Rule based trading strategies

Over the past four chapters, we’ve seen quite a lot of rule based trading. And in this final chapter of this module, we’re going to be looking at the various strategies that you can employ when leveraging this trading technique. These trading strategies that we’re about to take a look at, when executed accurately, can give you a better chance of generating profits. That said, let’s jump right into the chapter.

Rule based trading strategies

As far as rule based trading strategies are concerned, there’s absolutely no dearth of options. However, in this chapter, we’re going to be focusing only on the most popular and commonly used strategies. Here’s a quick overview of the same.

1. Market trend strategy

This is arguably one of the easiest and most commonly used rule based trading strategies out there. Unlike many other complex strategies, the market trend strategy is easy to understand and implement. According to this strategy, all that you would need to do is identify the current market trend and implement a rule based trading strategy that can leverage the trend to generate profits. Here’s an example to help you better understand how this strategy works.

Say you’re interested in purchasing a stock. And that you’re waiting for the right time to enter. Since you’re into rule based trading, you can create an algorithm that’s capable of identifying market trends using moving averages. You could also code the algorithm in such a way that it executes a buy order once the market trend is identified as bullish. Also, you can code the algorithm to execute a sell order once the market trend is just about to turn bearish.

2. Arbitrage strategy

Arbitrage is essentially a trading technique that involves buying and selling the same asset in two different markets. The profit that you get to enjoy from an arbitrage opportunity is the price difference between these two markets.

For instance, let’s say that you’re interested in a stock that’s listed on both the BSE and the NSE. Now, you notice that the price at which the stock is trading on the NSE is higher than that of the BSE by Rs. 0.50. And so, you decide to take advantage of this opportunity by buying the stock on the BSE and simultaneously selling it on the NSE. The profit that you get to make from this transaction is Rs. 0.50 per share.

Since arbitrage opportunities tend to be rare and last only for a few seconds or minutes, executing a successful arbitrage strategy manually is near to impossible. However, with the help of rule based trading, you can take advantage of this pricing difference.

For example, you could create an algorithm that constantly monitors the tick-by-tick market data feeds of a basket of stocks. And when the algorithm detects a price difference between the two exchanges - BSE and NSE, you could code it in such a way that it executes a buy order on the exchange that quotes a lower price and simultaneously executes a sell order on the exchange that quotes the higher price.

3. Range-bound trading strategy

This rule based trading strategy works best when a stock is seemingly trading within a range; i.e. when it constantly moves between its support and resistance levels. It involves creating an algorithm that places a buy order at or near about a stock’s support level and places a sell order at or near about the stock’s resistance level. Also, you could code the algorithm to short-sell the stock at the resistance level and buy it back as soon as it hits the support level.

This way, you get to make gains both ways - when the share price falls and when the share price rises back up. However, this strategy would work only if the stock is really range-bound. Therefore, it is crucial to accurately identify range-bound stocks using the help of technical indicators.

Wrapping up

And with this, we’ve come to the end of another module of Smart Money. Hope you’ve learned enough to start with your very own rule based trading system. Remember, practice makes you perfect. As far as rule based trading is concerned, it involves a lot of trial and error. And so, make sure that you backtest your algorithms and strategies extensively before deploying them in real-life market scenarios.

A quick recap

• The market trend strategy is arguably one of the easiest and most commonly used rule based trading strategies out there. According to this strategy, all that you would need to do is identify the current market trend and implement a rule based trading strategy that can leverage the trend to generate profits. 
• Another common strategy is arbitrage. Arbitrage is essentially a trading technique that involves buying and selling the same asset in two different markets. The profit that you get to enjoy from an arbitrage opportunity is the price difference between these two markets. 
• The range-bound trading strategy works best when a stock is seemingly trading within a range; i.e. when it constantly moves between its support and resistance levels. It involves creating an algorithm that places a buy order at or near about a stock’s support level and places a sell order at or near about the stock’s resistance level.