How to Generate New Trading Strategies

Developing a trading strategy isn’t just about following a set formula; it’s about crafting an approach that resonates with your individual strengths, preferences, and personality.

Trading ultimately should excite you in the sense that you actually enjoy it and look forward to it, not leave you bored or stressed.

Think about what aspects of trading truly engage you.

Do you thrive on quick decisions and high-energy environments?

Or do you prefer methodical analysis and longer-term positions?

Your strategy should reflect these preferences.

Let’s look into this more below.

Key Takeaways – How to Generate New Trading Strategies

• Tailor to Your Strengths
  • Build strategies that align with your personality, whether it’s fast-paced or methodical trading.
• What Are Your Goals?
  • Most fundamentally, everything flows from your goals.
  • What kind of return do you need?
  • How much risk are you willing to take?
  • What’s your time horizon?
• Leverage Experience
  • Real trading experience shapes practical strategies.
  • This is where you’re most likely to get new ideas, including from mistakes.
• Spot Market Patterns
  • Identify market inefficiencies and patterns to develop unique strategies.
• Test and Adapt
  • Constantly refine your approach by testing in different conditions and adjusting to market changes.

The Role of Experience in Strategy Creation

Traders tend to be less influenced by academic teachings and more about actual trading experience because that’s where the practical skills come in.

There’s no substitute for hands-on experience in trading.

Books and courses provide knowledge, but the real learning often happens when you’re in the thick of it.

Don’t be afraid to dive in, make mistakes and get knocked around, and use those experiences to learn how to improve things (in a risk-limited way, of course).

Each trade, whether successful or not, offers insights that can shape your future strategies.

We tend to learn the most from what doesn’t go well.

Identifying Market Inefficiencies

Spotting Patterns and Anomalies

Start by observing market behavior closely.

Look for recurring patterns or anomalies.

These could be price movements at certain times of day, reactions to specific types of news, or behavior around key price levels.

Not every pattern is tradable, but identifying them is the first step in developing a unique strategy.

Market Microstructure

Understand how orders are placed and filled in your chosen market.

Understanding the mechanics of order flow, bid-ask spreads, and market depth can reveal opportunities that aren’t obvious at first glance.

This knowledge is particularly important for short-term trading strategies.

Integrating Economic Indicators

Don’t overlook the power of fundamental analysis, even in shorter-term strategies.

For example, a stock that you perceive to be undervalued – as well as the general tendency for equity prices to rise over time – might bias your decisions going long a stock for short-term trades.

Sector and Industry Analysis

Expand your strategy beyond individual assets to include sector and industry dynamics.

Understanding how different sectors interact and respond to economic conditions can inform both entry and exit decisions.

For example, how do oil prices affect airlines?

How do interest rates affect mortgage REITs?

Develop methods to quantify and track inter-sector correlations and divergences.

Technology & Data

Big Data and Machine Learning

Though not for everyone, the explosion of available data and advances in machine learning offer new avenues for strategy development.

Machine learning algorithms can help identify complex patterns that human analysis might miss.

However, be cautious of overfitting – be sure your models generalize well to new data.

Developing Custom Indicators

Standard technical indicators have their place, but creating custom indicators tailored to your specific strategy can provide an edge.

These could be variations on existing indicators or entirely new creations based on your market observations.

The process of developing these indicators often leads to deeper market understanding.

If anything, writing things down in a disciplined way forces you to think about your criteria, which can also allow you to stress test them.

Risk Management and Position Sizing

Developing a Risk Framework

A strong risk management framework is crucial for any trading strategy.

Design your risk controls before focusing on entry and exit rules.

Consider using dynamic position sizing based on market volatility, account equity, and trade conviction.

Use strict stop-loss rules and consider using options or other derivatives for downside protection.

Stress Testing Your Strategy

Subject your strategy to rigorous stress testing.

If possible, simulate extreme market conditions (where synthetic data comes in handy) and see how your strategy performs.

This could involve historical backtesting during known crisis periods or Monte Carlo simulations to generate thousands of potential scenarios.

The goal is to understand your strategy’s breaking points and build in safeguards.

Recurring themes that traders learn through stress testing periods tend to be:

• diversify
• limit position sizes
• hedge where necessary

Psychological Aspects of Strategy Development

What Goes into a “Trading Personality”?

A trader’s personality shapes their trading approach.

Key aspects include:

• Risk Tolerance – Comfort with potential losses influences aggressive or conservative strategies.
• Decision-Making Style – Quick thinkers may prefer active trading. Analytical types might choose passive investing.
• Emotional Resilience – Ability to handle stress affects consistency.
• Patience Level – Impatient traders might opt for short-term trades. Patient traders may hold long-term positions.
• Time Commitment – Availability can dictate frequency of trading. Some people simply don’t have the time to day trade.
• Desire for Control – Some prefer hands-on management. Others trust automated systems.

Aligning Strategy with Risk Tolerance

Your trading strategy should align with your psychological makeup.

Consider your risk tolerance and emotional capacity for drawdowns.

A strategy that looks great on paper but (literally) causes sleepless nights is unsustainable.

If your body is telling you a strategy doesn’t work with you, then it’s right.

Building Confidence Through Incremental Testing

Confidence in your strategy is important for consistent execution.

Start by paper trading or using small position sizes to build confidence.

Gradually increase your exposure as you gain experience and refine your approach.

This incremental approach allows you to learn and adapt without risking significant capital.

Combining Multiple Strategies

Creating a Strategy Ensemble

Don’t limit yourself to a single approach.

Consider developing a suite of complementary strategies that work well together.

This could involve strategies for different market environments, timeframes, or asset classes.

The key is to make sure these strategies are truly uncorrelated to maximize diversification benefits.

Dynamic Strategy Allocation

Develop a system for dynamically allocating capital across your strategy ensemble.

This could be based on recent performance, current market conditions, or a combination of factors.

Consider having a portion of your capital deployed in strategies well-suited to the current environment.

Don’t Be Afraid of Beta

A sound approach to trading strategy development is to start simple.

Begin with a beta-focused strategy, emphasizing passive allocation to capture market returns.

This approach allows you to gain experience and understand market dynamics without the pressure of constant active management.

As you grow more comfortable and knowledgeable, you can gradually incorporate alpha-generating techniques and active trading.

Only shift toward more active strategies when clear opportunities come up or when they align with your evolving goals and risk tolerance.

This measured progression helps build confidence and skills while minimizing unnecessary risks.

We cover more about balanced beta approaches here.

Custom Derivative Strategies

Options are something that many traders learn about some time into their trading career.

Design unique options or futures strategies, like spreads or straddles, which can be customized to specific market conditions.

Continuous Improvement & Adaptation

Implementing a Feedback Loop

Trading is an iterative process.

Establish a systematic way to review and improve your strategies.

This could involve daily trading journals, weekly performance reviews, and monthly strategy assessments.

Be brutally honest in these reviews – identify what’s working, what isn’t, and why.

There are other approaches to markets besides active trading.

Scalping is an aggressive form of day trading, but swing and position trading allow for larger moves and somewhat more passive holding periods.

Investing is, of course, the most passive.

Staying Ahead of Market Evolution

Markets are constantly evolving, and strategies that work today may become ineffective later.

Stay attuned to changes in market structure, regulations, and participant behavior.

Regularly reassess the fundamental assumptions underlying your strategies.

Be prepared to adapt or abandon strategies that no longer fit the current market reality.

Leveraging Community and Collaboration

Engaging with Trading Communities

Consider community engagement in its various forms, whether online or in-person.

These interactions can provide new ideas, challenge your assumptions, and offer fresh perspectives on market behavior.

Remember that there are many buyers and sellers, of many different sizes in terms of the pools of capital they trade/invest, and all sorts of different motivations.

Something can be learned from many.

Collaborative Strategy Development

Consider collaborating with other traders or researchers to develop strategies.

This could involve sharing ideas, co-developing algorithms, or pooling resources for data acquisition and analysis.

Be sure you have clear agreements on intellectual property and profit-sharing before starting on such collaborations.

Conclusion

Generating new trading strategies is a dynamic, ongoing process that combines analytical skills, creativity, and personal insight.

The most effective strategies are those that not only perform well but also align with your personal strengths and preferences.

Trading should energize and engage you, not drain you.

Don’t be discouraged by setbacks – they’re an inevitable part of the process.

Each trade, whether profitable or not, offers important lessons that can inform your future approach.