How to Generate a Trading Idea

Basic elements

The foundation of any trading strategy begins with the generation of an idea, which could come from market analysis, news events, or a broader economic perspective. Ideas can be driven by fundamental factors (e.g., economic reports, earnings), technical indicators (e.g., chart patterns, volume analysis), or a combination of both. Understanding the context and aligning your trading plan with the current market environment is critical.

Time Restrictions: Duration of Trades vs Your Daily Schedule

The duration of a trade defines your strategy and risk profile. Different trading styles require different levels of commitment and timing du:

Scalping: Extremely short-term trades (minutes or seconds) aimed at small but frequent profits. Scalping requires constant monitoring, high liquidity, and precision in timing.
Day Trading: Positions are opened and closed within a single trading day. The goal is to capitalize on intraday price movements, avoiding overnight exposure to risk.
Swing Trading: Medium-term trades, often lasting from days to weeks, where traders attempt to capture price swings in trending markets.
Position Trading: Long-term trades that can last for months or even years, often ignoring short-term fluctuations in favor of macro trends.
Investing: The longest horizon, where positions are held for years. Investors typically focus on the intrinsic value of assets, aiming for growth over time.

Time Restrictions: Sessions

Market sessions (e.g., London, New York, Asian sessions) influence trading strategies. Some instruments are more liquid or volatile during specific sessions, which impacts timing. For instance, a trader focusing on high volatility and liquidity might prefer to trade during the overlap of the London and New York sessions.

Instruments

The selection of instruments is key to matching your strategy with the markets you trade. You can start with one:

CFDs (Contracts for Difference): A popular derivative allowing traders to speculate on price movements without owning the underlying asset. CFDs offer flexibility, leverage, and a wide range of markets, but they come with a higher risk profile due to leverage.
Futures: Contracts to buy or sell an asset at a future date for a fixed price. Used by both speculators and hedgers, futures often require a deeper understanding of the market and larger capital due to the standardized contract sizes.
Options: Provide the right but not the obligation to buy/sell an asset at a predetermined price. Options allow more strategic flexibility but require a more complex understanding of market movements.
Stocks: Shares in a company, providing ownership and typically traded over longer periods, though can be used in shorter-term strategies like day trading.
ETFs (Exchange-Traded Funds): Baskets of assets that trade like stocks, offering diversification. They are generally better suited for longer-term investors or swing traders.

Correlation

Understanding the correlation between different instruments is crucial for risk management. For example, a trader might avoid holding multiple positions in highly correlated assets (e.g., gold and silver) to minimize exposure to the same market risks.

Liquidity

Liquidity is vital in trading because it affects how easily you can enter or exit a position. Highly liquid instruments, like major currency pairs or blue-chip stocks, are favoured in short-term strategies, while less liquid instruments may be suited for longer-term holdings.

Volatility

Volatility reflects price movement and is essential in determining a strategy. High volatility is preferred in scalping and day trading because it provides more opportunities for profiting from fast trends within shorter timeframes, but it also increases the risk of slippage or taking more stop losses on otherwise legitimate strategies. Lower volatility may be better suited for swing or position trading.

Personal Affinity

Your personal affinity for a particular trading style or instrument plays an important role. Some traders thrive on fast-paced action (scalping, day trading), while others prefer taking a more methodical, long-term approach (swing trading, investing).

Strategy: Methods and Rules

Having a clear, well-defined strategy is essential for success. A strategy should outline specific methods and rules for:

Entry: What signals will trigger the entry of a trade (e.g., a moving average crossover or price hitting a key level)?
Exit: When and how to exit the trade, including stop-loss orders and profit-taking strategies.
Risk Management: Position sizing and risk/reward ratios to ensure consistent and sustainable trading.

Lets see how to determine them.

Sets of Tools Used for Analysis

Different tool sets are employed depending on the trading style:

Technical Analysis (TA): Predominantly used in short-term strategies like scalping and day trading, where traders rely on price patterns, volume, and indicators to make quick decisions.
Fundamental Analysis: More relevant for longer-term strategies, such as investing or position trading, where traders assess the intrinsic value of an asset based on economic data, earnings reports, or geopolitical events.
Sentiment Analysis: Gauging the overall mood or sentiment in the market, often derived from news, social media, or surveys. This can help in aligning trades with broader market psychology.

Support and Resistance

A critical element of technical analysis, support and resistance levels help traders identify where the price may reverse or pause. Key factors include:

Chart Structure: Identifying zones of support and resistance using historical structure of the data on the chart.
Volume: Analyzing volume at certain price levels to confirm the strength of support or resistance.
Candle Patterns: Using specific candlestick formations (e.g., dojis, hammers) to determine entry/exit points.

Confirmation

Confirmation is necessary to increase the probability of success when trading around support/resistance levels. Common confirmation tools include:

Time: Waiting for a candle to close above/below a certain level before entering a trade.
Formations/Patterns: Identifying classic chart patterns like head and shoulders, double tops/bottoms at support/resistance levels to confirm direction.

Types of trading strategies

In trading terminology, we can classify strategies based on market conditions and key levels in the market. The two primary market conditions are:

Trending Markets: Where the price is consistently moving in one direction, either up (bullish trend) or down (bearish trend).
Range-Bound Markets (Consolidation): Where the price fluctuates between a defined support and resistance level, without breaking out in either direction. Markets are bracketing for most of the time.

Additionally, within these market conditions, we can identify key price levels that traders focus on:

Breakout Levels: A significant price level that, when breached, indicates a potential continuation of the trend or a start of a new trend. In a trending market, this is usually a level that the price breaks through to continue the trend.
Holding Levels (Support/Resistance): A level where the price is expected to hold, either rebounding back from this level (support in a downtrend or resistance in an uptrend) or continuing within a range.

Given these definitions, we can classify trading strategies into four main categories:

1. Trend Following – Breakout Strategy

In this strategy, traders look for a continuation of the existing trend by identifying key breakout levels. When these levels are breached, it signals that the trend is likely to continue.
Ideas for execution:
- Go long (buy) when the price breaks above a key resistance level in a bullish trend, expecting the upward movement to continue.

2. Trend Following – Holding Level Strategy

Here, traders anticipate that the trend will resume after a pullback to a key support or resistance level. The expectation is that the level will hold, and the trend will continue.
In a bullish trend, a trader might buy when the price pulls back to a support level, expecting the price to rebound and continue the uptrend.

3. Range-Bound – Breakout Strategy

This strategy involves identifying a range-bound market and waiting for a breakout from the range. Traders enter a position in the direction of the breakout, anticipating a new trend to begin.
A trader might enter a long position when the price breaks above the resistance level of a consolidation range, expecting a bullish trend to start.

4. Range-Bound – Holding Level Strategy

In this approach, traders aim to profit from the price remaining within the range. They buy at support and sell at resistance, expecting these levels to hold.
A trader might buy near the support level within a consolidation range and sell as the price approaches the resistance level, anticipating that the price will remain within the range.

Putting it all together

Creating a successful trading strategy requires balancing simplicity with effectiveness. Traders often use a combination of technical analysis, charting, and backtesting to ensure their approach is robust, adaptable, and profitable. Here’s a structured approach to developing a trading strategy, using the principles you’ve outlined.

Before Backtesting: Chart Observation

Before diving into backtesting using historical data, it’s essential to manually analyze charts and draw at least 20 situations that fit the criteria of your strategy. This manual analysis has several benefits:

Familiarization: It helps you visually understand how your strategy would have worked under real market conditions.
Pattern Recognition: You train yourself to recognize potential trade setups by seeing them form across different charts.
Adaptability: By manually checking charts, you can refine your entry and exit criteria before spending tens or even hundreds of hours on actual backtesting.

Hypothesis Development for Your Trading Strategy

When creating a hypothesis for your trading strategy, it’s essential to clearly define the parameters that will guide your decision-making process. Below is an expanded and refined explanation of the key elements to consider when formulating your hypothesis:

Describe the Situation You Will Be Spotting on the Chart

Clearly outline the specific market situations or patterns you plan to identify. Will you focus on breakouts, pullbacks, reversals, or range-bound behavior? Define the conditions you’re looking for, such as a consolidation zone break, reaction at key levels, or a moving average cross.
Example: “I will be spotting breakouts above key resistance levels after a period of consolidation and will execute my trades on the retest of those broken key levels.”

Timeframe or Combination of Timeframes

Specify the timeframe(s) you will be using for trade setups. Are you focusing on a single timeframe, like daily or hourly charts, or are you combining multiple timeframes for better confirmation and Risk-to-Reward Ratio?
Example: “I will use the 1-hour chart for spotting overall market direction and the 15-minute chart for fine-tuning entry points.”

Support and Resistance (SR) Level Definition Methodology

Define your methodology for identifying support and resistance levels. Will you rely on horizontal levels, Fibonacci retracements, moving averages, or trendlines? Ensure that your method for defining these levels is consistent and objective.
Example: “I will define SR levels based on the most recent swing highs and lows, as well as significant pivot points visible on the daily timeframe.”
There is a lot of different approaches to define the SR levels or zones that increase in complexity and demand for traders skill and attention. Refer to Technical analysis.

Type of Strategy and Market Conditions

Clarify the type of strategy you’re developing (trend-following, mean-reversion, breakout, etc.) and specify the market conditions in which it is designed to perform. Does your strategy work best in trending markets, range-bound conditions, or highly volatile environments?
Example: “This is a breakout strategy designed to perform in trending markets after a consolidation phase, where volatility is expected to increase.”

Confirmation: With or Without?

Decide whether you will require additional confirmation before entering a trade. Confirmation can come in the form of candlestick patterns (e.g., engulfing patterns or pin bars), volume spikes, or other technical indicators like moving averages or oscillators.
Example: “I will enter trades only if there is confirmation in the form of a bullish engulfing candle after a breakout, accompanied by an increase in volume.”

Risk Management

Define your risk management rules, including the placement of your initial stop-loss, how you’ll manage the trade as it progresses, and whether you will trail the stop-loss or move it based on new price action. Also, specify where your target will be and if you plan to take partial profits.
Initial Stop-Loss: Determine where you’ll place your stop based on recent price action (e.g., just below the last swing low for a long trade).
Trailing Stop: Will you trail your stop-loss to lock in profits as the trade moves in your favor? If so, how will you trail it—based on new SR levels, a moving average, or another rule?
Target: Specify how you will determine your profit target. Will you aim for a fixed risk-reward ratio (e.g., 1:2) or target a specific level like a key resistance or support area?
Partials: Will you take partial profits at certain points? For example, you might close 50% of your position once the price reaches a 1:1 risk-reward ratio.
Example: “The initial stop-loss will be placed just below the SR level. I will trail the stop-loss using the 20-period moving average once the trade is 1:1 in profit. The target will be the next significant resistance level, and I will take partial profits (50%) when the price reaches a 1:2 risk-reward ratio.”

Conclusion

Developing a clear and detailed hypothesis for your trading strategy is essential for maintaining consistency and discipline. By defining the specific market conditions, timeframes, confirmation criteria, and risk management rules, you create a structured approach that is easier to test, refine, and execute.

As a trader, you can start by mastering historical price action and market structure. As your skills improve, progressively integrate more advanced tools like volume profile, footprint charts, and DOM to gain deeper insights and enhance your trading edge. Each of these methods builds on the previous, allowing for more nuanced and precise market analysis as you become more experienced.

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