What are the parts of a trading strategy?

May 31, 2022

What are the parts of a trading strategy?

I was doing a backtest on a new concept yesterday, and I realized the different parts of my testing strategy. At that moment, I became aware that the way I see any trading strategy is like an algorithm with several filters or steps. When those filters become "TRUE," we can check the following filter until we have a valid setup. Another way of understanding a trading strategy is like a funnel with different filters. At the end of the funnel, we have two possible outcomes.

Outcome 1. You are allowed to set pending orders.
Outcome 2. Do not place orders because one or more filters are not "TRUE."

Why am I writing about this? Because it was clear to me that even if you are doing it consciously or not, every strategy is like an algorithm; it doesn't matter if you trade manually. In the end, your brain is taking the price and making it go through a funnel of filters. So my intention today is that by putting together those different filters/stages/steps I realized yesterday, you can try to see them in your strategy and make improvements to your system or maybe become aware of something you have been doing.



It's important to say that this is a template, maybe you are using 2 filters, or perhaps you are using 5. The key point is understanding the step-by-step process that systematic strategies follow every time a setup is developed.


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FILTER 1: GENERAL CONTEXT
The most probable thing is that your first filter is about general context. What we are trying to answer here is, "Are we in a valid place for the strategy or not?" Some examples can be:
- The price must be in contact with a support/resistance zone.
- The price must be above/below (a certain technical level)
- The price must be on a drawdown of (time)

(TRUE / FALSE)?. IF true, proceed with the following filter; IF false, you are not allowed to trade.

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FILTER 2: SPECIFIC CONTEXT.
Now that your first filter is TRUE, the most probable thing is that you are using the 2nd filter regarding context; this is pretty similar to the previous filter but happens after the first one is true. Example:
- Moving averages should be in the following order...
- The price must be above/below (a certain secondary technical level)
- On a lower timeframe, the price must be (technical condition)

(TRUE / FALSE)?. IF true, proceed with the following filter; IF false, you are not allowed to trade.

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FILTER 3: FINAL CONTEXT BEFORE THE TRIGGER.
Here you will be paying attention to the final filter before the trigger; this is the last thing that, if TRUE, you will be able to wait for your trigger. Example:
- A technical indicator must be overbought/oversold.
- Volume at a certain level should be...
- I need to see a divergence.

(TRUE / FALSE)?. IF true, proceed with the following filter; IF false, you are not allowed to trade.

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FILTER 4: THE TRIGGER
All the filters are TRUE, and we are allowed to wait for the last thing before executing a setup, "The Trigger." Your trigger is a set of parameters that will enable you to place pending orders. Let's take a look at some of them:
- Candlestick Patterns
- Technical Structures (like Zig-Zag, Triangles, Irregulars, Flat, etc.)

(TRUE / FALSE)?. IF true + Risk to Reward ratio is aligned with the minimum requirements. Then set, Entry level / Stop level / Break-Even level / Take Profit level.

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My conclusion:

If I understand the different filters I'm using on my strategy, from general to specific ones, it becomes straightforward to make improvements or detect elements that require fixing. Instead of saying "My strategy is not working" or "My strategy requires improvements," we can say: My trigger is excellent. However, my filters regarding general context are not on point so I will work on that.

Understanding the parts of your trading strategy, like parts of an engine, will bring you insights into what you are doing. Try to see your system as a series of gears working together.

Thanks for reading!