A trading strategy is a systematic methodology used for buying and selling in the securities markets. A trading strategy is based on predefined rules and criteria used when making trading decisions. A strategy aims to provide postitive expected returns on average over time.
We all know that financial market returns are not normally distributed. Instead, the body is narrower and the tails are fatter (i.e. extreme events happen more frequently than expected). Let’s look at the annual returns of the S&P 500 index. I have plotted the price returns of the S&P 500 since 1871 together with the expected normal distribution of returns. The data is from Prof. Robert Shiller’s homepage. As you can see, on an annual scale, market returns are essentially random and follow the normal distribution relatively well. Put in this context, the year 2019 was one of the better years in the history of the S&P 500 but not an extreme year.
Given that trading outcomes are probabilistic or random - they cannot be forecast accurately before placing a trade, risk management is therefore key to preserving capital. Returns can't be certain only risk can be measured and controlled by the trader. Employing risk management means that you reduce your exposure to potential negative outcomes.
Perhaps there's a better way of describing a trading strategy: Imagine you're in a room with a bag of dollar coins worth $1,000 and there's two identical slot machines that cost $1 per play. You are told one of them has a 80% payout ratio and the other 120%. You must spend all of your dollars to earn the highest possible profit. What strategy would you employ?
Most people would take a few dollars and try one machine. If they lost after a period of time, they might conclude they're playing the "losing" machine. They would move to the other and play a few dollars, testing each machine and continue switching back and forth hoping to win a big payout.
The optimal strategy is to take 50% of the dollars and put into one machine and the other half of the money into the other. In theory, the expected outcome would be breakeven (50% * 80% + 50% * 120% = 100%). But then there's luck. Whilst executing your strategy you might hit the jackpot!
Its important not to mistake good luck as a good strategy and bad luck as a bad strategy but nonetheless, luck does play an important part in trading outcomes especially in the short term. As the saying goes "you've got to be in it to win it!".
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