How to select an investment strategy

There are several critical factors that need to be considered in selecting the right trading system for you. Investors are always looking for a trading edge to exploit. Finding such an edge is akin to the quest for the Holy Grail and many would be traders spend their time bouncing from one system to another, constantly looking for the perfect system. If this sounds like you, let me suggest that you change your ways, quit searching, and start making money.

First, realize that every system will have loosing trades and there will be a series of such trades. The draw down is always a challenging time. You have to be prepared mentally and financially to ride out the draw downs. The way to prepare is to check the historical performance. The historical performance period should be appropriate for the number of trades and the rules in the system. What this means is that a system with many rules will need more trades to prove its validity. I like at least 50 trades per rule and be very conservative on the number of rules. For example, if the system is:

“Go long when the current price is greater than the 20 period moving average. Close when the price drops below the 20 period average.”

There are two rules in the above. One for the entry and one for the exit, which means I’d want to see a historical performance of at least 100 trades.

Another consideration is the average holding period and frequency for trading. Both these need to match your preferences or you will be soon looking for some other trading system. Some investors want a “set and forget” type of trading plan where they enter their trades and just make updates on a weekly, monthly or annual basis. For others this approach would be far too boring.

The major consideration is return on investment. There is no one answer as to what a reasonable number might be. It depends on several factors. First is the leverage used in the investment vehicle. For example, the least use of leverage would be to pay cash for shares of stock and own them outright. More leverage would be to purchase the stocks on margin or buy options on the stocks.

Even greater leverage would be commodities or currency trading. As the leverage goes up, returns should be greater to offset the increased risk.

Another consideration for acceptable returns is the frequency of trading. One would expect day trading to produce higher returns than a long term buy and hold approach, for example.

Let’s say that you’ve found the right combination of risk and reward. A strategy with trading frequency that suits your personality. What next? Paper trade! Always start by paper trading the strategy. The length of time to paper trade isn’t as important as the number of trades. Refer back to the previous section on number of trades to validate. The more the better, but at some point you just need to leap in. Ideally I’d like to see 25% or more of the total trades as calculated above.