1. Know What Are You Going To Trade
Knowing what to trade will help you clarify what you don't want to trade.
The first step of becoming a trader is to know what securities to trade. The smaller group of securities to trade, the better specialized knowledge you are going to accumulate.
- What market or exchange?
- Types of Securities?
- Sectors?
- What size stocks?
Types of Security
Common shares, ETFs, REITs, preference shares, convertibles, hybrids, notes, debentures, corporate bonds, municipal bonds, government bonds, options, warrants, or futures. And, when it comes to futures, there are index futures; currencies; energy; grains and oil-seeds; bonds and interest rates; metals; meats; and softs.
Sectors
Specialize in certain sectors at one time I only traded IT and Communications Industries.
Size
Large caps, mid-caps, small-caps, penny stocks or some other criteria based on size or liquidity.
2. Know What Directions To Trade
Know whether you are going to trade long and short, or long only.
3. Know When To Trade
The character of the market changes when bears are in control. Anxiety levels are a lot higher and panic spreads faster than overconfidence. Declines are a lot steeper in a bear market than advances in a bull market; rallies in a bear market are more tentative than corrections in a bull market; and, because the falls are steeper, bear markets tend to have a shorter duration.
Trade when the time is right. When it is not right, trade another system or take some time off and go fishing.
4. Know How Much Capital To Trade
Only trade with money you can afford to lose. If you have money set aside for an upcoming operation, or your kid's college fees, don't trade with it. The market makes a living out of punishing those with a nonchalant view towards risk.
Leverage
Beware of leverage. Leverage is great when you have predictable returns. It can also deliver substantial tax advantages, given the right structure.
Example 1:
50% Leverage
If you invest in the stock market, with historic returns of 12.5% a year and volatility (measured as standard deviation of returns) of 25%, your Risk-Reward ratio is calculated as
12.5/25 = 0.50
I find Risk-Reward a useful tool as it weighs expected return against your expected risk.
Now if we borrow an equal amount to our capital, at an interest rate of 8.0%, our returns will be enhanced. The expected return on equity is now
(12.5%*2) - 8.0% = 17.0%
Expected volatility, however, also doubles, to 50%. And the new Risk-Reward ratio is
17.0/50 = 0.34
So our enhanced return is not sufficient to compensate for the increased risk.
Now, imagine if you are offered a CFD (contract for difference) with 90% leverage.
Example 2:
CFD with 90% Leverage
Investing in the same market, with historic returns of 12.5% a year and volatility (measured as standard deviation of returns) of 25%, and assuming a lower interest rate of say 6.0%:
We are now investing ten times our capital, giving an expected return on equity of
(12.5%*10) - (9*6.0%) = 71.0%
Expected volatility also increases 10 times, however, to 250%. The new Risk-Reward ratio is
71/250 = 0.28
The lower interest rate softens the blow, but again enhanced return is not sufficient to compensate for the increased risk. And volatility of 250% is the stuff of nightmares, with constant margin calls as your equity is wiped out by the magnified swings.
5. Know Your Cost
Brokerage and slippage are two important costs that you need to factor into your calculations. And the shorter the time frame that you trade, the higher your turnover, and the more important those two numbers become.
Slippage is as important as brokerage and occurs when a trade executes at a price other than the expected price. Stop losses may be executed at a worse rate than the trigger level because price is falling fast and liquidity is low, a common experience when market volatility is high.
Another instance is when markets gap up/down overnight. If you take signals on the close, you will frequently find that price moves overnight, so your execution in the morning is better or, more often, worse than the close of the night before.
Slippage also occurs when market orders are executed at worse than the expected price — when the spread alters. In a long trade, the Ask may increase. In a short trade, the Bid may fall. The larger the order, the more likely this is to occur when there is insufficient stock available at the Bid or Ask.
6. Know What Time Frame To Trade
Time frame is closely related to risk and cost. The longer your time frame, the lower your brokerage and slippage costs as a percentage of your capital. And the longer your time frame, the closer your actual return is likely to conform to your expected return, based on historic performance.
7. Know How Much To Trade
Trade all your capital on a single position and one wrong call will wipe you out. Trade a small percentage of your capital on any individual position and you are far more likely to survive any false steps.
8. Know How To Trade
Your choice of trading style is related to the time frame you trade.
Long-term
Positions are held for several months or longer.....often years.
- Value investing
- Trend-following
- Momentum
- Mean reversion
- Medium-term
Positions are held for several weeks...... sometimes months.
- Momentum
- Swing trading
- Mean reversion
- Short-term
Positions are held for several days...... sometimes weeks.
- Swing trading
- Mean reversion
- Pairs trading
- Day trading
Positions are closed by the end of the day.
- Scalping
- Fading
- Pivot trading
- Pairs trading
- High frequency trading (HFT)
Positions are held for milliseconds...... sometimes seconds, seldom minutes.
- Scalping
- Pairs trading
- Arbitrage
9. Know When To Quit
Probably the most important step besides position-sizing (step #7). Knowing when to take profits and cut losses is crucial to profitability — more so than entering at the right time — for most systems.
Source/Reference:
Incredible Charts - Trading
