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Basic Trading Concepts

Tutorial

If you decide to become a trader,

it’s difficult to just jump into a market and be one. Before you can

even move into the nuts and bolts of trading, there are some basic

concepts you need to understand – the idea of trading itself, your

perception of trading, your resources, the use of money, the role

you play in the trading process and a number of other items that

deal mainly with the trader and not the trading.

The trading issues – trading

instruments available, how markets work and other trading basics –

are covered in the next tutorial. You may think you can just breeze

through these first two tutorials, but they are the foundation of

your trading education. 

Knowing What You Don’t Know

That

headline may sound like a strange way to start a tutorial, but when

it comes to something as complex as trading, it is important to

acknowledge the preconceived notions you may have about trading and

to understand that you probably have much to learn about this

complex subject, especially if you intend to master what could be

the most difficult undertaking you will ever attempt.

First

and foremost, despite what you may have heard or read about trading

being an easy, get-rich-quick scheme, the truth is that there are no

trading secrets and no easy paths to quick success in trading

markets. Beware of anyone who tries to tell (or sell) you such. It’s

no coincidence that trading markets is similar to most other human

endeavors: Hard work and experience are required to achieve notable

success. By the same token, understanding the process of trading can

be achieved with perseverance and a willingness to continue to

learn.

Ironically, a major advantage of being an experienced trader is

knowing what you don’t know about markets and trading. There are

certain elements of trading that you may never know nor understand,

like knowing for sure what a market is going to do in the future.

Market analysis and trading is not a business of bold predictions

but one of exploring market probabilities based upon market

knowledge, price history, human behavior and trading experience.

Knowing that you don’t know exactly what a market will do actually

gives you a trading edge because it means you probably will exercise

more caution and think about and plan for what could happen if a

trade turns against you. Successful traders know that some trades

will turn against them and that they need to take steps to preserve

capital to trade another day.

Anyone who plans to trade for a while absolutely must respect the

markets. Most people do not like to be “wrong,” but only the market

is 100 percent right. Traders who think they “know” exactly what a

market will do are not showing the markets respect.

Why do you want to trade?

You may be comfortable accepting the fact that

you don’t know everything there is to know about trading yet, but

you definitely should have a good idea about several things when you

get into trading. The first is why you want to trade in the first

place. People have a number of motives for trading, all of which

have merit, but you should be clear what it is that is driving you

into trading. Your reasons for trading may go a long way in

determining your trading style.

Profits

Probably every trader’s goal is to make money.

But if that is your main reason for trading, are you willing to do

what it takes to achieve this goal? It will mean you have to provide

the seed money and other resources you need to be successful, and it

will involve a commitment to learning to gain trading experience.

If trading is going to be your business, you

obviously have to put making money high on your list of goals. That

requires consistent, strong discipline and the ability to control

your emotions as none of the experience or success you have gained

in other areas will guarantee that you will be a success in trading.

Your trading approach may even be boring, but if your real goal is

making money, you will have to have the discipline to stick with a

trading plan.

Being ‘right’

Are you a person whose greatest satisfaction

comes from being right about things? Traders generally love to

compete and be better than everyone else in whatever they do. Just

having the opportunity to crow a little about their prowess is their

biggest reward.

However, trading may be one of the worst places

to look to feed an ego. Whatever success you have had in other

aspects of your life may not transfer very well to the trading

arena, which has been known to humble even the strongest ego. Of

course, traders have to have a strong sense of ego to have enough

confidence to trade, but you’ll have to keep that ego in check

whenever you enter a market position if you want to survive as a

trader.

Excitement

Trading certainly can provide plenty of

excitement, both highs and lows, and that may be reason enough for

trading. But expect to pay an entertainment tax. Just being in a

market position can be exhilarating and can inspire you to keep up

with what’s happening in the market and in the world’s news events.

However, to be successful over a longer term – unless you have deep

pockets – you usually will have to forego the excitement and emotion

generated by trading, just as you have to keep a lid on your ego

trip. You naturally will experience some excitement whenever you are

trading, but it is a factor you must control. If excitement is an

objective of trading for you, perhaps the solution is to have one

account you trade conservatively and another account where you get a

little wilder.

What Are Your Resources?

In addition to your goals for trading, you also

should be well aware of the resources you bring to the trading

table. They will play a big part in the markets you can trade and in

the way you trade them. If you think you can be a big-time bond

trader with a $5,000 account or a day-trader while working a

full-time job, you’ll soon get a dose of reality when it comes to

trading.

Here are some resources you have to

consider as you ponder what and how to trade:

Money

There’s that word again, but the fact of the

matter is that you can’t trade without sufficient capital – your

trading stake that you need to guard carefully. You may be able to

begin trading without having enough time or knowledge, but you won’t

be able to begin trading without money. You have to have money to

make money.

Your trading account will have to meet minimum

requirements set forth by the trading industry. How much money you

need depends on what you intend to trade. If you are buying stocks,

you have to have at least half of the purchase amount in your

account. If you are trading futures, you usually have to have a

minimum of about 3 percent to 7 percent of the value of the contract

in your account.

Those are the regulatory requirements, and

there is no negotiating the amount. If you plan to trade the

full-size S&P 500 Index futures contract, for example, you have to

have about $20,000 in your account for each contract. If you are

trading the e-mini version of the S&P 500, the requirement is about

$4,000. The key point is that the amount of money required to trade

limits what you can trade and the number of contracts you can hold.

In addition to the minimum regulatory

requirements, you should also have a cushion above that to withstand

the fluctuations of the marketplace. That suggests you should always

have enough extra cash in your account to cover possible worst-case

scenarios. At any one time, you may not want to have more than 50

percent of your account tied up in active positions.

If you are not adequately capitalized and the

market makes even a slight adverse price move, you may either be

forced to put up more money to hold your position or you may be

forced out of the market. Having extra money in the account also

relieves the pressure of having to be right about your position from

the start, pressure that is not conducive to making wise trading

decisions.

You also do not want to have the pressure of

having the funds for trading come from money you need to pay the

rent or buy groceries or from funding the account with your credit

card. Your trading money should come from discretionary funds that

you can afford to lose without affecting your lifestyle.

Time

Everyone has 60 minutes in an hour and 24 hours

a day, but how much of your time can you devote to market analysis

and trading? If you have a full-time job, it will be difficult to be

a day-trader, no matter how well you think you might do with that

style of trading. 

The priority you place on the use of your time will play a big role

in selecting the type of trading resources you need and the style of

trading you can do. Time may be an important trading constraint for

you.

Trading Help

To perform the market analysis you need to make

a trading decision, you will need information and educational

resources. Typically, that includes expenditures for the following:

Electronic connection.

Today’s active

trader almost needs to have a connection to the internet, both to

have access to information resources quickly and easily and to enter

orders.

Data/price quotes.

Today’s active

traders also need real-time quotes as well as access to historical

market data for their analysis. Brokers may provide sufficient data,

but many traders want to subscribe to a source that will provide the

most accurate, reliable data possible.

Analytical software. Another requirement

for many active traders is software that can turn data into charts

and technical indicators deemed necessary to analyze markets. All

you need to do is specify the type of software you want, and some

vendor is likely to have it.

Advisory services.

In

general, it’s probably advisable to do your own research, but your

lack of time or knowledge may limit what you can do, causing you to

turn to other more expert sources for information, analysis and

perhaps trading recommendations.

Developing a Trading

Mentality

Much has been written about what type of

personality it takes to be a successful trader. What makes this

question particularly difficult is that there is no definitive

answer about the characteristics a trader should have to be

successful. If you assess your personal traits honestly and

realistically, you can probably develop a trading program that fits

your personality more easily than you can adapt your personality to

a particular trading program.

But what provides a common thread among many

successful traders is that they all have a trading mentality. That

doesn’t mean just shifting from the traditional buy-and-hold mindset

of the past to jumping into and out of positions readily, however.

That is part of it, but a trading mentality includes several other

factors related to attitude that may be somewhat different from what

you have heard and believed in the past.

Speculation

is okay.

You may have heard complaints about how

speculators are to blame for all kinds of price distortions and how

they manipulate prices, even when they are responding to perceptions

of supply and demand. None of today’s economic developments or

technological advances would have been possible without speculation.

No one would have started a company without speculation. Speculation

is simply a part of growth.

“Speculating” is not the same as “gambling.”

Speculating can turn into a crapshoot, but successful speculating

means two things: You always limit your risk, and you always try to

have favorable probabilities.

Gambling creates risk. A bet in a casino or at

a racetrack creates a risk to your money that did not exist before.

In trading (speculating), the risk already

exists. Someone is carrying that risk, and a trader/speculator is

willing to assume the risk that someone else wants to pass along

because they do not want it. Trading is all about transferring risk

from those who want to insulate themselves from adverse price moves

to those who are willing to take on the risk in exchange for the

possibility of profiting from a price move that would be favorable

to them.

Speculators play a vital role in this process

by always being available to take the other side of these trades and

providing liquidity to the marketplace to make prices flow

efficiently. Without speculators, prices for many stocks and

products would be much more erratic and uncertain and potentially

much more detrimental to the development of a sound economy. Trading

allows both producers/consumers and speculators and to achieve their

goals. As a trader, you are “speculating” on what will happen, not

“gambling.”

Losing is

okay.

Nobody likes a “loser,” especially if it means

money, but in trading you can be a winner by liking to take losses.

You expect all of your trades to work or you wouldn’t have taken

them. But because of the uncertainties of the marketplace, the

reality is that many successful traders have built outstanding track

records with only 40% or fewer winning trades.

One of the most important market adages is,

“Cut your losses short.” When the market tells you that you are

wrong, get out of your losing position quickly so the loss doesn’t

grow and wipe out your trading stake, the key to staying in the

trading game. If your analysis was wrong, the sooner you find out,

the better off you usually are.

The market

is not ‘against’ you.

You may not believe this when the market seems

to be gunning for your stops or reaching a certain price level just

to take your money. The market does try to confuse most participants

most of the time, but don’t take it personally if you are the victim

of an adverse price move. The market is not out to “get” you but is

just flowing along, and your position just happens to be carried

along with it. 

It’s okay to

sell what you don’t own.

Many newcomers to trading have a difficult time

comprehending this fact. That’s understandable if your experience

has been limited to buying stocks, but with trading instruments such

as futures or options, it is as easy to sell as it is to buy. In

fact, selling means no difference in the amount of money required or

in the trading procedure other than saying “Sell” instead of “Buy.”

So you can “Sell high, buy low,” even if you have never bought the

instrument in the first place.

It’s okay to

be a ‘bear.’

Generally, a market that is going up or is

“bullish” is perceived as “good,” and  a market that is going down

or is “bearish” is called “bad.” But, as the previous item about

going short suggests, being a bear and watching prices decline may

be a good thing for your account. In reality, you should always have

a two-sided view, neither bullish nor bearish but reacting to what

you see the market doing. When you see an opportunity arise, being a

bear or shorting the market works no differently than being long or

bullish.

It’s okay to

be emotional about trading.

Most

advice about trading suggests taking the emotion out of trading, and

it is true that you should not let emotions rule your trading

decisions. But if you want to be a successful trader, you have to

have a passion for trading – a passion that will push you to learn

about the markets and trading, force you to study price action to

become a well-versed expert in whatever method you choose and give

you the desire to stick with trading when things may not be going so

well. Passion drives people in many successful endeavors, and

trading is no exception.

As with many other

fields, traders have their own arcane terms and phrases to describe

various conditions. Trading newcomers may be frustrated by a lingo

they do not understand and which seems to make no sense at all.

A glossary of terms

on this site provides the meaning of many words used by traders, but

here are some of the more widely used trading terms and their

explanations so you won’t be confused when you see or hear them used

to describe some basic trading concepts.

“Dead-cat

bounce.”

Many times a market will experience a modest rally (a

bounce) from depressed price levels. But most of this price rise is

due to short-covering or weak long positions getting back into a

market that very likely will exert little or no upside power.

“The trend is

your friend.” This simple sentence is a very powerful one and is

important for most traders. If you trade with the market’s trend,

your odds for success are higher than if you trade against the

trend. Most successful traders employ some type of trend-following

trading strategy.

“Buy the rumor,

sell the fact.” This is a frequently occurring phenomenon

whereby a market makes a price move in anticipation of an expected

result of a fundamental event. Then, when the event does actually

occur and the result was as expected by traders, the market price

will move in the opposite direction. For example, if grain traders

expect a bullish report, the market will rally in the days before

the report’s release but then actually sell off once the actual

bullish figures are released.

“Bulls make

money, bears make money, but pigs get slaughtered.” In other

words, don’t be a greedy trader. Don’t try to take too much profit

out of a market too fast. The two biggest and potentially most

damaging human emotions in trading are “fear” and “greed.”

“Cut your losses

short.” This trading maxim is even more important than “The

trend is your friend.” Traders must limit their losses on their more

numerous losing trades by using strict money management and by

employing buy and sell stops.

“Markets

‘discount’ events.” This phrase is similar to the “buy the

rumor, sell the fact” phrase. Markets many times “factor in” or

discount events before they occur. For example, forecasters may

predict a U.S. Corn Belt drought. Although the growing season for

soybeans and corn does not end until early fall, corn and soybean

futures prices may top out in June. Traders factor in the damage to

crops well before most of the damage had actually occurred.

“Never meet a

margin call.” In other words, traders should never let a trade

become so much “under water” that a margin call from the broker is

initiated. “Cut your losses short.”

“Short-covering.” This phenomenon occurs when traders who have

established short positions decide to exit the market, either to

take profits or because their trading positions have moved too far

“under water.” Many times short-covering will occur after a market

has been in a sustained downtrend without much upside movement

recently.

“Long

liquidation.” Traders decide to “ring the cash register” and

take profits from long positions or weaker longs exit the market

when it appears to be showing weakness. Long liquidation usually

occurs when a market has been in a sustained uptrend and many bulls

decide to bail out, knowing the market is vulnerable to a downside

correction.

Consolidation,

 also known as

“sideways trading.”

Many times a market

that has undergone a sustained trend will “pause” to catch its

breath or move into a consolidation phase. This means price action

on the charts turns more sideways and choppy.

A price

“breakout.” This occurs when prices move solidly above or below

a “congestion area” (or a sideways trading area) on a price chart.

Many trend traders like to trade price breakouts.

“Basing” action.

This is extended sideways trading at recent historic lower price

levels. Prices are forming a “base” at lower levels, from which

prices will eventually make an upside “breakout.” Keep in mind that

markets can also see a downside price breakout at what was perceived

to be a basing area at lower levels.

A market

“correction.” When a market has made a sustained price trend, it

will make a shorter counter move in the opposite direction. After

this correction, odds favor the eventual resumption of the trending

move.

“Locals.”

These individuals

trade in the futures trading pits in open-outcry markets at the

exchanges. They trade for their own accounts and are a needed

function of pit trading because they provide the important market

liquidity for better trade execution (fills).

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