical strategy as a general principle (lets recall that technical tools never predict anything with complete precision and certainty) its clear that the search for a perfect strategy is futile from the beginning. Yet the fear of failure is what makes so many traders apprehensive about creating their own approaches. The merit of each strategy is strongly tied to the market conditions and the personal qualities of the trader using it. What may work perfectly for George Soros as a long term strategy may be unsuitable to a retail trader with less conviction and financial power to survive financial misfortunes. If we also recall that market dynamics change continuously, that no technical approach will be successful at all times by definition, we will acknowledge that the fears about creating a botched technical strategy are in fact empty. We do need experience, and practice in formulating our strategies, but those can not be acquired if we are frightful about making mistakes.

Now lets take a look at how a technical strategy in a simple, step-by-step approach. In time, you may develop an altogether different method, but in the mind this template may serve your needs for clarity as a beginner.

1. Identify the type of the market

The first step must be the identification of nature of the market. Our choice of indicators will largely depend on the main characteristics of the market relating to its volatility, and whether it presents a range pattern or a trend for exploitation. It is not hard to determine what type of market the one that we are analyzing is, and only a cursory study with a few basic tools like trend lines, or horizontal lines for determining support/resistance levels should be sufficient.

The longer the timeframe, the more relaxed we may be in considering the impact of spreads, or the need for precision in determining the most suitable indicator type. In fact, it is a general principle that the longer the time frame of your chart, or the average lifespan of your positions, the easier it is to profit. Not only do long-term strategies decrease the proportional value of the spread cost, but they also entail a larger number of opportunities at the shorter timeframes that constitute the longer-term. You will have more chances to exit a faulty trade.

2. Choose the technical tools

The key point at this stage is picking only the tools that contribute to your goals in the trade, and provide the degree of precision that you require. The precision of signals generated by RSI and MACD are different, for example. Although the first will be very clear about the overbought/oversold levels in a range pattern, the MACD is used in conjunction with the divergence/convergence phenomenon, and is vague with regard to trends and market action as a result. In addition, your own risk tolerance, and money management style play a great role in deciding which indicators will yield the greatest value in your trades. For example, if you prefer a low volatility, low risk-reward trading style, indicators that perform best in strongly directional markets, such as the Williams Oscillator, will not find frequent use in your strategies. Conversely, as a trend follower, your strategies may consist entirely of moving averages.

At this point it is important to recall that there are no standard ingredients for forex strategies. It is definitely possible to create a forex strategy, and a perfectly viable one with only support and resistance levels and the RSI, or with moving averages and trend lines, as we mentioned. The decision about which indicators shall be used must not be arbitrary, but must depend strongly on the markets type, and the traders own style and preferences in trading. On the web its common to encounter sites where a cocktail of various strategies are offered or even sold to traders as valid configurations in many types of markets. Once again, well mention that the markets dynamics change all the time, and that theres no perfect tool or strategy that will be valid under all circumstances.

For those who seek a more precise list of what kind of tools may be usable in different market conditions, heres a sample list.

Trend Patterns: It is possible to create workable strategies with only moving averages in trending markets. In this case, the trader will treat each major moving average level (30-50-100) as being an attraction center, hurdle, goal, whatever youd like to term them, between which the price action will travel. Combining moving averages, while measuring how overextended the short term action is in various legs of the trend with various momentum indicators, is a generally valid method for the creation of forex strategies.

Range Patterns: Range patterns can be traded efficiently with support and resistance lines, and oscillators. The fundamental principle in the construction of forex strategies for range patterns is defining a range area with the support/resistance lines, and then remaining confident and aggressive as long as the price action remains in this region. Many different approaches, including layered entries, staggered trades on multiple timeframes, as well as simple range bouncing between the support and resistance points are all possible, and can be formulated with only a medium degree of learning and exertion of our mental powers.

Volatility: The Bollinger Bands, as well moving averages can be used to gauge volatility. When the moving averages of varying periods come closer, or the Bands contract, we have a low volatility environment, and vice versa. On this basis, scalpers, or trend followers may follow their favored methods.

3. Decide the Inputs

Once the basic structure of the strategy is created, it is time to decide on the various inputs related to the timeframe and period of the indicators. Only in cases where the price is demonstrating a well-identified pattern of periodic oscillations should we change the basic configuration of the indicator periods. On the other hand, there are some arbitrary values that help clarify the visual signals, and these can be modified in accordance with your tastes.

There are also some indicators where the starting conditions can be crucial to analysis. With Fibonacci Indicators, you can get drastically different results depending on where the initial phase is located. In that case, it will be a better course to carefully pick price extremes and apply our strategy beginning at these values in order to get a better long term perspective. Thus, if youll apply your trend strategy to this weeks price action, and it is the case that todays trend is part of a bigger one with origins a month ago, it is better to take this extended period into account while deciding the inputs to the indicators, and performing the analysis.

4. Perform the final analysis

The final analysis involves the comparison of different approaches that arose during the examination phase, and the choice of the most favorable one with respect to profit potential, and risk profile. You can make use of back testing as well at this stage, but only to see if you made simple mistakes in formulating your strategies. For example, if you were creating a strategy that would avoid periods of high volatility, a little back testing may be useful to see if this goal is achieved. But back testing can never be used for determining the profitability of a strategy. This is because although volatility is well-defined as a concept, profitability is not. It is not hard to recognize a volatile market, but theres no such definition about a profitable market. (The conditions that lead to profitability will be different in every market; they cannot be back tested.)

5. Execute the Trade

Once all the stages are completed, it is time to execute our strategy. It is important that you have enough confidence in your skills as a trader at this stage and avoid making arbitrary changes to your well-crafted strategy every time the market seems to be behaving in an unfathomable fashion. In the absence of major events (such as a major news release that contradicts the previous analysis, or the emergence of a divergence/convergence pattern in opposition to our previous scenario), the trade should be left to run its course, for better or worse, so that we can gain the necessary experience in forming and testing a strategy. Theres no expectation that each strategy will result in profits, and indeed, if your goals is discovering such a tool, youre advised to never begin forex trading. You may be better equipped to complete your quest as an academic. As traders, we use the tools available, and they do not allow perfect predictions about the future at this stage.

Last edited by newdigital; 09-21-2010 at 02:12 PM.

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