Short-Term Trading Strategy (Backtest)

Last Updated on November 13, 2022 by Oddmund Groette

Because of its potential for quick profits, the short-term trading strategy is the most popular trading method among retail traders. Unlike traditional long-term investing methods, this strategy offers an exciting opportunity to profit from relatively minor changes in market conditions. But what exactly is the short-term trading strategy?

A short-term trading strategy is a trading strategy that aims to open and close positions in a short period, typically a few days or weeks, but it can be even shorter. Traders who make use of this strategy focus on the analysis of price movements rather than the long-term fundamentals of an asset.

In this post, we take a look at the short-term trading strategy, and at the end of the article, we make a backtest.

What does short-term trading mean?

Short-term trading involves traders taking positions that can last from a few seconds to several days. It focuses on the short-term price movement rather than the long-term fundamentals of an asset. This trading strategy looks for periods of high market volatility, such as those surrounding important economic data releases, company earnings, and political events, to profit from the sharp fluctuations in market prices. 

Also known as active trading, this approach is not used to engage in passive investing in funds but rather it is used to speculate on financial assets of different kinds, including derivative products. In fact, most short-term traders prefer derivative instruments because they allow them to enter and exit trades without owning the underlying asset. Contracts for difference (CFDs), spread bets, futures, and options are examples of financial instruments that allow traders to profit from rising and falling market prices.

What does short-term trading strategy mean?

Short-term trading is a trading strategy that aims to open and close positions in a short period, typically a few days or weeks, but it can be even shorter. The most common users of this type of trading strategy are retail and institutional traders who hope to profit from small price movements and short-term trends. It is an alternative to the more common “buy-and-hold” strategy, in which you would hold a position for as long as you want, often several years.

Short-term vs. long-term trading

In contrast to short-term trading, which aims to make small, quick profits, long-term trading aims to make bigger profits over a longer timeframe by banking on the asset’s growth. Hence, while short-term trading focuses on the short-term price action of a financial instrument and uses technical analysis, long-term trading focuses on long-term trends and often makes use of fundamental analysis. As a result, trading over short periods is regarded as a more speculative form of investment than the traditional strategy of long-term investing or buy and hold.

Long-term trading is often done with real assets, such as equities, ETFs, and funds. Short-term trading, on the other hand, frequently entails using derivative products such as futures, options, spread bets, and contracts for difference (CFD) but can also be done on equities with the right account size. With a CFD, you can open a buy or sell position based on whether you believe the asset’s price will rise or fall, and whether you will profit or lose depending on the market’s direction.

While both long-term and short-term trading can make use of leverage, short-term trading is more likely to involve the use of leverage because of the shorter duration and perceived reduced chance of adverse price movement. However, leverage and margin trading carries a high level of risk, which is why long-term investors prefer to pay the full value of the position up front and take ownership of the asset. If you use leverage and you incur a loss, the amount of the loss will be calculated based on the total value of the position and subtracted from your account. This means that you could lose more than you invested unless the broker offers negative balance protection.

Before deciding whether to play the short-term game or long-term investing, you should consider your personality, the amount of money you are willing to risk, and your overall trading goals. All of these factors can potentially impact your position’s outcomes.

Short-term trading tips

Here are some tips to get you started on short-term trading:

  • Always have a trading plan: A trading plan can be considered a set of rules that govern how you should behave while trading. It is a road map you use to determine how to find and execute trades. Your trading plan should cover everything from how to find trade setups to how to manage your specific positions and how to exit. For any trader, you should have a clear strategy for how to enter a position and how to exit it.
  • Learn to control your emotions: To be successful in short-term trading, you must be able to make multiple decisions quickly while keeping a large amount of complex information in your head. The fact you’re your money and, possibly, your livelihood is at stake, creates a volatile mix of emotions.Fear of loss and greed for profits can be powerful motivators for traders. Both mental states cloud judgment, making traders more likely to make decisions that aren’t in their best interests. An easy way to reduce the effects of emotions in your trading is to automate your trading by converting your strategies into trading algorithms.
  • Practice risk management: As a short-term trader, you may choose to use stop loss to manage risks. However, you should note that while it may help to limit losses, it may not help the overall profitability of your strategy. So, consider other alternatives, such as diversification across assets and strategies.
  • Be mindful of slippage: Because of the rapidity with which short-term trades are executed, the price at which your order is executed may differ from the price at which you specified it should be executed. Limit orders may help avoid that but you may end up missing some trades.
  • Find your best time of day to trade: When the market is most liquid and when there is the most price movement can vary depending on your trading strategy. Find the best timeframe for your strategy.
  • Practice with a demo account: A demo account helps you to practice your short-term trading strategies without risking your funds. Demo accounts are often preloaded with virtual funds for practice purposes.

List of short-term trading strategies

These are some short-term trading strategies:

Scalping

Scalping is a trading strategy that focuses on extremely short timeframes. Scalpers enter and exit positions as quickly as possible (within seconds or minutes) with the aim of making little profits, and they can make hundreds of trades during a typical trading day so that their little profits can accumulate to a substantial amount. 

This group of traders doesn’t usually use fundamental analysis; instead, they focus solely on price action and technical analysis. The strategy is mostly used in forex because of the nature of price fluctuations in that market. Scalpers don’t bother about trends as their trades are closed relatively fast for any trend to develop. The risks of trading are much higher for scalpers than for other short-term traders because of the large number of trades and the resultant commission costs.

Day trading

With this style of trading, the trader opens and closes his trade within the same trading day. This means they do not carry positions over into the next day, avoiding the fees associated with overnight positions. Day traders try to capture the price trend of the trading day and thus, focus on intraday timeframes. These traders could use hourly charts to analyze price data and identify recent emerging or declining trends to decide whether to buy or sell the asset.

Compared to scalpers, day traders have more time to evaluate their trades, reducing risk slightly. They can examine price charts to determine the highs and lows of the previous trading day, which will help them develop an efficient strategy for the current trading day. As with scalping, Day trading avoids the risk of price overnight price gap, which is a risk for any position carried overnight.

Swing trading

Swing traders hold open positions for several days or weeks at a time. Swing trading is a strategy for trading in the short to medium term. Traders may examine an asset’s swing highs and swing lows to determine whether or not the asset has the potential to generate future profits, as the term “swing analysis” implies.

Most swing traders look for trading opportunities on the daily timeframe, as their game is to ride the individual price swings. They can use both fundamental and technical analysis, unlike scalpers and day traders who focus only on technical analysis and price action, but they still tend to rely more on technical analysis.

Short-term trend trading

Trading with the trend is a strategy that can be used in short-term and long-term trading strategies. In short-term trend trading, the focus is on short-term trends that appear on hourly and 4-hourly charts. The strategy assumes that the price of an asset will continue to move in the direction that it is currently headed and will not reverse direction for the duration of the position.

In general, traders will buy an asset (if it is trending upward, and they will sell the asset if it is trending downward. They use trendlines to help them identify price chart trends that are developing or shifting in direction. Trendlines can also be useful in identifying breakouts from a trend that is about to change direction.

Examples of short-term trading strategies

There can be many examples of short-term trading strategies. Here, we will show two: scalping and swing trading.

Scalping example:

Scalpers take quick trades, so they focus on 5-minute and 1-minute charts. You can see a 1-minute chart below showing stochastic oversold and overbought signals. A scalper could have used those to make quick profits from the market. Each of those trades would have lasted a few minutes. Please note that this is just an example, not a tested strategy.

Short term trading strategy scalping

Swing trading example:

Take a look at the Nasdaq price chart (D1 Timeframe) below. You can see that the trend is up, with the price bouncing off the trendline at intervals. A swing trader can decide to trade the impulse price swings after each pullback to the trendline. The trade entry method would be an oversold signal from the stochastic plus the price hitting the trendline. In the chart, you can see that each time the price hit the trendline, the stochastic gave an oversold signal. Another confirmation for experienced traders is the reversal candlestick patterns that form at the trendline (circled).

Short term trading strategy (swing trade)

Short-term trading fees

There are a number of fees that should be taken into account when short-term trading. They include the following:

  1. Spreads: These are differences between the bid and ask prices. They are already accounted for in the instrument’s buy and sell prices and will appear on your order ticket when you enter their values.
  2. Commissions: These are fees the brokers charge for executing trades on your behalf. You pay trading commissions when you enter and exit a trade. The commission rates vary from broker to broker and may also vary with the country from where the share originated.
  3. Holding costs or overnight fee: Any trades held overnight, such as in swing trading or other similar strategies, will incur holding costs. These are tallied at the end of each day and are determined by the appropriate holding rate for the instrument you have

Short-term trading indicators

The most effective technical indicators for short-term trading strategies are those that can help traders define entry and exit points over a shorter period. Although technical indicators should not be used exclusively and should be combined with other trading tools to achieve the best possible results and analysis, the following are a few examples of effective indicators that are commonly used for short-term trading:

Moving averages

Traders can use moving averages to determine whether the price of an asset is rising or falling, which is useful information to have. A simple moving average (SMA) typically uses a timeframe of approximately 10-20 days when analyzing short-term trends; however, this can be modified to reflect the timeframe you wish to analyze.

When an asset’s price is rising, the moving average will start to slope upward. That may be an indication to buy the asset. On the other hand, when the price is declining, the moving average would point downward, which could be an indication to sell short. 

Relative strength index

The relative strength index, or RSI, can be used to determine whether a security is overbought or oversold. It measures a security’s relative strength or weakness in comparison to the strength or weakness of other market assets. Generally, a reading of 70 indicates that the asset has been overbought, while a reading of less than 30 indicates that the asset has been oversold.

Divergence, failure swings, and centerline crossovers on a trading chart can all be used to generate buy and sell signals for short-term trading. For example, some traders may choose to buy on a decline when the RSI shows an oversold condition or bullish divergence and sell on a rally when the RSI shows an oversold condition or bearish divergence. 

Stochastic oscillator

A stochastic oscillator can be used to determine whether or not a financial instrument has a good value based on the closing price range of the instrument over a short period. When the stochastic lines fall below 20, it indicates that the instrument has reached an extreme level of overselling, which may be a signal to buy the asset.

On the flip side, when the stochastic indicator lines are above 80, it indicates that the asset has been overbought, which may prompt a trader to liquidate their position. The stochastic indicator can also be used to anticipate short-term shifts in the direction of an existing trend as part of a divergence strategy.

Pros and cons of the short-term strategies

Pros

  1. They provide the opportunity to make quick profits.
  2. You have the option of reinvesting any profits.
  3. You can avoid some of the inherent risks of holding a position overnight
  4. Capital requirements are reduced.

Cons

  1. The risk of a loss is more in short-term trading.
  2. It is unquestionably more stressful, and dealing with it requires a specific psychological makeup.
  3. You are effectively tethered to your computer screen due to the increased time commitment.
  4. You must become acquainted with the fundamentals of technical analysis to succeed.

Short-term trading and taxes

Long-term and short-term investments are taxed differently, and you should take note of this as a trader. Short-term trades are taxed at the same rate as regular income, whereas long-term investments (trades held for more than one year) are taxed at a lower rate. 

The taxpayer’s ordinary income tax rate determines the portion of the proceeds from the sale of an asset that is exempt from taxation when the asset was only held for a short period. Depending on their income and how they file their taxes, traders may be subject to taxes ranging from 10% to 37% for their short-term trading profit. Long-term rates are usually between 5% to 15%.

Short term trading strategy backtest

We have thus far given you several examples of how you can develop a short term trading strategy. However, none of them are quantified. In this section of the article, we’ll make a specific trading strategy with trading rules and settings that you can backtest yourself.

A backtest is coming shortly

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