The investment/speculation website investopedia.com lists many different trading strategies, among the dozens I've read about there are: entry trading, scalping, fading, trading using various market fundamentals, trading price momentum, daily pivots and multiple variations of pivot point analysis, counter trend trading, trend following, various reversal strategies etc, etc... The list of different types of trading strategies is virtually endless and usually the more obscure ones are just rehashed versions of the more commonly used ones, but as I said previously in the technical trading systems library, there are only three way (that I currently know of) to gain an edge on which to build a mechanical trading system, and these ways are –
The long-term underlying trend.
Statistically significant price levels – these levels are caused by the effects of support & resistance.
Market momentum.
In addition to these technical trading strategies there are various other 'non-technical' trading methods such as market sentiment indexes and the commitments of traders report. But for the purposes of this article I will only talk about the three methods that can be used using purely technical (i.e. price) data; the long-term trend, support & resistance, and price momentum. Before I go into each of these three methods in more detail I would just like to mention that each or any of these methods will only work if the market is in an ideal state for them, and my experience also tells me that more favourable the market in question is to one of those 3 methods, the more unfavourable it's likely to be to the other two (although there is without a doubt some degree of over lapping). For example, when the market is in a strong up trend it's far better to buy high and hold the position until you get a trend reversal signal than it is to gamble on being able to get in at a better price by waiting for a price retracement to buy at the support level. Or if the market in question is ideal for momentum trading systems, then it's probably not wise to look for a reversal signal to exit the position and support & resistance is unlikely to be effective during those conditions. For more information I've a really brief article on different types of markets.
Edge #1: Trend Following With the Long Term Trend,
Trend following is attempting to exploit large price movements that occur over several weeks, several months or longer. A typical trend following system involves entering after the market makes a new high or low and holding that position until a signal is given that the trend has reversed or failed to follow though. One common variation on this is entering when a new high or low closing price has occurred and simply waiting for a predefined period of time (often around a month or more) before exiting. An example of a mechanical entry signal that a trend following system might use could be, for example, the price reaching a new 3-month high (a long signal) or a new 3-month low (a short signal). A trend reversal signal that may be used with this type of system might be the price making a new 1-month high or low in the opposite direction of the trade which could indicate that the trend is in doubt or reversing, whilst a lack of follow-through signal might be the market failing to make a new high or low in our trade's favour for a month. A suitable time-based exit to use with this type of system might be a period of several weeks to several months.
Trend following works best on large liquid markets like Forex (most notably the EUR/USD currency pair) and interest rates that are driven by economic fundamentals rather than speculators. Important macroeconomic events can continue to drive these markets in the same direction creating a good clean trend that lasts for many months (or even years) regardless of what speculators think. Trying to pick tops and bottoms using support and resistance generally won't work to well on these types of markets and those who try will generally end up on the wrong side of the big moves as they're wrong time after time when they bet on a trend reversal. The only way to trade markets like these is to determine the direction of the long-term underlying trend, enter in that direction and hold the position until either enough time has passed to take your position into profit (a time-based exit) or you get a clear signal that the trend has ended (or at the very least failed to follow through).
Edge #2: Counter Trend Trading With Support & Resistance,
Counter trend trading is essentially aiming to buy low and sell high, it works best on markets like stock indices where the price is driven by speculators rather than major global macroeconomic events. Support and resistance levels are often very effective in these types of markets. If a mechanical trend following system makes use of the general trend in these types of markets it should be as a 'filter' only. An example of such a system might be my S&P 500 trading system that buys when the market closes lower than it has closed in the last 3 days and sells when the market closes higher than it has closed in the last 3 days, and a 'trend filter' of comparing the closing price to the closing price 60 days ago is merely there to try and stop the system catching falling knifes.
Edge #3: Trading Momentum,
Trades taken because of momentum are usually very short-term and can happen on any type of market providing that market is prone to reacting very violently to events, some examples of these types of markets are oil and the GBP/USD pair. Illiquid markets that are highly susceptible to price shocks are also great for momentum trading systems. Momentum such as a huge weekly move can also be used to signal a change of trend, however this is not momentum trading. Trades taken using market momentum typically last for anything from a few minutes to a few days.
The idea behind momentum trading systems is that when enough momentum is behind a price movement to push it very violently in one direction then it takes a lot to stop it and there's money to be made by entering in the direction of the movement and exiting after a short period of time before the momentum ends. These types of systems tend to produce a high percentage of winning trades more than large number of pips won. On some markets such as stocks/shares and commodities, an increase in volume is also used to confirm momentum; obviously getting reliable real time data on volume is harder on the Forex market due to there being no central exchange.
