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Building an algorithmic strategy

Building an Algorithmic Trading Strategy

By: | 05/14/2015


Building a fully automated, algorithmic trading strategy can seem like a daunting task but can actually be broken down into a series of simple steps.

In this post, we’ll go through the three steps to building an algorithmic strategy: Idea, Test, and Trade, and break down what you need to know at each step.

1. Idea

Every strategy starts with an idea, or theory, about the market that you believe can be consistently exploited for profit.

However, before you can start acting on your ground-breaking idea, you need to answers a few questions first:

Most traders know the answers to these questions but putting them down on paper can help organize your thoughts and reduce headaches down the road.

Next, you need to decide what a successful strategy means to you. Without having a clear goal set out, there is no way to get there.

Defining what success looks like to you is an important step that most traders pass over in search of the “Holy Grail” that they never seem to find. Approaching trading as a business, with clear profit targets and a growth plan, gives you an achievable goal that can drive the development of your strategy.

Okay, moving onto the fun part: the underlying idea of your strategy. You need to have some belief as to why you should be trading and why you will be successful. Whether you believe the market behaves in cyclical waves and you want to find a statistically significant pattern to exploit or you have a view about the underlying fundamentals of the asset that you believe are not reflected in the price, you need to have something driving you to get into the market. While your initial theory may not turn out to be correct, there must be a starting point for your journey into developing a strategy.

Your final task in this first step is research, another step that many traders skip.

Chances are someone has attempted something similar to you and learning about their process can give you a huge jump start in your development. It is also important to look at other people’s work objectively. If someone did exactly what you were going to do and they just couldn’t make it work, you need a good reason why you will be successful.

Now that you have figured out the basics to your strategy, defined what a successful strategy means to you, and researched similar strategies, it’s time to actually build and test your idea!

2. Test

Testing your idea is the most important and difficult step to do correctly. It is also an area that will differ the most between strategies.

There are a couple of themes that should guide the testing of your strategy:

Out-of-sample, out-of-sample, out-of-sample

I cannot stress the importance of out-of-sample testing enough and while most traders think they are doing it correctly, it is very easy to have your biases creep in. I suggest breaking the available data into three different data sets:

Importance of Risk and Money Management

The impact of your risk and money management approach on your strategy cannot be understated. Not only will it help you avoid blowing out your account but it can actually turn an unprofitable strategy into a profitable one.

There are a couple of important points to consider when approaching the risk and money management aspects:

Testing your strategy is an incredibly important step and if you are looking for more resources on evaluating your strategy, I covered the topic in more detail here.

3. Trade

So you’ve tested your strategy to best of your ability, you feel confident in your risk and money management and you are ready to trade live; congratulations but your work is just beginning!

Monitoring your strategy and knowing when it has fallen out of sync with the market is more difficult than it sounds but is very important.

Many traders will trade their strategy on a demo account or smaller live account as another check before going live on their full account. Even one or two weeks of live performance can help spot any mistakes in your strategy’s development process.

Building an algorithmic trading strategy is not an easy task but by clearly defining your goals, following a rigorous testing process, and closely monitoring its live performance you can greatly increase your chances of success.

At Inovance, we are focused on the idea and testing stage of this process. TRAIDE allows you to leverage machine-learning algorithms to uncover actual patterns and unbiased signals in the asset, and by exporting and testing on your trading platform, you can greatly decrease the chances that your own biases will lead to a strategy that doesn’t perform as well in live trading.