Trading in stock markets without a defined strategy can be suicidal, you may wipe out your account in no time. A strategy is a set of rules to enter/exit the trade along with risk management and position sizing.
And talking about the trading strategies, they can be of different types, and you should pick one based on your personality and risk appetite.
In this article, we’ll discuss the 4 most common types of trading strategies along with their pros and cons.
Trend Following Strategy
The basic premise behind trend following is that the market moves in a particular direction for a period of time. This movement is driven by the emotions of market participants and triggers heavy momentum. As a trader, there is no proven way to identify when the trend starts, but once you identify that a stock is trending, you just need to ride the trend and make profits.
A trend can be identified directly by visual inspection of the chart, or you can use lagging indicators such as moving averages, MACD, etc. In a long run, a trend-following strategy would always yield good profits, however, there would be drawdown periods as the market moves sideways most of the time.
“A Trend following strategy is suited for individuals aiming for high profits, and can bear moderate to high risks”
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Mean Reversion Strategy
Mean reversion is the opposite of trend following, where a trader believes that stock would eventually return to its mean price. The mean price, according to them represents the correct valuation of stock, and any deviation from the mean indicates a trading opportunity. In simple words, a trader following a mean reversion strategy buys on lows and sells on highs.
The market continuously moves in phases of in and out of the mean price, allowing investors to formulate their investment strategies based upon mean reversion. An example of a mean reversion strategy is buying a stock post its price has experienced an unusually large fall. When the price of a stock falls, there are good chances for the price of the stock to bounce back towards its normal levels.
The method of utilizing this strategy while investing in stocks is to look out for extreme events and bet on things reverting to normal.
Technical indicators like Bollinger bands and RSI can be used to detect mean reversion.
“Mean reversion strategies are suited for individuals targeting small profits with a large number of trades”
Check out a mean reversion trading system developed in Amibroker at this link.
Pair Trading Strategy
A pair trading strategy capitalizes on the correlation between trading instruments. For example – statistics say equities and gold are negatively correlated i.e. when equities rise gold price fall, and when equities fall gold price rise. A pair trading strategy seeks opportunities when there is any deviation from a historic correlation stats.
Pair Traders watch the co-related stocks over time and take action when they see any weakness in the co-relation. They go long in one of the stock and go short in another. The basic assumption is that the long position would profit more than the short position when the co-relation is strong again, or vice versa.
“Pair trading strategies are suited for individuals with high capital, seeking moderate returns with negligible risks”
Check out a pair trading strategy spreadsheet at this link.
Arbitrage is a trading strategy where one takes advantage of the difference in the price of a particular security on different exchanges it is traded on. The basic assumption behind this strategy is the fact that price tends to converge to an identical value at the end of the trading day, even when there is a significant difference in price during market hours.
You can also find arbitrage opportunities when there is an unusual difference between spot and futures prices. For example, for a given security, let’s suppose the futures instrument normally trades at a 20 point premium over the spot. But if you observe that the premium increases to say 50 points on a particular day, you can short the futures and buy the spot.
“Arbitrage is the safest strategy suited for individuals who don’t want to risk a lot of capital at the cost of very limited trades over the year.”
Check out the NSE-BSE arbitrage strategy at this link.
The below table shows the pros and cons of each of these strategies:
In a nutshell, all these types of trading strategies are proven and worth trying. However, you should not try all at once. Check the pros and cons of each strategy, see which one suits you the best, and then start practicing it. If you can’t figure out which one to select, go for the trend-following strategy, as that is the simplest and has the highest profit potential.