Automated Trading Strategies
What is an Automated Trading Strategy?
In trading, an Automated Trading Strategy (commonly referred to as a trading system) is a predefined set of rules which govern the decision making process. Typically, an automated trading strategy will include the ability to backtest a strategy using historical market data. Backtesting is the process of running a predefined set of rules on historical market data in order to obtain hypothetical performance results (what trades the strategy would have made during the historically tested period). The hypothetical performance results provide the trader with a confidence that the strategy will make money in the future. Additionally, an automated trading strategy provides the ability to automatically execute trades based on the predefined rules, eliminating the need for a trader to be at the computer.
Components of an Automated Trading Strategy
Automated trading strategies typically include the following components:
- Entry Rules - A set of rules used to define when trades are entered.
Example: - When price crosses above the 14 period simple moving average, enter a long trade.
- Trade Management - A set of rules used to define when trades are exited.
Example: - Initial stop loss at 20 ticks. - Exit 1 share/contract at 10 ticks profit. - Exit remainder of position at 20 ticks profit. - Move stop loss to break even after first profit target is hit (10 ticks).
- Filters - A set of rules used to define when trades are allowed to occur.
Example: - No trades will be allowed if the 20 period Average True Range is below 5. - Trades will only be allowed between 9:30 am and 3:30 pm. - All trades will be exited at 3:30 pm.
- Position Sizing - A formula used to calculate the number of shares/contracts to trade.
Example: - Trade Size will be calculated as follows: CAE = Current Account Equity SP = Strategy Profits CP = Current Stock Price Trade Size = ((CAE + SP) * .25) / CP
Features of Automated Trading Strategies
- Backtesting - Backtesting is the process of running a predefined set of rules on historical market data in order to obtain hypothetical performance results (what trades the strategy would have made during the historically tested period).
- Optimization - Optimization is similar to backtesting, except optimization is the process of running multiple backtests with various parameter settings (for instance testing a profit target of 10 ticks versus a profit target of 20 ticks). The goal of optimization is to find the parameter settings that have been most profitable throughout history.
- Simulated Trading - Simulated trading is simply the practice of mimicking trades without actually risking any capital. Simulated Trading is also commonly referred to as Paper Trading.
- Automated Exuection - Automated Execution occurs when a trading strategy has been programmed to send actual orders to the broker. Hence, the orders are automatically executed, without the intervention of a trader.
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