How to Develop a Profitable Day Trading Strategy

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Markus Heitkoetter

31 Dec, 2007

in Getting Started and 1 more

In this article I will explain to you how to develop a profitable day trading system in five steps:

Step 1: Select a market and a timeframe
Step 2: Define entry rules
Step 3: Define exit rules
Step 4: Evaluate your day trading system
Step 5: Improving the day trading system

Let’s take a closer look at these steps.

Step 1: Select a market and a timeframe
Every market and every timeframe can be traded with a day trading system. But if you want to look at 50 different futures markets and 6 major timeframes (e.g. 5min, 10min, 15min, 30min, 60min and daily), then you need to evaluate 300 possible options. Here are some hints on how to limit your choices:

  • Though you can trade every futures markets, we recommend that you stick to the electronic markets (e.g. e-mini S&P and other indices, Treasury Bonds and Notes, Currencies, etc). Usually these markets are very liquid, and you won’t have a problem entering and exiting a trade. Another advantage of electronic markets is lower commissions: Expect to pay at least half the commissions you pay on non-electronic markets. Sometimes the difference can be as high as 75%. 
  • When you select a smaller timeframes (less than 60min) your average profit per trade is usually comparably low. On the other hand you get more trading opportunities. When trading on a larger timeframe your profits per trade will be bigger, but you will have less trading opportunities. It’s up to you to decide which timeframe suits you best. 
  • Smaller timeframes mean smaller profits, but usually smaller risk, too. When you are starting with a small trading account, then you might want to select a small timeframe to make sure that you are not overtrading your account.

Most profitable day trading systems use larger timeframes like daily and weekly. These systems work, too, but, be prepared for less trading action and bigger drawdowns.

Step 2: Define entry rules
Let’s simplify the myths of “entry rules”:
Basically there are 2 different kinds of entry setups:

  • Trend-following
    When prices are moving up, you buy, and when prices are going down, you sell.
  • Trend-fading
    When prices are trading at an extreme (e.g. upper band of a channel), you sell, and you try to catch the small move while prices are moving back into “normalcy”. The same applies for selling. In my opinion swing trading is actually one of the best trading strategies for the beginning trader to get his or her feet wet. By contrast, trend trading offers greater profit potential if a trader is able to catch a major market trend of weeks or months, but few are the traders with sufficient discipline to hold a position for that period of time without getting distracted.

Most indicators that you will find in your charting software belong to one of these two categories: You have either indicators for identifying trends (e.g. Moving Averages) or indicators that define overbought or oversold situations and therefore offer you a trade setup for a short term swing trade.

So don’t become confused by all the possibilities of entering a trade. Just make sure that you understand why you are using a certain indicator or what the indicator is measuring. An example of a simple swing daytrading strategy can be found in the next chapter.

Step 3: Define exit rules
Let’s keep it simple here, too: There are two different exit rules you want to apply:

  • Stop Loss Rules to protect your capital and
  • Profit Taking Exits to realize your profits

Both exit rules can be expressed in four ways:
• A fixed dollar amount (e.g. $1,000)
• A percentage of the current price (e.g. 1% of the entry price)
• A percentage of the volatility (e.g. 50% of the average daily movement) or
• A time stop (e.g. exit after 3 days)

We don’t recommend using a fixed dollar amount, because markets are too different. For example, natural gas changes an average of a few thousand dollars per day per contract; however, Eurodollars change an average of a few hundred dollars a day per contract. You need to balance and normalize this difference when developing a day trading system and testing it on different markets. That’s why you should always use percentages for stops and profit targets (e.g. 1% stop) or a volatility stop instead of a fixed dollar amount.

A time stop gets you out of a trade if it is not moving in any direction, therefore freeing your capital for other trades.

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