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.