Trade Creation Methodology
The below information is from my time on sell and buy side institutional desks. Ideally the takeaways are a high level framework to create a thesis for a trade and then how to execute.
Alpha can be capture from trades and enhanced with great execution and trade management. From there it can be improved as you review the process with each trade (see execution and post trade sections)
While this might be dry, its critical for anyone serious about their trading.
Top down analysis
Establish Context with Macro and Policy Drivers:
Begin by forming a broad view of the economic environment, focusing on recent and expected central bank policies, macroeconomic data releases, and global economic events. These factors set the foundational “big picture,” showing where major trends in rates, inflation, and growth are likely headed. This context helps inform whether a market environment is broadly supportive of risk-taking or defensive strategies.
Incorporate Market-Based Indicators and Funding Conditions:
Market-based indicators, like OIS rates, futures pricing, and the yield curve, serve as more immediate barometers of sentiment and expectations. Funding and liquidity measures provide insights into stress levels in short-term markets. Together, these help to validate or adjust your macro view with near-real-time data, showing where markets expect rates, yields, or liquidity to move next.
Confirm and Fine-Tune with Sentiment and Technical Analysis:
Market positioning data, risk sentiment, and chart analysis can help refine timing. For example, sentiment and positioning can reveal overextended trades, while technical levels provide insights into entry and exit points. This final layer ensures that trades align with both macro trends and shorter-term market dynamics, ultimately improving risk management and timing.
Trade Execution
Translate Macro Hypothesis into Trade Idea
Identify Specific Market Expression: Determine which asset or instrument best expresses your view. For example, if your hypothesis is that inflation will rise, you might consider commodities, or short-term interest rates.
Define Trade Objective: Clearly outline the trade goal, such as capturing a directional move, benefiting from relative value between two assets, or managing volatility.
Set Up Technical and Timing Confirmation
Technical Entry and Exit Points: Use chart analysis and technical indicators to define optimal entry, stop-loss, and take-profit levels. Confirm timing based on support and resistance levels or momentum indicators to reduce premature entry.
Market Sentiment Check: Confirm that market sentiment and positioning align with your hypothesis, as heavily skewed sentiment might suggest a crowded trade, prompting caution.
Assess Risk and Position Sizing
Quantify Risks: Identify potential risks (e.g., unexpected central bank decisions or geopolitical shocks) that could invalidate your hypothesis.
Position Sizing: Use risk management principles to determine an appropriate position size, accounting for volatility and the risk-reward ratio. Ensure sizing aligns with your tolerance and account objectives.
Implement and Monitor the Trade
Execute the Trade: Enter the trade using the planned strategy and predefined levels for risk control.
Ongoing Monitoring: Track economic releases, policy updates, and any changes in market conditions that could impact your view. Adjust your stop-loss and take-profit levels based on evolving market dynamics.
Review and Adapt as Needed
Evaluate Performance: Regularly review trade performance relative to the original hypothesis. If the market moves against your position but fundamentals remain valid, consider whether to hold, exit, or even add to the position.
Post-Trade Analysis: After closing the trade, conduct a review to assess what worked and what didn’t. This step refines your approach, helping improve your future decision-making and strategy adjustments.
Post Trade Review:
Profit and Loss (P&L) Metrics
Total P&L: Track overall profit or loss to gauge profitability over a specific period (daily, weekly, monthly).
Win Rate: Percentage of winning trades versus total trades. This metric helps identify the effectiveness of trade selection and strategy.
Average Win and Loss: Calculate the average amount made on winning trades and lost on losing trades to understand risk/reward balance.
Profit Factor: The ratio of gross profit to gross loss. A profit factor greater than 1 indicates profitability, with higher values suggesting stronger performance.
Risk and Volatility Metrics
Drawdown: Measure the peak-to-trough decline in equity for an individual trade and over time (e.g., daily, weekly). This reflects risk tolerance and exposure.
Maximum Drawdown: The largest single drawdown during a period, highlighting the worst-case capital reduction, important for stress-testing resilience.
Sharpe Ratio: The ratio of average return to standard deviation of returns. This metric adjusts returns for risk, with higher values indicating better risk-adjusted performance.
Sortino Ratio: A variation of the Sharpe Ratio that only penalizes downside volatility. It provides a clearer picture of risk-adjusted performance when returns are asymmetric.
Value at Risk (VaR): The maximum potential loss over a set time frame at a specific confidence level. This metric helps quantify downside risk and adjust exposure accordingly.
Trade Execution and Efficiency Metrics
Average Holding Period: Measures how long trades are held on average, providing insight into trade duration and style (e.g., scalping, day trading, swing trading).
Trade Frequency: The number of trades executed within a specific period. Higher frequency can indicate over-trading, while lower frequency may suggest missed opportunities.
Execution Slippage: The difference between expected trade price and actual execution price. Tracking slippage helps identify inefficiencies in order execution.
Commission and Fees: Total costs from commissions, fees, and slippage. It’s essential to account for all costs that impact net returns.
Risk Management and Exposure Metrics
Position Sizing: Track the percentage of capital allocated to each trade. This metric ensures that trades align with risk management principles.
Leverage and Margin Usage: Monitor the degree of leverage employed and margin exposure. High leverage can amplify gains but also increases risk.
Stop Loss Adherence: Measure how consistently stop-losses are respected, providing insight into discipline and risk control.
Risk/Reward Ratio: The ratio of potential profit to loss for each trade. High risk/reward ratios indicate favorable trade setups.
Behavioral and Psychological Metrics
Trade Journal Entries: Document reasons for entering, exiting, and managing trades to analyze decision-making patterns and emotional influences.
Emotional and Psychological State: Track mood or stress level for each trade. Over time, this can highlight emotional biases (e.g., revenge trading, overconfidence).
Deviation from Plan: Record instances of deviation from the trading plan, as this metric can reveal discipline lapses and areas for behavioral improvement.
Strategy-Specific and Market Environment Metrics
Market Conditions: Note market regimes (e.g., trending, range-bound, volatile) and how strategy performs in different environments to understand its adaptability.
Trade Setup Success Rate: Track the success rate of specific trade setups to identify which setups yield the best results.
Correlation with Benchmark: Compare your returns with a benchmark index (e.g., S&P 500) to understand performance relative to the broader market.
Growth and Development Metrics
Monthly/Quarterly Performance Reviews: Regularly evaluate performance over longer periods to capture trends and assess progress.
Skill Improvement Tracking: Track new skills or strategies learned, applied, and refined over time, ensuring continuous improvement.
Great read! It would be helpful if you could write an article discussing how you implemented these in a past trade of yours.