Trading is an active style of participating in the financial markets, which seeks to outperform traditional buy-and-hold investing. Instead of waiting to profit from long-term uptrends in the markets, traders seek short-term price moves in order to profit during both rising and falling markets. As a trader, you can be your own boss, work from home, set your own schedule and have the opportunity to achieve unlimited income potential. These factors, combined with the ease with which someone can enter the field, help make trading attractive.
While it’s relatively easy to start trading – after all, you don’t need any advanced degrees or specialized training – it is very difficult to become good at it and to become successful. It’s not uncommon for someone who wants to trade for a living to overlook the financial, emotional and time commitments that are required to build a successful trading business. As a result, about 90% of day traders fail within the first year. Having a strategic approach, both in terms of your overall business and your actual trading activity, is an essential part of becoming a profitable trader.
In the first part of our beginner trading series, How To Start Trading, we emphasized the need to approach trading as a business and not as a hobby. In addition, we explored:
- Trading styles – position, swing, day and scalp trading
- Trading technology – computers, trading software, market analysis, testing and order execution
- Order types – market, limit, stop, stop loss, conditional and duration
- Trading plan development – market, chart interval, indicators, position sizing, entry rules, trade filters and exit rules
- Testing your trading plan – backtesting, in-sample and out-of-sample testing, and forward performance testing
- Live trading performance – trader errors, fills, technical problems and unique trading conditions
Here, in the second part of our beginner trading series, we introduce additional concepts that are important to traders, including:
- Leverage and margin
- Popular trading instruments
- Strategy automation
- Record keeping and taxes
Going hand-in-hand with margin is leverage; you use margin to create leverage. Leverage is the increased buying power that is available to margin account holders. Essentially, leverage allows you to pay less than full price for a trade, giving you the ability to enter larger positions than would be possible with your account funds alone. Leverage is expressed as a ratio. A 2:1 leverage, for example, means that you would be able to hold a position that is twice the value of your trading account. If you had $25,000 in your trading account with 2:1 leverage, you would be able to purchase $50,000 worth of stock.
Not all securities are eligible for margin borrowing, and the available leverage for those that areeligible varies greatly by market. Stock traders, for example, typically utilize a 2:1 leverage. It is not uncommon, however, for forex traders to use 50:1 leverage (prior to late 2010, forex traders had access to 100:1 leverage, which many believed made it too easy to suffer catastrophic losses). While more seems better, it’s important to understand that leverage magnifies both gains and losses. Here’s an example:
Stock ABC is trading at $100 per share and you feel that it is poised to rise in price. With 2:1 leverage, you use the $10,000 in your trading account and $10,000 of margin from your broker to buy 200 shares of the stock (($10,000 X 2) / $100 = 200 shares). Without the margin, you would have been able to purchase only 100 shares.
Following the release of a new product and strong earnings, the stock jumps 25% to $125 per share. Your investment is now worth $25,000 and you decide to close out the position. After you pay back your broker the $10,000 you borrowed, you have $15,000 left and realize a $5,000 profit. Because of leverage, you were able to realize a 50% return on your money (less commission and interest) even though stock ABC went up only 25%.
Now assume the trade goes the other way. Instead of climbing 25%, a scandal involving the company’s management causes the stock to suddenly drop 25%. With a share price of $75, your investment is now worth $15,000. You conclude that price is only going to continue dropping and decide to close out your losing position. After paying back your broker the $10,000 you borrowed, you have $5,000 left. This represents a 50% loss, not including commissions and interest. Had you not traded on margin, this would have been only a 25% loss.
While this example may not be realistic for active traders who typically seek small price moves, leverage does allow traders to make more money off smaller moves. While trading on margin and using leverage can increase your returns and allow your account to grow faster, it should always be used judiciously. It is possible to lose more than you originally invested when trading on margin.
The bottom line is trading on margin has inherent risks and may not be appropriate for everyone. You can mitigate some of those risks by using protective stop loss orders and limiting your use of leverage by not using your entire margin balance (just because you have the margin, doesn’t mean you have to use all of it on any given trade). In addition, you should adequately test any trading plan before putting it in a live market and risking real money.
3. POPULAR TRADING INSTRUMENST
- Width – How tight is the bid/ask spread?
- Depth – How deep is the market (how many orders are resting beyond the best bid and best offer)?
- Immediacy – How quickly can a large market order be executed?
- Resiliency – How long does it take the market to bounce back after a large order is filled?
Markets with good liquidity typically trade with tight bid/ask spreads and with enough market depth to quickly fill orders. Liquidity is important because it helps ensure that your orders will be:
- Filled with minimal slippage
- Filled without substantially affecting price
Volatility measures the amount and speed at which a price moves up and down. When a trading instrument experiences volatility, it provides an opportunity to profit from the change in price. Any change in price – whether rising or falling – creates an opportunity to profit; it is difficult to make a profit if price stays the same.
You can get a good idea about an instrument’s liquidity and volatility by looking at:
- Average daily trading volume (ADTV) – the average number of shares or contracts that are traded in a day or over a specified period of time. When ADTV is high, the instrument has good liquidity and can be easily traded.
- Average daily trading range – the average difference between the high and low prices for a given instrument over a specified period of time. A wider trading range equates to more volatility, which, for traders, means greater potential for profits (and losses).
Volume indicators can be added to any price chart; volume typically appears as a histogram beneath the price chart. Each bar of the histogram represents the volume that occurred during the corresponding price bar. For example, if you are trading with a 5-minute chart, each price bar shows the price movement that took place during that 5-minute period, and each volume bar indicates the trading activity for the same period. A moving average can be added to volume to determine the average values. A 20-day moving average, for example, would show the average daily trading volume over the previous 20 days.
The average daily trading range shows how much price movement there is, on average, over a selected time period. This value can be determined by calculating the difference between the daily high and low prices over a specified number of days. An easy way to do this is to apply a moving average to a daily chart that uses the high-low price (rather than just the high or low) in its calculation. The length of the moving average will determine the number of days that are used in the calculation.
Most traders choose instruments that trade under good liquidity and with enough price movement to allow profits. That said, just because the e-mini S&P 500 (ES) contract fits that bill, doesn’t mean it will be appropriate for your trading style or risk tolerance. Finding an instrument that matches your style may take a bit of research. As a starting point, these instruments tend to be popular among active traders:
Commodities are typically bought and sold through futures contracts on exchanges that standardize the quantity and minimum quality of the commodity being traded. The main categories of commodities include agricultural, livestock and meat, energy, precious metals and industrial metals. The most actively traded commodities include crude oil and its derivatives (i.e., heating oil and gasoline); precious metals; and agricultural products such corn, sugar, soybeans, wheat, coffee and cotton.
An “e-mini” is an electronically traded futures contract that represents a portion of a standard futures contract. As futures contracts, the e-minis represent an agreement to buy or sell the cash value of the underlying index at a specified future date. The contracts are sized at a certain value times the futures price; this value depends on the particular e-mini. The e-mini S&P 500, for example, has a contract size of $50 times the e-mini S&P 500 futures price. If the value of the e-mini S&P 500 is $1,320, the value of the contract is $66,000 ($50 X $1320). The value of the contract changes as the price of the futures moves. Mini contracts are available on a variety of products; however, traders typically refer to the e-mini stock index futures contracts when discussing e-minis: the e-mini S&P 500 (ES), e-mini Russell 2000 (TF), e-mini Dow (YM) and the e-mini Nasdaq 100 (NQ) contracts.
Exchange Traded Funds
Exchange traded funds (ETFs) are uniquely structured investment funds that track broad-based or sector indexes, commodities and baskets of assets. ETFs trade just like stocks on regulated exchanges and can be sold short and purchased on margin. And, like stocks, ETF prices fluctuate throughout each trading session in response to market events and investor activity. Some of themost actively traded ETFs include SPDR S&P 500 (ARCA:SPY), MSCI Emerging Markets Index Fund (ARCA:EEM), S&P 500 VIX Short-Term Futures ETN (ARCA:VXX), Financial Select Sector SPDR (ARCA:XLF), Russell 2000 Index Fund (ARCA:IWM), MSCI Japan Index Fund (ARCA:EWJ) and PowerShares QQQ Trust (Nasdaq:QQQ).
Forex is the foreign exchange market where currencies are traded. The forex markets are the largest and most actively traded financial markets in the world, accounting for more than $4 trillion in average daily volume. Forex is appealing to many traders and investors for a variety of reasons including its relative stability, its round-the-clock nature and access to significant leverage. The four pairs that are the most heavily traded are known as the “majors.” They include the euro/U.S. dollar (EUR/USD); U.S. dollar/Japanese yen (USD/JPY); U.S. dollar/Swiss franc (USD/CHF); and the British pound/U.S. dollar (GBP/USD).
Stocks are a type of investment that signifies ownership in a company. The number of companies in which investors and traders can buy stock has been steadily declining over the past decade as firms are delisted, go private or are bought out. In 2000, for example, there were 6,639 listed stocks; by the end of 2012, that number had dropped to 3,687. Despite the shrinking list of publicly traded companies, stocks continue to be popular among active traders because of their liquidity. The actual trading volume varies day to day; however, certain stocks including Bank of America (NYSE:BAC),Zynga (Nasdaq:ZNGA), Sirius XM Radio (Nasdaq:SIRI), Ford (NYSE:F), Standard Pacific(NYSE:SPF) and Intel (Nasdaq:INTC) tend to hang out at the top of the list.
Treasuries are negotiable U.S. government debt obligations backed by the full faith and credit of the United States. The four that trade with the most volume are the 10-Year Note, 30-Year Bond, 5-Year Note and 2-Year Note. There are also exchange traded funds available that provide exposure to government debt markets, including the iShares Barclays 20+ Year Treasury Bond (ARCA:TLT) and the ProShares Ultra Short 20+ Year Treasury (ARCA:TBT).
4. LIMITING RISK
It’s important to acknowledge that you can lose all of the money in your trading account and even wind up owing more. As a result, you must have the financial means to support yourself during the learning process and to adequately fund your trading account. It is extremely important that the money used for trading capital is money that you can afford to lose. This means you should not use the kids’ college funds, your emergency fund or the money you’ll need for your mortgage payments.
Although it may seem counterintuitive, trading is mostly about losing: learning from our losses, controlling our losses and accepting our losses as a part of trading. While it’s easy to assume that profitable traders win a really high percentage of their trades (for example, many shady websitespurport their trading systems win “close to 100% of the time”), the reality is that most winning systems win about 40% of the time. The key is to take more money on each winning trade than you give up on losing trades. This is what allows traders to make money over time.
You can evaluate a trade’s risk to reward ratio by comparing the expected returns of your trade (the profit target) with the amount of risk you undertake to capture these returns (your stop loss). The ratio is calculated by dividing the amount of risk by the expected reward. The following figure shows two scenarios: in the top chart, our trading system either wins $200 or loses $200 each trade. In this case, we have a 1:1 risk/reward ratio ($200 risk / $200 reward = 1). In the bottom chart, our system either wins $400 or loses $200 each trade. Here, we stand to gain twice as much as we stand to lose, so our risk/reward ratio is a more favorable 1:2.
What’s interesting to note is that our 1:1 strategy does not make money until we are 60% profitable; that is, until we win six out of the 10 trades. Using a 1:2 risk/reward ratio, however, we become profitable after winning only 40% of trades (four out of the 10 trades). This is a really important concept to understand in trading: a system isn’t necessarily profitable just because it wins 80% of the time. What matters is the relationship between the average winning trade and the average losing trade. A system that is profitable only 40% of the time can make money as long as its wins are greater than its losses. The bottom line is when you are developing a trading plan or system, don’t focus only on the percent profitable metric. This is only part of the picture.
One of the most valuable measures of risk involves the concept of probability. In trading, we can never be absolutely sure which direction the market will move, so we have to rely on probability to help us understand the odds of making a correct decision. Probability can be expressed either as a decimal from 0.00 to 1.00, or as a percentage from 0 to 100%. A probability of 1.00 or 100% means something will always occur, while a probability of 0.00 means it will never happen. Keep in mind that when we analyze risk, we begin by looking at the probability of losing and not just the probability of winning.
Before making a trade, we should know exactly how much we are willing to risk. Understanding riskallows us to make decisions that will help us develop safer and more profitable trading plans. By testing a trading plan on historical data we can view performance reports that tell us the expectancy of the system. The average trade net profit metric represents the expectancy of the system, or the average amount of money that was won or lost on each trade during the specified period. It is calculated by dividing the total net profit by the total number of trades. This metric shows the average profit the trader can expect on each trade to make over time.
Limiting Trading Risk
Managing risk is at the root of trading, and how you go about it can make or break you as a trader. To limit risk, you can:
- Use the right equipment – a fast computer, a fast and reliable internet connection, advanced analysis and trading platforms, etc.
- Use a protective stop loss – limiting your loss on each trade is an excellent way to preserve your trading capital. That said, it has to be balanced with giving the trade room to move. If you set your stop loss too tight, you’ll have a hard time making a profit (conversely, if your stops are too loose, you’ll also have a tough time making a profit). The only way to figure out the “best” stop levels for your trading plan is through testing and optimization.
- Stick to your plan – your plan has a mathematical expectancy: how much you can expect to make on each trade. If you skip trades, jump out early or stay in too long, you remove any expectancy from the system. Keep in mind, your methodology needs to be consistent in order to have any type of expectancy.
- Use margin and leverage prudently – take into consideration your potential losses instead of focusing on your potential gains.
- Use appropriate position sizing – sure, trading in big lots gives us the chance to make much more money, but we can lose a lot more money that way too. If you have a new trading plan in the market, give it time to prove itself – under a variety of conditions – before increasing your position size.
- Treat trading like a business – have a strategic plan for both the business and your actual trading. Your trading plan needs to specify what you will trade and how you will trade it. It should be thoroughly researched, tested on historical data, tested in a live market and evaluated at regular intervals.
- Remember that getting good at trading takes time – You wouldn’t expect to pick up a football and be signed with an NFL team the next day. It’s the same with trading. Even though you don’t need an advanced degree, you still have to put in your time.