8 steps to build your own rule-based investment strategy (2024)

A month ago, we emphasized the significance of measuring trading performance for investors.

Subsequently, we delved into the calculation of the key parameters, which can aid in assessing trading performance such as success rate, average gains, and average losses. Later on, we explored ways in which investors can improve their trading performance. We also examined how rule-based investing can help investors in curtailing their losses by eliminating emotional biases and including objective analysis.

Rule-based investing is basically following a systematic approach to making investment decisions by formulating predefined sets of rules to buy or sell a particular stock or security. In this article, we will discuss the steps for constructing a rule-based investment strategy. So let us simplify this seemingly complex task into a more manageable process.

Step 1: Define the investment objective

This step involves the assessment of the investor’s financial goals, risk tolerance, and time horizon. In order to align the investment objectives with the investment actions, one must clearly outline his goals such as generating short-term profits, hedging risks, or long-term growth.

Step 2: Identifying core investment competencies

An investor might have expertise while investing in a particular market segment or stocks from specific sectors. They can analyze their historical trades where they were able to generate profits. This can help them identify the investment patterns which they usually follow when executing the trades. Focusing on these investment patterns can also assist them in executing future trades.

Step 3: Select the technical and fundamental indicators
This stage assumes immense importance, given that the entry and exit guidelines are dependent upon the indicators meticulously chosen. The selection process significantly relies on an investor’s inclination toward either fundamental or technical analysis.

For instance, a practitioner of fundamental analysis is likely to scrutinize companies’ latest results, valuation metrics, discounted cash flow valuations, and more.

Conversely, a technical analyst would prioritize breakouts, chart formations, relative strength index, etc… An investor may combine and blend the fundamental and technical indicators according to his investment strategy which he usually follows.

Step 4: Determine the Entry and exit rules
Without rule-based investing, this stage is particularly susceptible to significant human and emotional biases, often resulting in flawed judgments and substantial financial losses. Behavioral biases frequently prompt investors to enter trades belatedly or prematurely exit them thereby culminating in marginal profits and considerable losses. The formulation of rule-based entry and exit parameters can help eliminate these biases, ultimately improving financial outcomes. For example, a trader purchases a stock solely when it surpasses the 50-Day SMA, and exits the position immediately upon its closure below the 20-Day SMA.

Step 5: Set risk management and position sizing rules
It is rightly said that "Risk management is the safety net that turns a potential fall in the stock market into a calculated step forward.” Maintaining strict stop-loss levels and position sizes help investors preserve capital while seeking opportunities. An investor must follow these risk management rules for each trade that he executes without leaving any room for biases. For instance, an investor can set the stop-loss at either 5 percent or will not invest more than a certain percent of his capital on each trade.

Step 6: Back-testing the strategy
In the previous steps, we have defined the entry and exit points along with the stop-loss levels. Based on predefined entry, exit, and stop-loss levels, one can calculate hypothetical profits or losses using historical stock data available on NSE/BSE website. One can fine-tune the strategy parameters on the basis of back-testing results in order to improve performance. For instance, an investor might observe improved back-testing results by modifying the 50-Day SMA to a 50-Day EMA.

Step 7: Paper Trading
There might be cases where a particular strategy gives excellent results while back-testing historical data but poor results when tested during a live market. This issue can be detected and resolved with the help of paper trading. It involves implementing the strategy in a simulated trading environment to validate its performance in a real-time market without risking actual capital.

Step 8: Implementation
If we yield positive results after back-testing the strategy on historical data and live data through paper trading, we can implement the strategy in the live market and monitor its performance closely.

Developing a successful investment strategy involves knowing your financial aims, and understanding the market. By matching the goals with the strengths and eliminating behavioral biases with rule-based investing, investors will be able to make better investment choices and increase the chances of beating the index. A smart strategy based on clear goals and effective results sets the foundation for a successful investment approach.

Technical Outlook

ETMarkets.com

Nifty consolidated in the 19,500-19,650 range throughout the week before breaking down on Friday and closing at 19,428, down 89 points. Nifty has now closed in red for the third consecutive week.

The Foreign Portfolio Investors (FPIs) have been liquidating long positions and increasing their short exposure since the start of August Expiry as indicated by the Long-Short Ratio. Nifty has closed below the 38.2% Fibonacci Retracement of 19,489 drawn from the low of 18,647 made on 23rd June to the high of 19,992 made on 20th July. The India VIX rose 9% in this week and closed at 11.52, giving major discomfort to the bulls.

Nifty has been moving in a downward channel since 27th July. The immediate support for Nifty is placed at 19,400. A break below 19,400 can take the Index until 19,300, which is the previous swing low level. A decisive breakout on the upper end of the range, which is placed at 19,650, is likely to ignite fresh buying interest.