Basic Stock Trading Strategies

8.1 Introduction to Basic Stock Trading Strategies

The stock market can be pretty chaotic and volatile at times, with fortunes made and lost seemingly overnight. While there is more hyperbole than truth in that statement, the fact remains that attempting to trade the stock markets without knowing what you’re doing is a surefire recipe for disaster.

Because we don’t have a magic crystal ball that can predict the future, the next best thing we can do is to arm ourselves with a set of trading strategies.

In simple terms, trading strategies are a systematic approach to buying and selling stocks and shares on the stock market. They are based on predefined rules and criteria, and are used to inform trading decisions.

Many trading strategies hinge on technical indicators, which facilitate the expectation of a certain outcome. When combined with fundamental analysis, trading strategies allow you to better navigate the market and set up trading positions with a greater potential of success.

This module introduces some basic stock trading strategies, and discusses how you can develop and hone your own strategies.

8.2 Foundations of a Basic Strategy

The key to trading strategies is to ensure you use objective data and analysis, and adhere to them diligently. Also, no matter if they are basic or advanced, trading strategies are only as effective as far as you’re willing to stick with them.

This means trading strategies should take into account a variety of factors, including investing goals, personal preferences and risk tolerance.

In addition, it is important to continually evaluate and refine your trading strategies to keep pace with changes in market conditions, and as your skills and understanding evolves.

Here are some factors to consider when developing your own trading strategies.

Your trading goal

Define clearly why you want to trade, the outcomes you want to achieve, and how you will achieve them. Besides your financial objectives, be sure to also define your time horizon, and your risk tolerance.

Articulating your responses here will help you identify potential trading strategies that can help you succeed. For instance, if you are averse to high trading costs, strategies that involve several transactions in conjunction may not make a good match for you.

Your trading style ^[1]

Generally, there are three types of trading styles –day trading, swing trading, and position trading. Each of these differ in the duration positions are held, giving rise to a variety of different trading techniques.

Day trading usually occurs between a few seconds to a few hours; swing trading may last days to weeks; and position trading may be held for up to several months or even years. This variation in timeframes means that traders must adopt different strategies, tools, and mindsets to align with their specific trading horizon.

You should choose a trading style that is aligned with your objectives, preferences and time available. For example, if you don’t have time to keep checking the markets, long-term position trading may be more suitable for you.

Fundamental analysis or technical analysis?

Fundamental analysis involves studying company financial data and economic factors to evaluate the potential of a stock.

Technical analysis ignores other factors in favour of price action, and may involve multiple technical indicators to confirm or deny trading ideas.

Both are different sets of skills. The former entails digesting multiple datapoints to form a coherent understanding of a potential trade, while the latter focuses on the price chart to discern opportunities.

You may find yourself drawn to one or the other. Or you may be equally comfortable with both. In any case, it is advisable to learn either fundamental analysis or technical analysis to help you understand and improve your trading outcomes.

Evaluation and refinement

It is also important to evaluate and refine your trading strategies as you go along. This will help you to learn and hone your skills as a trader.

To do so effectively, you will need to have a system of recording your trades and the strategy used, and whether the outcome was in line with your expectations. Note down when the strategies worked, when they didn’t and why.

Perhaps there was sudden company news that caused the stock price to move in an unexpected manner. Or maybe the strategy chosen was not a good fit for the stock. No matter the reason or outcome, every trade is a chance to learn.

Consider making use of a trade journal to record, evaluate and refine your trading strategies. You can use software such as spreadsheets, or a paper notebook – whichever one works best for you.

8.3 Trend Following Strategy

What is the trend following trading strategy? ^[2]

The trend following trading strategy is simple and effective, making for a great basic trading strategy for beginners.

Also known as “trend trading”, this trading strategy works by identifying the direction and momentum of the market, and making trades that align with the trend. That’s to say, you’d take a long position during an uptrend, and a short position during a downtrend.

To be successful with this strategy, investors need to know how to identify the market trend. More importantly, they should also be willing and able to make changes when the market trend changes.

Just like the popular saying goes, “the trend is your friend, until it is not”. A common mistake when utilising a trend following strategy is refusing to acknowledge that the trend is changing, and continuing to make trades that essentially goes against the trend.

How to identify market trends

Market trends are identified by applying technical indicators to a price chart. Some commonly used ones include trendlines and moving averages.

The screenshot above displays a 1-month chart of the SPDR S&P 500 ETF, which tracks the S&P 500 index.

The two technical indicators used here are trendlines, in blue, and the triple-Exponential Moving Average (3EMA), the green, yellow and red lines.

The first trendline, sloping downwards, shows the market was in a downtrend for the first two weeks. However, the market underwent a trend reversal and began trending upwards, as seen in the second blue trendline.

This is reflected in the second technical indicator used on the chart, the 3EMA. In the left half of the chart, the three lines are also sloping downwards, confirming the downtrend. In the right half, we see the three lines moving upwards.

All well and good, but how do we know if the uptrend would continue?

In this screenshot, we’ve zoomed in on the right half of the chart.

The blue trendline suggests that the market will continue to rally upwards. The 3EMA agrees – as seen in the three lines continuing to slope upwards without crossing each other.

If the green line reverses course and moves downwards far enough to cross the yellow line, this could sign that the market uptrend is ending and a downtrend is coming. The downtrend will be confirmed if the green or yellow line moves downwards to cross the red line.

This is a very simple explanation of the trend following strategy, but in a nutshell, that’s how it works.

8.4 Support and Resistance Strategy

Another basic stock trading strategy to know is the Support and Resistance strategy.

Lines of support and lines of resistance are another technical indicator that you can use on a price chart. They are horizontal lines drawn at the highest and lowest points of the chart. See the screenshot below for an example.

This is a screenshot of the 3-month price chart of Apple Inc stock (AAPL). Here, the blue lines at bottom are lines of support, and the ones on top are lines of resistance. The 3EMA is also present in the screenshot. 

What does this tell us? Ok, firstly, the stock had been grappling with volatility, but is now clearly on an uptrend. The top blue line suggests that there is room for the share price to move up further, as evidenced by the previous high.

Next, notice how the price had bounced off the bottom blue line (line of support) three times already? Generally, when the more times a stock bounces off the line of support, the stronger the likelihood of an uptrend.

The reverse is also true. When a stock bounces off the line of resistance multiple times in a row, a breakdown to a lower low is likely. Once the price settles down around the new lower price, a new support line is formed.

This is the gist of the Support and Resistance trading strategy. Support and resistance lines help us establish a range within which the stock price will stay. This gives us useful information when setting stops and making trades.

But how do we know how long the price will stay within the range? Well, that’s where other technical indicators such as the 3EMA come in. When there are signals of a severe trend reversal, you should expect support/resistance to be broken through.

Returning to AAPL, notice how the 3EMA lines are all sloping steeply upwards on the right of the screen? This suggests that the stock is enjoying strong upwards momentum, and there is a good chance that it will hit a significantly higher price than seen in the previous high.

8.5 Risk Management in Trading Strategy ^[3]

After understanding how basic trading strategies like trend following and support and resistance strategy works, you hopefully have a better idea of how stock trading works. You may even be inspired to start trading!

But before you do, it’s important to discuss risk management.

While technical indicators and trading strategies can be very helpful, they are never foolproof. The market is ultimately unpredictable, and investors must have a proper risk management plan in place when trading stocks.

In this section, we will discuss three overarching risk management principles which will form the foundation of an effective risk management strategy.

Minimise your losses

Firstly, it is crucial to understand that losses are part and parcel of investing. No matter how advanced or well-trained or experienced you are, or how many technical indicators you use, there is always the possibility of making a loss.

But that’s ok. In investing, the goal is not to avoid all losses. Rather, it is always to minimise losses and maximise gains.

There are two ways to minimise losses in stock trading.

Controlling capital-at-risk

When you’re opening a position, you should control how much capital you are willing to put at risk. It is not advisable to risk too much of your capital at one go, as you will be quickly wiped out in a losing streak.

By putting only a small part of your capital into each trade, you will have more staying power and be better able to absorb the losses that inevitably come your way.

As a general rule, consider limiting each trade to between 1% to 2% of your capital, and even less as your account grows. If you’re trading on leverage, be sure to take into account that losses will be amplified.

Cutting your losses

When your trade goes against you, the pain of taking a loss can tempt you to stay in the trade, in the hopes of making a quick recovery.

Recall that this is exactly what you shouldn’t do in trend trading, as you risk taking an even larger loss should the trend reversal worsens.

Or, you may be tempted to double down on your next trade to make up for the previous one which went against you. Again, this is what you should not do, as you are taking on more risk than you should.

Stick to the rules

When you boil it down, risk management is about sticking to the rules. This goes not only for the size of your trade and not exceeding predetermined levels, it also applies when choosing what stocks to trade, and the strategies you will use.

But before you can decide on the rules you will follow, you first need to articulate what you are trying to accomplish. This brings us back to knowing your trading goals and objectives, as well as finding trading styles and strategies that suit your needs and preferences.

Essentially, you should establish a trading plan before you trade, which you follow diligently by sticking to the rules.

On that note, learn how to use stop-loss and take-profit points. When applied properly, these tools can help you approach stock trading in a disciplined manner while keeping emotions calm and steady.

Diversify your positions

Another essential pillar of risk management in trading is diversification. Instead of putting all your eggs in one basket, you spread your investments across different assets, classes, or markets. The main game here is to avoid relying too much on one thing, so if anything goes south, you’re not hit as hard.

The cool part? Diversifying your trading portfolio can amp up your overall risk-adjusted return. Different assets don’t always dance to the same tune in the market – they react differently to conditions, events, or what’s happening in the world. So, mixing it up with assets that have different risk and return vibes can make your portfolio more of a superhero cape in the trading world.

Diversification isn’t just about picking different assets; it’s like putting together a dream team. Think about tossing in stocks, bonds, commodities, currencies, and maybe even going global to dodge that concentration risk.

Now, let’s be real – diversification doesn’t wipe out risk entirely. It’s more like a strategy to keep risk in check by making sure one bad day doesn’t wreck your whole portfolio. Traders often dig diversification as their go-to move for a chill, balanced, and long-term investment strategy.

8.6 Backtesting and Practice ^[4]

Backtesting allows a trader to test out how a trading strategy would perform without having to risk actual cash. This is accomplished by setting up and running the trade using historical market data. The results are then analysed to gauge the viability of a proposed trading strategy or model.

Because historical data is the closest way to simulate real-world conditions, backtesting can give traders the confidence to go ahead with their trade ideas. The results from backtesting can also offer valuable insight and uncover blind spots or erroneous assumptions. Retail investors can carry out backtesting of their own trading strategies and ideas with most modern trading platforms. They can also use backtesting to practise and hone their skills before committing to a stock trade with real money.

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Module recap

• Trading strategies are a systematic approach to buying and selling company shares on the stock market. They are based on predefined rules and criteria, and often involve the use of technical indicators.
• To be effective, a trading strategy must rely on objective and accurate information and data. It should also take into account investing goals, timeline, preferences and needs.
• Generally speaking, there are three types of trading styles, each differing in how long positions are held.
  • Day trades – a few seconds to several hours
  • Swing trades – days to weeks
  • Position trades – up to several months or even years
• You should pick a trading style that suits your goals, preferences and time availability.
• Fundamental analysis and technical analysis are core skills for investors and traders. You may choose either one, or blend both together.
• A popular basic stock trading strategy is trend following. This involves identifying a market trend, and trading in line with it.
• The key in trend following is to go with the trend. Know when the trend has changed, and adjust accordingly.
• Another basic stock trading strategy to know is support and resistance. This involves charting lines of support and resistance on a price chart to discern a likely price range.
• Technical indicators used in basic trading strategies include trendlines, lines of support and resistance, and triple exponential moving average (3EMA).
• An important component of trading strategy is risk management. The three pillars of risk management are minimising your losses, sticking to the rules, and diversifying your positions.
• Backtesting uses historical market data to discern the viability of a proposed trading strategy or model. It allows traders to build confidence, and uncover blind spots in their trading ideas.
• Retail investors can practise their stock trades with backtesting tools found in most modern trading platforms.

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References

1. “4 Common Active Trading Strategies – Investopedia” https://www.investopedia.com/articles/active-trading/11/four-types-of-active-traders.asp Accessed 22 Dec 2023
2. “Trend Trading: Definition and How Strategy Aims For Profit – Investopedia” https://www.investopedia.com/terms/t/trendtrading.asp Accessed 22 Dec 2023
3. “Risk Management Techniques for Active Traders – Investopedia” https://www.investopedia.com/articles/trading/09/risk-management.asp Accessed 22 Dec 2023
4. “Backtesting: Definition, How It Works, and Downsides – Investopedia” https://www.investopedia.com/terms/b/backtesting.asp Accessed 22 Dec 2023