Foreword
Contrary to the perception of many people, a lot of things go into a good trading strategy.
It is not simply just “a good idea”, but really, the orchestration of many different disciplines towards a common goal.
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
Investing vs Speculating
Before we begin, let’s address the elephant in the room. Are we talking about investing or speculating?
Both. While most associate “trading” with speculation, in this particular post, I’m using the word in a more mechanical way — a “trade” is just a transaction, an exchange, in this case, of cash for some asset.
In the world of speculation, a “successful trade” is actually 2 (or more) separate trades — one or more to get into the “position”, and one or more to get out of it, sometimes also called a “roundtrip”. A speculative trade is never a success until you close out the position.
In the world of investing, most “successful trades” are also “roundtrips”. However, there is a separate class of trade which are perpetual, or near perpetual, where a “successful trade” is simply how you edge into a long term advantageous position. Recall that when investing, you are hoping to profit off the productive capacity of the asset. Therefore, a successful long term trade could simply just be getting into a long position with an asset that is productive and stable, at a good price — in such a trade, you are not looking to sell, instead, you are looking to hold the asset for an indefinite amount of time and let the productive capacity accrue profits.
There is an old trader’s adage which goes roughly, “An investment is a trade gone pear shaped”. And therein lies the difference as explained above, albeit with a tragicomedy twist.
Components of a trading strategy
So what are the components of a trading strategy? In broad terms, a good trading strategy should always have these 3 main components:
- Base thesis
- Why are we even considering this trade?
- What is the catalyst, or driver for this trade to perform well?
- Examples:
- Inflation trade, e.g.: we believe inflation is going up/down over the next N months/years
- Macro trade, e.g.: we believe this country/industry/sector will go up/down over the next N months/years because of <reason>
- Execution
- How would we translate the base thesis, from a purely analytical state, to one or more trades?
- Embedded in this, are considerations such as:
- Time horizon – How long are we holding the position in each roundtrip?
- Instrument – What asset are we going to trade to express the base thesis?
- Price – At what price are we looking to trade?
- Trading – Are we going to edge into the position slowly? Or buy everything at once?
- Example:
- Base thesis: We believe that inflation will go up slightly in the next 2-3 years
- Time horizon: 2-3 years
- Instruments:
- Short short/medium term Treasuries
- Long stocks of businesses with fixed input costs and variable output prices
- Price: At the market based on trading strategy.
- Trading: Form a basket of the instruments with some ratio, rebalance every 3 months
- Risk management
- How would we know that our base thesis/execution strategy was wrong?
- And if one (or both) was wrong, what are we going to do to salvage the situation?
- Example (follow up on the above):
- We’ll know our inflation thesis is wrong if inflation does not go up at least 0.1% on a year over year basis every month for the next 6 months.
- If our thesis is wrong, immediately close out the short Treasuries leg of the position, keep the long stock leg as long as it is still performing at or near broad market performance, and slowly close it out over 2-3 quarters.
- We’ll know our execution strategy is wrong if inflation does go up as described, but out position does not appreciate faster than broad market performance over a 1 month moving window, sampled daily.
- If our execution strategy is wrong, immediately close out all positions and rethink.
Case study – Inflation in the 1970s
Base thesis
We are currently in 1971, we predict inflation is going to be much higher for the rest of the decade into 1980.
Execution strategy
Buy near month exchange traded gold futures, and continually roll the contracts forward until expiration of thesis. We believe market pricing is currently fair, so we’ll trade at the market.
We’ll leverage our position by 3x of equity, rebalanced yearly.
Case study result
Anyone who predicted (in 1971) that high inflation will be a problem that decade would have been absolutely correct — inflation went from around 5% in 1971 to 12% in 1975, and finally around 14% in 1980.
However, this simple summary is misleading. Inflation actually fell after 1971 to a low of around 3% in mid 1972, before its enormous rise to 12% in 1975. After that, it again fell to around 5% in 1977, before another huge surge, before ending at around 14% in 1980.
So while the base thesis was, on the whole, correct, the sampling period and how we decide we were correct or wrong (risk management) may have led to us conclude that high inflation was over in 1972 or 1977!
The execution strategy, on the other hand, likely would have given us a roller coaster ride. From 1971 to 1975, gold prices raised from around $260 per ounce to $929 in early 1975. At 3x leverage balanced yearly, we’d have suffered a devastating 91% loss in 1976, ending up with a value worse than if we had simply just bought gold outright without leverage:
| Year | Gold price in Jan | Annual % change | 3x leverage annual % change | 3x leverage value |
| 1971 | 261.07 | – | – | 261.07 |
| 1972 | 305.34 | 17.0% | 50.9% | 393.95 |
| 1973 | 419.44 | 37.4% | 112.1% | 835.57 |
| 1974 | 762.30 | 81.7% | 245.3% | 2885.22 |
| 1975 | 929.38 | 21.9% | 65.8% | 4783.69 |
| 1976 | 647.59 | -30.3% | -91.0% | 430.53 |
| 1977 | 619.89 | -4.3% | -12.8% | 375.42 |
| 1978 | 760.83 | 22.7% | 68.2% | 631.46 |
| 1979 | 912.96 | 20.0% | 60.0% | 1010.34 |
| 1980 | 2390.52 | 161.8% | 485.5% | 5915.54 |
If we had closed our position then, however, we’d have lost out on a magnificent rise in value till 1980. True, it’s quite a bit less than 3x what the underlying did, but it was still pretty decent!
The astute reader will notice that in the case study, a section on risk management was left out. This is intentional, because since we are looking at the data in hindsight, any risk management strategy can be crafted to make any arbitrary point. That said, a good risk management strategy would hopefully have gotten us out of the trade either in 1972 (because the base thesis, at that point in time, looked like it might have been wrong), or in mid 1975, because gold prices and inflation were both turning down, or (albeit a very risky strategy) it could have given us the courage to held on to our convictions till 1980.
Why bother?
The reason why a good trading strategy plans out the base thesis, execution strategy and risk management way before even entering a trade, is so that these decisions can be made with a level head. Imagine if you were the portfolio manager of the strategy above. Would you have the conviction to hold in 1972, after a very decent (almost double) gain, but with inflation lower than expected? What about in 1976, after a devastating 91% drawdown? Or would you have folded, expecting gold prices to go even lower (as it did the next year by 1977, by another 12.8%)?
Laying out your strategies, and putting them to paper while you still have a clear head helps to eliminate emotional biases that creep in in the heat of the moment. This gives you a chance to at least think clearly about the issues, and decide what your risk tolerances are.
Janky Thoughts 