Education

Investing and Trading

People refer to investing as the long term financial commitment in order to gain returns. Investing is based on longer term views of a company and how the company and the sector will develop over time. Investors look at fundamental aspects of the company, analyze the sector, the management etc. The typical investor looks at various key metrics of the company helping determine the health of the company. One of the greatest investors ever is Warren Buffett.

Trading on the other hand is much more short term than investing. There is no strict time frame between investing and trading. Trading can be long or short positions in equities, currencies, commodities etc that the trader holds for only a few seconds up to several days or weeks. Traders are primarily driven by price and volume of the stock itself, while investors base their views on the underlying company and the underlying sector.

Day trading is the art of trading the markets predominantly during the day, where most of the positions the day trader holds are liquidated during the day and no overnight positions are held. Day traders usually rely on intraday charts, read the tape, trade the flow, follow news and rumours, all in order to trade profitably.

Day traders often use margin to trade, ie they leverage their accounts and trade with more capital than they have in their accounts. Leverage depends on the broker house used. Different brokers offer different leverage.

One concept in very short term day trading is called scalping, which is trading in and out of an asset many times during the day and making small incremental profits. The slightly more long term day trader mostly trades momentum setups, which is basically trading the asset when it breaks out of formations, many times driven by news hitting the market. Momentum trading is often done with relatively large leverage. Since the positions are held for short time periods, leverage is used to try maximising the moves.

Swing trading is usually referred to trading conducted over a few days up to a few weeks. Traders rely on charts but also have other input such as new information, post earnings input or specific sentiment regarding a stock/asset they believe will change near term prices. In swing trading positions are held overnight. The typical swing trader uses a combination of chart analysis (day and week charts), newsflow, short term fundamentals and other sentiment related aspects that can affect a stock price movement for several days or even weeks.

Often a day trader might start an intraday position where he/she closes out most of the position but keeps a portion of it over a few days. This type of trading is a hybrid between a day trader and a swing trader.

The most extreme form of short term trading is called high frequency trading, HFT. This is trading conducted with complex algorithms where the power of computers is used to make very quick trades. There are various strategies in HFT trading. HFT trading requires high investments in computer power, close location (co location) to the exchange etc.

There has been a lot of controversy regarding HFT trading firms. The HFT community claim they are liquidity providers since they are so active in the marketplace, but any active trader would probably claim the inverse. HFT are extremely active, but don’t forget, they are in the game to make money and will often disappear as liquidity providers when markets get volatile. Traders know that bid/ask prices tend to disappear when markets get volatile.

Often short term traders experience frustration with the HFT as they often post bid/offers that practically no one can trade on. Try not to get carried away and sucked into the dynamics created by the HFT companies. It is far better to adapt and try using the moves caused by HFT in your trading, than getting run over by their algos.

To sum it up; investing relies on fundamental research in order to reach a conclusion whether a company is under or overpriced, while trading relies on reading charts, processing new information quickly, reading the flow in the market. Trading is much more dependent on trading software and what online broker one is using. Leverage, commissions, risk management etc are all factors important to decide upon prior to starting your trading career.


Leverage and risk

Leverage works both ways of course. Small moves with leveraged positions can produce big gains, as well as big losses. Generally speaking day traders use margin and gear their exposure while holding them for relatively short periods of time. Volatility, momentum and liquidity are important inputs for day traders. Make sure to adjust positions to how volatile the stocks is, and always try to adjust positions for liquidity. The day trader should not get stuck in positions because they can’t close out trades efficiently due to poor liquidity.

Liquidity and volatility creates momentum in the market, offering the short term trader opportunities to trade.

Risk reward should always be used in all forms of trading as well as investing, but I would argue it is even more important to think about the risk reward ratio when you day trade. Many day traders tend to overtrade and their risk reward tends to diminish with frequency of trading.

Let’s assume a hypothetical trade where you think you can gain 300 usd and the downside is 100 usd . This is an ok risk reward scenario. If you enter trades with the possible gain of 100 usd and downside is 100 usd then your odds are as bad as going to the casino.

We speak more on risk management in our risk management section.

Traders usually focus on being right more often than wrong, but unfortunately they lack proper risk management tools to follow up on their trading. A trader can be right less than 50% and still make more money than a trader that is right 75% of the time (the 75% trader can even lose money with poor risk management).


Risk/reward thinking

Consider a trader with 50/50 hit/loss ratio where the gain is 200 usd and the loss is 100 usd. This trader makes (0.5*200)-(0.5*100)= 50 usd profit over time (profit will be a function of how many shares are traded).

What happens to the 75% win ratio trader with poor risk management, where the gain for example is 100 usd and the loss is 400 usd?

This trader will make a (0.75*100)-(0.25*400)= -25 usd loss over time.

Limiting your losses is the first step in all risk management.

Recall that even monkeys fall from the trees.

Most traders know about the stop loss but still manage to let the losses become huge. You can find in depth reading about stop losses as well as the next step in truly profitable trading, maximising your profits, in our risk management section.


Focus stock list

With literally tens of thousands of stocks available to trade globally the short term trader easily gets lost in the jungle of stock price moves. You should narrow down your focus area and try to find an approach that fits your preferences. Unless you run sophisticated algorithmic trading, you will not be able to track thousand, nor even a few hundred stocks. The trader needs to create a watchlist comprising for example of certain stocks in specific sectors, a specific geographical location, extra volatile stocks or other criterias. Incorporating liquidity is also a good idea.

The trader might be following a lot of stocks on a general level, but for the day trader there should be a daily focus watch list. Having 10-20 stocks on your focus list is sufficient for the short term trader, unless of you trade a more systematic approach, where the pre set rules dictate your trading and the subjective part of trading is absent.

One pitfall for many novice day traders is that they start following too many stocks and end up trading sloppy and unfocused. Respect the rules you have set up prior to trading. If your focus list is boring and not creating opportunities at a given time, don’t start deviating from your strategy and frantically search for new stocks to trade instantly.

Apply a structured approach to what stocks you decide trading.

Most trading systems have stock screeners allowing the trader to screen for stocks according to predetermined parameters. There are also several web based stock screeners that could be helpful. Some of the better ones are;

www.stockfetcher.com , www.finviz.com , www.chartmill.com , www.stockrover.com .

Below are two important concepts that are important to the short term trader; volume and liquidity.

Volume traded is the total amount of shares traded in a given time period. It can be volume during a day, during 30 minutes, during 5 minutes etc. Every transaction is counted for, hence buying and selling 1000 shares 5 times will result in 10 000 shares traded in total (1000 buy, 1000 sell is one round trip and produces 2000 shares traded per trade, so 5 of those transactions will produce 10 000 shares traded).

Volume is usually represented by a histogram in the lower part of a chart and is an important input for traders. You will see relatively high volume at market open and close. Many institutional orders are placed for the market open action, as well as many rebalancing orders etc are placed at the end of the trading day. You will also see increased volume around news and events, both on specific stocks, but also around general news such as the Fed decision on interest rates etc.

Generally speaking an increase in volume is telling us that something serious is taking place. A stock that breaks out of a range with an increase in volume tends to continue the move in the break out direction and is telling us that either some news is out/will be out, a fund manager is loading up/selling the stock or other interesting information. Large moves without an increase in volume tend to revert the initial move.

Getting involved in large trades with poor volume has been a painful experience for many traders. You can get easily shaken out of trades due to poor volume in stocks you are trading. Applying stop losses and managing your positions should not be affected by poor volume.

Volume and liquidity have a strong relationship. Liquidity is practically the amount of money one can buy or sell in a stock without moving the price significantly. The more money that can be traded at a certain price the better the liquidity of the stock. Liquidity usually diminishes with an increase in volatility. Be sure to watch the volume and carefully calculate how the liquidity can impact you trading. If your trades are impacted by poor liquidity in a given stock, your trading will incur big slippage costs.

Today’s markets are dominated by HFT algorithms trading multiple strategies of which many are based to profit from large orders that impact markets. A HFT strategy will typically front run and trigger the fund manager/investor/trader’s order currently being executed to look for paying higher or selling lower and thereby making the HFT profit from the trade.

Trading momentum setups is one of the most important strategies for short term traders. Momentum can be described as sudden price action due to news about the company, the general market, geopolitical news, institutional large orders to be executed rather quickly etc.

Momentum can be a break up or break down in the short term trend. Day traders usually get involved in this type of trading action, due to often an increase in liquidity, providing opportunities to trade leveraged positions and possibly profiting should the direction of the move be properly predicted.

The momentum trader often relies on short term intraday charts such as 5, 10 and 30 minutes charts. With the presence of HFT algorithms these days, the momentum moves tend to be faster than before and partly more frustrating to the manual trader as liquidity moves very fast as well.

Make sure to adapt your trading style to volume, liquidity and the presence of HFT.