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Trading is the speculative purchase and sale of financial instruments (stocks, bonds, futures contracts, options, currencies, etc.) with the intention of profiting off a change in price. Trading strategies are speculative. Unlike an investor who buys financial instruments with the goal of selling them after an appreciation in price (usually over the course of a year), the trader can make money when the instrument goes up or down in value, and does so over a considerably shorter period of time than an investor.
For example, an investor may believe that IBM is a good company. The investor purchases ownership shares (stock) in IBM, expecting that over the course of time the company will be profitable and the stock will appreciate in value, as well as pay dividends. The investor may buy IBM at $10.00 a share, and hope to sell these shares ten years from now at a considerable premium, i.e. $100 a share. Once the investor purchases the shares, he or she usually will hold on to the investment (called "buy and hold") until either there is a need to cash out the investment, or there is reason to believe that the long term prospects of the company will be changing for the worse. Throughout the course of time, IBM stock may fall below what the investor paid for it, either due to general market forces or poor earnings reports. However, the investor is not interested in these relatively short movements, expecting that as time passes the investment will be realized at a profit. Most people who own mutual funds through retirement accounts are investors, their money is invested for the long term in a pooled fund of stocks.
A trader on the other hand will be searching for stocks that will be exhibiting significant movement, either up or down, in a relatively short period of time. The trader is not interested in what will happen to a given stock in 10 years or even in 1 year as is often the case, and they are rarely if ever interested in dividends. The trader wants to ride the change in price quickly, then sell the instrument and move on in search of other opportunities. For example, a trader may buy IBM at $10 per share, with the expectation that it will surge to $12 per share in the next week. After the stock "pops" up, the trader quickly sells and may wait for the stock to come down to $10 again. The trader then finds another opportunity when IBM stock will be moving, and will "enter" the stock once more. This time the stock may climb to $13.00 a share. The trader can also make money if the price of the stock were to decline by $3 instead of going up, assuming this was correctly anticipated before entering the position. This is known as "going short".
In the above scenario, the trader will have made a $2 profit per share on the first trade, and $3 on the second trade, or a total of $5 (minus commissions and taxes). The buy and hold investor, in the same interim, will have only made a $3 profit per share (minus commissions and taxes).
Buy and hold investing anticipates that through time, the price of a financial instrument will climb, which for the stock market has historically proven correct (average annual returns of the S&P 500 index traditionally approximate 10% pre-inflation and pre-tax, when held for periods greater than 10 years). Trading, when successfully executed, takes advantage of small price moves (up and down) and enables more effective compounding of money. Profits earned from successful trades can be reinvested and used to create even larger trading profits, while investors have committed their capital for a long period of time and cannot use it to create additional profits.
As a comparison, an investor in an S&P 500 index mutual fund may expect an average return of 10% a year over a long period of time, while a trader aims to beat this benchmark by a significant amount, by as much as 20% and greater. A small percentage of highly successful traders have managed to produce annual returns in excess of 100% on occasion.
The disadvantages of trading over investing are:
From a moral-religious point of view only investment oriented in the long term run is in compliance with religious rules.
Trading has been often likened to gambling since the trader, like the gambler, is speculating on an uncertain outcome with the intent of profiting. While this is true, a significant difference between trading and gambling lies in the concept of "edge". Most gambling games give a clear edge to the casino, without which the casino would not be able to sustain a business. A winner at a casino is usually not able to sustain their winning streak for long, the house will eventually win after a certain number of games simply because the odds favor the house. A trader, on the other hand, faces a relatively even playing field (a zero sum game). With proper strategy and money management, a trader can maintain an edge which will give him or her an opportunity to profit from the financial markets.
As traders aim to make money from their activities, trading can legitimately be classified as a business. There are several categories of professional traders:
Trading Retail
Retail trading is a particularly popular form of trading which many aspire to. One reason for its appeal is the potential for complete independence. Retail traders work for themselves and have no boss or customers to be responsible in front of. So long as the brokerage (the equivalent of a supplier in business parlance) is operating smoothly and the tax authorities are paid promptly, the trader has no need for any other human interaction and can work in total solitude. The retail trader can work from anywhere in the world where there is a reliable internet connection. With certain markets (i.e. the currencies market) it is even possible to have flexible working hours. Another point of attraction, possibly the greatest one, is the hope that a trader can compound their money through time and create wealth for themselves.
A disadvantage of retail trading is that the trader must rely entirely on their capital and skills for survival, since there is no institution to provide them with a base salary, a support team, and health insurance. Many retail traders in the United States find that they need at least a five figure account (US dollars) if they want to have the ability to live off their trading profits, some advise six. Traders who cannot do this are forced to trade part time, unless they have a secondary source of income (i.e. a pension or working spouse). Retail traders often do not have the same access that institutional traders have to certain market information (i.e. Bloomberg and Reuters terminals, which are too costly for most retail traders), as well as "street talk", though the latter is viewed negatively by a number of successful retail traders. One more issue the retail trader has to deal with is that it is often difficult to rely on a fixed amount of income from trading. As market conditions fluctuate, markets can offer many or few opportunities to profit. The trader's own personal confidence level is another variable that can affect trading results, much in the way a change in an athlete's physical or psychological condition can affect their performance.
Learning to Trade
It is generally estimated that from 80 to 90% of retail traders fail to become profitable, based on reports from brokerages and a few modest statistical studies. The reasons for this have never been accurately pinpointed in any statistical study, however most successful traders generally agree that it is usually due to a lack of a professional attitude, weak commitment, indiscipline (i.e. giving into gambling impulses), insufficient capitalization (starting on with an account that is too small in size for the specific instrument being traded) and unrealistic expectations that most retail traders fail to become profitable. It has often been argued that brokerages and purveyors of prepackaged trading systems frequently portray trading as an easy "get rich at home" activity which does not require much study, discipline, or work, which often attracts the wrong people to trading.
The common goal of professional traders is to be consistently profitable over a variety of market conditions. There is a tendency for some traders to aim towards becoming "big" traders (putting on very large positions and taking on a lot of risk in hopes of making large returns), but this can run counter to the goals of consistency, increasing the risk that a trader will deplete their account.
As an example, if a day trader is capable of averaging a 1% return on their account per trading day (a goal that is not easy but not impossible to reach), they could potentially achieve a 25% rate of return per month. If every month were so consistently profitable, and the trader increased their position size each month in accordance to their profits, their account could grow over 14 times in size in one year, before taxes. Traders who aim for very large returns, by contrast, can in some cases achieve even higher results over a much shorter period of time, but at cost to considerably greater risk. In most such cases, such high risk traders who manage to initially succeed often end up losing or "giving back" their huge gains just as quickly as they made them.
Many traders report that it takes anywhere from six months to over a year of full time trading in order to become profitable. Many would indicate that it takes an even longer period of time to learn to become consistently profitable in different market conditions. As an example, many day traders began trading during the Internet tech bubble of the 90's. When the bubble finally burst and tech stocks began to fall precipitously, many of these traders failed to remain profitable and were left out of business. A number of traders report that they have "blown up" (depleted) their accounts once or even several times prior to becoming profitable.
Traders are generally self taught, although traders who wish to work for an institution will often take a degree in finance or economics on the undergraduate and/or graduate level (i.e. an MBA). Most finance programs are not specifically geared towards trading and may feature only one or two classes that relate to trading. Those who trade for an institution often undergo a basic training program at the institution and may be required to pass a securities license exam (usually the Series 7 and Series 63, the Series 3 for futures contracts).
Retail traders traditionally study trading from books. There are commercial seminars and mentoring services that are marketed at new traders. Many traders find it challenging to discern the quality of a given trading teacher, as there is no professional accreditation system nor is there a way of independently verifying if the teacher is a consistently profitable trader. The industry aimed at servicing traders (selling education, news letters, and trading systems) is often viewed with considerable skepticism. The logic of this criticism stems from the fact that a successful trader will likely find that trading is a more profitable activity than selling trading goods and services. Consequently, many trading services are not reliable since they originate from traders who are either unprofitable or fell from profitability after having a "lucky streak".
Certain retail traders are fortunate enough to find a professional trader who is willing to mentor them, sometimes out of mere good will.
Most retail traders begin with "paper trading" (trading demo accounts), then switch to trading real cash once they feel confident that they can be profitable with some level of consistency.
Traders generally follow three different timelines:
While many traders chose to specialize in one time frame, many will learn to trade in several time frames. Traders tend to find a time frame that is best suited to their personality and consequently gives them the biggest edge in scoring profits.
Beginning traders tend to usually begin with the intermediate time frame (swing trading) and then move on to experiment with the other time frames. It is usually not recommended to begin by day trading, since day trading requires very fast decisions and calls for more astute analysis of price (which often features more randomness than the longer time frames). Position trading as a general rule requires greater capitalization, lower leverage, and the use of smaller share/contract sizes in order to accommodate the greater variations in market movement.
There are a number of financial instruments used in trading.
There are three basic skill groups necessary for trading. They are:
Prior to entering a trade, a trader must go through a decision making process which he or she has worked out in advance.
After answering these questions (which must sometimes be answered very quickly), the trader will place the trade. Thereon after, the trader is constantly asking him or herself:
Do I stay in as is, do I add more, do I take some money off the table, do I get out entirely?
A retail trader needs the following tools in order to be "in business" as a trader:
Prior to learning how to put together a trading strategy, a trader needs to grasp some of the basics of the financial markets in order to understand the dynamics of price movements, which are all based on supply and demand. This is called "fundamental analysis". While short term traders do not rely heavily on fundamental analysis, understanding the basics is helpful when parsing news and trying to understand why prices move in response to it. Afterwards, a trader proceeds to study "technical analysis", which is the study of actual price movements, in isolation from any external information (earnings reports and other news that is "fundamental data"). Technical analysis enables a trader to make some sense out of the squiggly price lines he or she sees on a price chart, and find areas where there is likely to be decisive price action. These are areas where the trader will be looking for "setups", opportunities to trade.
Stocks
The primary fundamental movers of stocks are:
Bonds
The primary movers of bonds (fixed income) are:
Futures
The movers here are varied depending on the specific instrument that is being traded.
Extraordinary events such as hurricanes or infestations can cause a shortage of supply in crops, terrorist attacks can cause a spike in oil prices, etc.
Options
The movers of options are the "underlying instruments", in other words an option on a stock will be affected by fundamentals that affect that stock.
Spot Currencies
The primary movers of currencies are:
Technical analysis is the study of price movement, or "price action". The technical analyst (sometimes called a "chartist") bases their premise that traders often remember significant price levels and usually respect these levels if there is no conflicting fundamental data. Based on this premise, technical analysis aims to predict more likely price movements by trying to locate a "trend" (the general direction in which prices seem to have been moving). The "trend" is based on the idea that when prices are set in motion (up or down), they tend to stay in motion unless disturbed by an outside force (fundamentals).
Prices tend to move in two different modes, "trending" and "ranging".
Trends are seen as a movement in a distinct direction, either overall up or overall down. Prices will often trend and then pause, briefly moving in the opposite direction (known as a "retracement" or "correction"), then resuming their original direction. The trend can take a more significant pause, sometimes moving up and down briefly or "consolidating", then continuing their direction. Finally, the trend can stage a "reversal", at which point it will move opposite of its original direction.
Ranges occur when prices move up and down within a confined price zone, staying within those confines over a large period of time. It is interesting to note that a market that is ranging does in fact have trends within the range: price will trend up towards the ceiling of the range, known as "resistance", then establish a declining trend towards the floor of the range, known as "support". Eventually, the price may "break out" of the range, and begin to establish a new overall trend, either upward or downward.
One of the main aims of technical analysis is revealing whether the prices are in a range or in a trend, in order to determine the best possible trading strategy.
There are a number of trading strategies in use. They can be generally grouped into the following categories:
Profitable traders adhere to a specific plan before entering each trade. The lack of a plan or violating a plan is what causes many traders to lose, consequently self discipline is a vital instrument to success ("plan your trade, trade your plan"). Some traders work out a rigid set of rules for entering and exiting trades, these are known assystem traders. Many will even program this system into their trading software in order to entirely automate the process. Traders who prefer more personal leeway in decision making are known asdiscretionary traders. They too follow a specific plan, but allow greater human intervention in making decisions while adhering rigidly to their risk parameters.
Traders resort to a number of different money management systems, which dictate how much money they may risk on a given trade. Some traders believe that even a mediocre trading strategy can be very profitable if proper money management is exercised, while a high probability trading system can be devastating without proper money management.
A common rule of thumb that is popular with many traders is to risk no more than 2% of their account equity on any given trade.
In addition, several money management methodologies exist, such as:
A few traders resort to the "Martingale" strategy, otherwise known as "doubling down" (increasing one's position twofold with each loss). This strategy has been heavily criticized as being ineffective as it tremendously increases the risk of a margin call (forced liquidation of trading positions) with each progressive loss, and can lead to very rapid losses in account equity.
This is often cited as the most difficult aspect of trading, and a reason why most traders fail to be profitable. The two emotional extremes that traders frequently cite arefear andgreed. Balancing these two emotions is critical for successfully executing a trading plan.
General psychological guidelines that traders adhere to are:
Professional traders treat their trading as a business. They keep regular records of their trades and will analyze them to learn and self reflect. Traders must also keep records for tax purposes, some will retain the services of an accountant to help them reduce their tax liabilities (the US taxation authority features a professional designation for traders).
Retail traders will usually be working from their home, although those who trade with a prop firm will be trading from an office (unless it is a "remote" prop firm). Successful full-time traders may earn very large sums of money, yet a significant number adhere to a fairly frugal lifestyle. A main reason for this is that many traders find it advantageous to apply a portion of their profits towards compounding, enabling their account and subsequent profits to grow significantly.
Some traders choose to manage other people's money, and may work for or start their own hedge fund or investment management firm. This permits the trader to earn an income as a percent of trading profits and total assets under management. Such traders usually trade their own money together with those of their clients, sharing in the risk and consequently demonstrating to their clients faith in their own abilities (referred to as having "skin in the game"). Others aim to trade their own money up to a sum that is sufficient for retirement (financial freedom), or to use trading as a supplement to other income.
Initially, trading was popular with people from high paying professions, i.e. people from the financial, medical, business, and legal fields, since commissions and contract sizes were only suitable to well capitalized traders. With the advent of computer technology, significantly reduced brokerage fees, and smaller sized trading contracts, trading has become accessible to a much larger pool of participants. Today's traders come from various social and professional backgrounds, operating from all different parts of the world.
Adding to a Loser - the process of adding to a position when it is moving in a non-profitable direction. This is also known as "averaging down", since adding to a position at a lower (or in the case of shorting, higher) price will allow for a potentially greater profit if the trade turns in a profitable direction, providing a better "average entry" cost. Averaging down, when part of a specific strategy, is considered an effective method. However, traders who average down without planning are often attempting to psychologically justify a losing position, which can greatly magnify their losses.
Arcade - a trading arcade is an establishment that features multiple monitor computer setups, fast, dedicated internet connections, and office space, usually targeted at day traders. Arcades have grown less common after the proliferation of broadband internet, faster computers, and less expensive hardware.
Blow Up - driving your account equity down to the point where you cannot place any more trades. See "out of business".
Bucket Shop - a brokerage that resorts to unethical practices, trading against its customers and manipulating price feeds.
Catching a Falling Knife - trying to buy when prices are rapidly falling. This is also referred to as "bottom fishing". See "fading".
Choppy Market - when the prices in a market move in an extremely unpredictable and volatile manner.
Fading - buying when prices are falling, and selling short when prices are rising, with the anticipation that the trend is about to reverse.
FX - an abbreviation for the foreign exchange spot currency market (forex).
Financial Freedom Figure - a sum of money that is sufficient for a trader's retirement, enabling a trader to no longer work and live off of passive income.
Gunning for Stops - a practice by market makers and dealers (most common in the spot currency market) to intentionally bid down or up prices in order to trigger stop orders. The stop orders are triggered with the intent of acquiring the orders at a lower or higher than market price and then trading them at the current market price at a profit to the market maker/dealer.
Meat of the Move - capturing a move in price after the move has already begun, and exiting while the price is still moving in the trader's favor. This is the opposite of "top/bottom fishing" and "fading".
Other People's Money (abbreviated as OPM) - trading the money of clients, as an investment/hedge fund manager. Such traders tend to earn a fee from their services (see Two and Twenty).
Out of Business - a trader who has blown up their account and has no more trading capital.
Scared Money - money used for a trading stake that would significantly worsen a trader's financial condition if it were lost. Scared money is usually a significant portion of one's savings that exceeds what would be normally allocated for speculative activities. It also can be borrowed money that needs to be returned (i.e. a home equity loan, personal loan, family money). It is usually suggested that traders do not trade with 'scared money' as the psychological effect will negatively impact their performance.
Stake - your trading capital. To "stake" someone means to give someone capital to trade with, usually in exchange for a share of the profits.
Test / Re-test - a certain price level which serves as a decision point for price action. The price will test this level by either breaking through it or bouncing back from it.
Two and Twenty - a standard compensation formula used by many hedge funds. 2% of total assets under management are paid annually to the fund manager, along with 20% of the returns. For instance, a $10,000,000 fund will pay the manager 2% of total assets ($200,000). If the fund has a return of 30% ($3,000,000) the manager would also get 20% of that return ($600,000).
The table below illustrates the possible profits from trading, with the assumption of consistent performance. This particular table is most suitable to day traders. The first column shows the monthly rate of return, the second shows the annual equivalent, the third shows the daily average over the course of 20 trading days (the assumption is that some days the trader may not trade due to unfavorable market conditions, sickness, vacation, or because the trader is devoting time to market research, software/computer maintenance, backtesting, or demo trading).
The figures in the following columns show the possible return from a given account size, in monthly and annual terms, as well as an annual return with "monthly compounding" (abbreviated asmonth cmp.). The annual "monthly compounding" figure is the annual return possible if the trader does not remove profits from the trading account, but at the end of each monthly cycle re-invests it into the account.
For example, the trader who is able to produce a monthly return of 0.5% and has an account of $1,000 can earn a profit of $5 a month (a performance that is just above the historical average yield of US treasuries and below the historical return of the S&P 500 index). If the trader removes that profit from the account, the trader will earn an annual profit of $60 before taxes. However, if at the end of each month the trader reinvests all profits (increasing their position sizes accordingly) and does not withdraw any money, the trader will have a profit of $62 in 12 months due to the effect of compounding. This assumes the trader is consistently able to produce a 0.5% return each month.
As the table illustrates, the monthly compounder does not win when their performance is as poor as 0.5% monthly, but the numbers considerably change when the performance increases. A 10% monthly performer (120% annual returns, uncompounded), will be able to multiply his or her account to 3 times its original size. A 20% monthly performer (1% 20 day average, which at a highly consistent rate is rare in the daytrading business) can multiply their account by a factor of almost 9 in one year.
| Monthly Return | Annual Equivalent | Daily avg 20 days | $1000 account | $5000 acct | $10,000 acct | $25,000 acct | $50,000 acct |
|---|---|---|---|---|---|---|---|
| 0.5% | 6% | 0.025% | $5/month, $60/yr, | $25/month, $300/yr, | $50/month, $600/yr, | $125/month, $1500/yr, | $250/month, $3000/yr, |
| 1% | 12% | 0.05% | $10/month, $120/yr, | $50/month, $600/yr, | $100/month, $1200/yr, | $250/month, $3000/yr, | $500/month, $6000/yr, |
| 2.5% | 30% | 0.125% | $25/month $300/yr | $125/month $1500/yr | $250/month $3000/yr | $625/month $7500/yr | $1250/month $15,000/yr |
| 5% | 60% | 0.25% | $50/month $600/yr | $250/month $3000/yr | $500/month $6000/yr | $1,250/month $15,000/yr | $2,500/month $30,000/yr |
| 10% | 120% | 0.5% | $100/month $1200/yr | $500/month $6000/yr | $1000/month $12,000/yr | $2500/month $30,000/yr | $5000/month $60,000/yr |
| 20% | 240% | 1% | $200/month $2400/yr | $1000/month $12,000/yr | $2000/month $24,000/yr | $5,000/month $60,000/yr | $10,000/month $120,000/yr |