Advanced Stock Market Trading - Level 1_2. Trading Methodology

Lesson 2: Trading Methodology

#What is Trading?
It is very important to have an understanding of what trading is before we venture
into the different trading methodologies available out there.
Trading is the act of buying and selling securities based on short-term movements to
profit from the price movements on a short-term stock chart. The mentality
associated with an active trading strategy differs from the long-term, buy-and-hold
strategy.
Where the buy-and-hold strategy employs a mentality that suggests price
movements over the long term will outweigh the price movements in the short term
and, as such, short-term movements should be ignored. Active traders, on the other
hand, believe that short-term movements and capturing the market trend are where
the profits are made.
There are various stock trading methodologies that work, each with appropriate
market environments and risks inherent in the strategy. It’s just all a matter of what
type of trader that you are and what your risk tolerance is. Are you a long or short
trader? Are you a short term or long-term trader? Do you prefer owning shares of a
stock or trading options? Are you a day trader or swing trader?
Many traders start off using particular stock trading techniques that they are
comfortable with and then add on additional stock trading methodologies over time.
Here are some of the most common stock trading methodologies:
#Day trading
Day trading, also known as session trading, is one of the most popular stock trading
strategies that work. This trading strategy is used by traders that are looking to get in
and out of trades the same day. This is also known as intraday trading or momentum
trading. Day trading, as its name implies, is the method of buying and selling
securities within the same day. Positions are closed out within the same day they are
taken, and no position is held overnight. Day traders map out support and resistance
levels on daily charts then look at intraday support and resistance levels. Once they
review the patterns and determine if the setup is one they like, only then do they
make a trade.

Day traders are typically in and out of trades within a matter of minutes and they are
looking to make quick scalps of $0.10, $0.20 or more. Every trader wants to hit a
home run and get huge gains. However, day traders are extremely disciplined and
use their account as leverage to capitalize on small gains.

Just think about it…if you purchased 10,000 shares of a $2.00 company
and you make $0.10 on that trade within a few minutes then you made $1,000
profit. Not bad for only a few minutes of being in a trade, right? Multiply these
types of potential daily gains over the course of a year and you’ll see that you can
be very profitable day trading.

Day trading is not risky, in fact it is one of the safest ways to trade, but only if the
trader is extremely disciplined. Less time in the market means less exposure to risk.
Traditionally, day trading is done by professional traders, such as specialists or
market makers. However, electronic trading has opened up this practice to novice
traders.

#Position Trading
Some actually consider position trading to be a buy-and-hold strategy and not active
trading. However, position trading, when done by an advanced trader, can be a form
of active trading. Position trading uses longer term charts – anywhere from daily to
monthly – in combination with other methods to determine the trend of the current
market direction. This type of trade may last for several days to several weeks and
sometimes longer, depending on the trend.
Position traders look for successive higher highs or lower highs to determine the
trend of a security. By jumping on and riding the "wave," trend traders aim to benefit
from both the up and downside of market movements. Position traders look to
determine the direction of the market, but they do not try to forecast any price levels.
Typically, trend traders jump on the trend after it has established itself, and when the
trend breaks, they usually exit the position. This means that in periods of high market
volatility, Position trading is more difficult and its positions are generally reduced.

#Swing Trading

Swing trading is also another one of the popular stock trading strategies that many
traders use. Swing trading involves holding your position for a few days up to a few
weeks. This strategy takes incredible discipline as well. It’s a bit different than day
trading though.
With day trading, you’re looking to make a couple trades or so each day. With swing
trading, you’re looking to make a couple trades per week. You’re looking at daily and
weekly charts, then focusing on the hourly charts and looking for entries on the 5 min
and 1 min charts.
After mapping out support and resistance levels you’re determining your profit target
level. It’s important to make sure to take profits along the way. Remember, you can
always look for re-entries and there will always be other trades to make.
When a trend breaks, swing traders typically get in the game. At the end of a trend,
there is usually some price volatility as the new trend tries to establish itself. Swing
traders buy or sell as that price volatility sets in. Swing trades are usually held for
more than a day but for a shorter time than trend trades. Swing traders often create
a set of trading rules based on technical or fundamental analysis.
These trading rules or algorithms are designed to identify when to buy and sell a
security. While a swing-trading algorithm does not have to be exact and predict the
peak or valley of a price move, it does need a market that moves in one direction or
another. A range-bound or sideways market is a risk for swing traders.

#Scalping
Scalping is one of the quickest stock trading methodologies employed by active
traders. It includes exploiting various price gaps caused by bid-ask spreads and
order flows. This methodology generally works by making the spread or buying at the
bid price and selling at the ask price to receive the difference between the two price
points. Scalpers attempt to hold their positions for a short period, thus decreasing the
risk associated with the strategy.

#Options
Options are a whole world in and of themselves and are one of the best stock trading
strategies that work. There isn’t enough time to break down this strategy in this post
because we don’t want to go on forever.

Options trading is incredibly popular because a trader is essentially almost renting
shares from another trader, at a premium price, without having to put out the
massive capital outlay upfront. This enables traders the capability of trading big
name stocks like Amazon, Google and Facebook.
When applied correctly, options trading can be very profitable, however they are also
very risky if one is not careful. Options trading requires disciplined risk management,
just like day trading and swing trading.

Now you’ve learnt about the most common stock trading methodologies available out
there However, for the sake of this course, we would focus more on the Day trading
methodology and Swing trading methodology.

#Swing Trading vs. Day Trading
Both day traders and swing traders seek to make profit from short-term stock
movements, but which trading strategy is the better one? Look at the pros and cons
of each trading methodology

#Day Trading Pros
Potential to make substantial profits: The biggest lure of day trading is the
potential for spectacular profits. But this may only be a possibility for the rare
individual who possesses all the traits – such as decisiveness, discipline and
diligence – required to become a successful day trader.
Being your own boss: The day trader works alone, independent from the whims of
corporate bigwigs. He can have a flexible working schedule, take time off whenever
needed, and work at his own pace, unlike someone on the corporate treadmill.
Never a dull moment: Long-time day traders love the thrill of pitting their wits
against the market and other professionals day in and day out. The adrenaline rush
from rapid-fire trading is something not many traders will admit to, but it is a big
factor in their decision to make a living from trading. It's doubtful this kind of people
would be content spending their days selling widgets or poring over numbers in an
office cubicle.
Expensive education not required: For many jobs in finance, having the right
degree from the right university is a prerequisite just for an interview. Day trading, in
contrast, does not require an expensive education from any school. While there are

no formal educational requirements for becoming a day trader, courses in technical
analysis and computerized trading may be very helpful.
Self-employment benefits: As a self-employed individual, a day trader can write off
certain expenses for tax purposes, which cannot be claimed by an employed
individual.

#Day Trading Cons
Risk of substantial losses: The U.S. Securities and Exchange Commission (SEC)
points out that "days traders typically suffer financial losses in their first months of
trading, and many never graduate to profit-making status." While the SEC cautions
that day traders should only risk money they can afford to lose, the reality is that
many day traders incur huge losses on borrowed monies, either through margined
trades or capital borrowed from family or other sources. These losses may not only
curtail their day trading career, but also put them in substantial debt.
Significant start-up and ongoing costs: Day traders have to compete with
high-frequency traders, hedge funds and other market professionals who spend
millions to gain trading advantages. In this environment, a day trader has little choice
but to spend heavily on a trading platform, charting software, state-of-the-art
computers, and the like. Ongoing expenses include costs for obtaining live price
quotes and commission expenses that can add up because of the volume of trades.
No consistent pay: To really make a go at it, a trader must quit his day job and give
up his steady monthly paycheque. From then on, the day trader must depend
entirely on his own skill and efforts to generate enough profit to pay the bills and
enjoy a decent lifestyle.
High stress and risk of burnout: Day trading is stressful because of the need to
watch multiple screens to spot trading opportunities, and then act quickly to exploit
them. This has to be done day after day, and the requirement for such a high degree
of focus and concentration can often lead to burnout.

#Swing Trading Pros
Does not have to be a full-time job: Anyone with knowledge and investment
capital can try swing trading. Because of the longer timeframe (from days to weeks
as opposed to minutes to hours), a swing trader does not need to be glued to his

computer screen all day. He can even maintain a separate full-time job (as long as
he is not checking trading screens all the time at work).
Potential for significant profits: Trades generally need time to work out and
keeping a trade open for a few days or weeks may result in higher profits than
trading in and out of the same security multiple times a day.
Constant monitoring not required: The swing trader can set stop losses. While
there is a risk of a stop being executed at an unfavorable price, it beats the constant
monitoring of all open positions that is a feature of day trading.
Less stress and risk of burnout: Since swing trading is seldom a full-time job,
there is much less chance of burnout due to stress. Swing traders usually have a
regular job or other source of income from which they can offset or mitigate trading
losses.
Expensive investment not required: Swing trading can be done with just one
computer and conventional trading tools. It does not require the state-of-the-art
technology of day trading.

#Swing Trading Cons
Higher margin requirements: Since swing trading usually involves positions held at
least overnight, margin requirements are higher. Maximum leverage is usually two
times one's capital. Compare this with day trading where margins are four times
one's capital.
Risk of substantial losses: As with any style of trading, swing trading can also
result in substantial losses. Because swing traders hold their positions for longer
than day traders, they also run the risk of larger losses.
Both trading methodologies have individual advantages and drawbacks. Neither
strategy is better than the other, and traders should choose the approach that works
best for their skills, preferences and lifestyle. Day trading is better suited for
individuals who are passionate about trading full time and possess the three Ds:
decisiveness, discipline and diligence (prerequisites for successful day trading).
Day trading success also requires an advanced understanding of technical trading
and charting. Since day trading is intense and stressful, traders should be able to
stay calm and control their emotions under fire. Finally, day trading involves risk –
traders should be prepared to sometimes walk away with 100% losses.

Swing trading, on the other hand, does not require such a formidable set of traits.
Since swing trading can be undertaken by anyone with some investment capital and
does not require full-time attention, it is a viable option for traders who want to keep
their full-time jobs, but also dabble in the markets. Swing traders should also be able
to apply a combination of fundamental and technical analysis, rather than technical
analysis alone.

#Types of Transactions – Long and Short
Trades can be entered in two different directions, depending on where an individual
expects the market to go. The terms long and short refer to whether a trade was
initiated by buying first or selling first. A long trade is initiated by buying with the
expectation to sell at a higher price in the future and realize a profit. A short trade is
initiated by selling, before buying, with the intent to buy the stock back at a lower
price and realize a profit.
Long trades are the classic method of buying with the intention of profiting from a
rising market. All brokers support long trades and you won’t need a margin account –
assuming you have the funds to cover the trade. Even though losses could be
substantial, they are considered limited because price can only go as low as $0 if the
trade moves in the wrong direction.
For example
When a day trader is in a long trade, they bought an asset and are hoping the price
will go up. Day traders often will use the terms "buy" and "long" interchangeably.
Similarly, some trading software has a trade entry button marked "buy," while others
trade entry buttons marked "long." The term often is used to describe an open
position, as in "l am long Apple," which indicates the trader currently owns shares of
Apple Inc. (AAPL).
Traders often say they are "going long" or "go long" to indicate their interest in buying
a particular asset. If you go long on 1,000 shares of XYZX stock at $10, the
transaction costs you $10,000. If you are able to sell the shares at $10.20, you will
receive $10,200, and net a $200 profit, minus commissions. This type of scenario is
preferred when going long. The alternative is that the stock drops. If you sell your
shares at $9.90, you receive $9,900 back on your $10,000 trade. You lose $100, plus
commission costs.

When you go long, your profit potential is unlimited since the price of the asset can
rise indefinitely.
If you buy 100 shares of stock at $1, that stock could go to $2, $5, $50, $100, etc.,
although day traders typically trade for much smaller moves. Your risk is limited to
the stock going to zero. In the example above, the largest loss possible is if the
share price goes to $0, resulting in a $1 loss per share. Day traders keep risk and
profits well controlled, typically exacting profits from multiple small moves.
Short trades, on the other hand, are entered with the intention of profiting from a
falling market. Once price reaches the trader’s target level, he/she buys back the
shares (or buy to cover) to replace what he/she originally borrowed from his/her
broker. Since the individual borrows shares/contracts from a broker to sell short,
he/she have to have a margin account to complete the transaction. Day traders in
short trades sell assets before buying them and are hoping the price will go down.
They realize a profit if the price they buy it for is lower than the price they sold it at.
"Shorting" is confusing to most new traders since in the real world we typically have
to buy something in order to sell it. In the financial markets, you can buy and then
sell or sell then buy.
Day traders often use the terms "sell" and "short" interchangeably. Similarly, some
trading software has a trade entry button marked "sell," while others have a trade
entry buttons marked "short." The term short often is used to describe an open
position, as in "I am short SPY," which indicates the trader currently has a short
position in S&P 500 (SPY) ETF.
Traders often say I am "going short" or "go short" to indicate their interest in shorting
a particular asset.
Similar to the example of going long, if you go short on 1,000 shares of XYZX stock
at $10, you receive $10,000 into your account, but this isn't your money yet. Your
account will show that you have -1,000 shares, and at some point, you must bring
that balance back to zero by buying at least 1,000 shares.
Until you do so, you do not know what your profit or loss on your position is.
If you are able to buy the shares at $9.60, you will pay $9,600 for the 1,000 shares,
but you originally received $10,000 when you first went short, so your profit is $400,
minus commissions. If the stock price rises and you buy the shares back at $10.20,
you pay $10,200 for those 1,000 shares and you lose $200, plus commissions.

When you go short, your profit is limited to the amount you initially received on the
sale. For example, if you sell 100 shares at $5, your maximum profit is $500 if the
stock goes to a price of $0. Your risk, though, is unlimited since the price could rise
to $10 or $50, or more. The latter scenario means you would need to pay $5,000 to
buy back the shares, losing $4,500. Since risk management is used on all trades,
this scenario isn't typically a concern for day traders that take short positions.
Not all trading instruments can be sold short, and not all brokers offer the same
instruments for short sale.
Long Trade= Profit from a rising market
Short Trade= Profit from a falling market
Trading short positions is an important part of active trading because it allows you to
take advantage of both rising and falling markets – but they require extra caution.
Unlike long trades, where losses are limited, short trades have the potential for
unlimited losses. This is because a short trade loses value as the market rises, and
since price can theoretically continue rising indefinitely, losses can be unlimited –
and catastrophic. However, one can manage this risk by trading with a protective
stop-loss order.

#Turning a Profit from a Falling Share Price
One of the biggest frustrations many people have with the stock market is that they
think that they can’t make money when it’s falling. After all, even during a rising
market stocks can spend nearly half the time falling as well as going up. So, it’s only
fair you should be able to make money when stocks fall. However, if you’re an
experienced investor you’ll know that you can make money from falling stocks. But
what few people realise (even experienced investors) is that investors can use this
same strategy to protect their portfolio too.

#So, How exactly does shorting work?
Short selling means you sell a stock you don’t own – hopefully at a high price – and
then buy it back later, hopefully at a low price.
The difference between the sell price and the buy price is your profit. Now, you don’t
need to know the mechanics of how short-selling works but put simply a broker
borrows the stock from another investor in return for a fee and then puts the stock in
your account so you can sell it.

When you buy the stock at a later date to close the position the broker puts the stock
back in the lender’s account. Easy.
But aside from profiting, it’s also possible to use short-selling as a defensive strategy.
Until recent years this was a strategy really only available to big sophisticated
institutional investors. But with the advent of online trading and the development of
derivatives markets, the ability to protect investments against a market crash is now
available to almost everyone.
For instance, you have a $50,000 share portfolio and you’re worried the market will
crash – just as Vern says it will.
One option is to sell everything, another option is to ‘hedge’ your portfolio by short
selling $50,000-worth of shares. The best way to do this is using a derivatives
product called Contracts for Difference (CFDs).
CFDs allow you to take part in the performance of a share without actually owning or
borrowing the shares – depending on whether you’re trading long or short.
Instead of selling every share in your portfolio, you could short sell nine contracts
covering the S&P/ASX 200 (assuming it trades for $1 per point, check with your CFD
provider before placing any trades). This would hedge your position. If the stock
market fell you would lose on your shares but should make up for it by gaining on
your short CFD trade.
Another option is to hedge part of your portfolio – by say short-selling two, three or
four CFDs on the S&P/ASX 200.
Just remember this isn’t a perfect approach. It assumes your shares move roughly in
line with the main blue-chip index. The other downside is that if the stock market
goes up rather than down, you’ll miss out on the gains.
That’s because although your shares will rise, you’ll lose on your short index CFD
position. So overall, you’ll have a neutral position.
Long term, if you believe the market is set to crash you may be better off just getting
out of the market. But using derivatives to hedge your portfolio can be an effective
way of combatting short term volatility.
Short selling isn’t for everyone. It’s certainly not the strategy for a ‘patient investor’.
And it’s not a strategy recommended by Vern.
But if you’re an active investor and you’re looking for a way to profit from a falling
stock market or to protect your wealth without selling all your shares, this is
something worth looking at.