Short-Term Trading-UNDERSTANDING THE GAME

Short-Term Trading

UNDERSTANDING THE GAME

There are various ways of getting engaged in short-term trading and it’s best to not only understand how it is done but also realize that there are several pitfalls that must be avoided. Here a quick guide to the art of short-term trading and the use of technical analysis

We are referring to short-term trading, a space that has a lot of opportunities to increase wealth but as much to destroy as well. We will refer to short-term investors as ‘traders’. The psychology of retail traders is known as “fear and greed” psychology i.e. when the market runs up quickly, the unprepared trader falls in a trap of greed, and in fear of missing out on the next big move chases the market. After the dust settles, the trader finds himself holding a long position at the high of a market poised to fall. This psychology of market participants leads to capital destruction and they end up blaming the market as “Satta bazaar”.

SHORT-TERM TRADING

Short-term trading means holding an asset for a short period of time. From an investing perspective, it is a security that matures in one year or less. Short-term trading involves the opening and closing of positions in as little as five minutes, at the most 12 months. In many cases, technical analysis is an ace tool used in short-term trading by the trader. It takes a considerable time to analyze fundamental studies and as such fundamental tools have little value in evaluating short-term events. Technical analysis, however, is the ultimate for trading in volatile and changeable market conditions. Short-term trading helps a trader to define his risk and reward and it also helps a trader to encash on short-term trading opportunities with limited exposure of capital. However, the above sentence would be hard to digest for some of the traders as statistics say that most of the traders end up on the losing side. However, if proper discipline is exercised and the art of choosing the right stocks is followed, this could be a fruitful journey.

MANAGING CAPITAL EFFICIENTLY AND EFFECTIVELY

Money management has many names such as asset allocation, position-sizing, bet size, portfolio allocation, or capital management. Money management or capital management strategy is one of the most vital variables that will give a retail trader the edge in short-term trading. A retail trader cannot control the volatility or price fluctuation of the market but he can control his money and risk on each and every trade that he executes. Follow proper money management i.e. if one loses X percent in the trade he moves out and this X is determined by the risk appetite of the trader.

William O’Neill, the founder of Investor’s Business Daily, has said that “the whole secret to winning in the stock market is to lose the least amount possible when you are not right.” Money management is a defensive concept. It keeps you in the game to play or trade another day. For example, money management tells you whether you have enough new money to trade additional positions.

IMPORTANCE OF MONEY MANAGEMENT

Determining your bet size in trading is crucial in short-term trading. If a trader is not aware of how much to buy or sell at all times than he is in trouble. If you start with Rs 1,00,000, is your first trade 10 percent of that or 5 percent? What is the number? A trader should be aware of the bet size. Below is an illustration that helps you to understand why position sizing or money management is important in trading.

There are two traders named Trader A and Trader B. Both these traders trade in Nifty future and have a starting capital of Rs 1,00,000 for trading. They trade in Nifty contracts daily and each contract size of 50. Both the traders follow similar analysis and enter the Nifty contract at a similar price and exit similarly as well. However, the only difference is that Trader A has kept his position sizing constant with two contracts daily and on the other hand Trader B picks up a random number of contracts. Let us see which trader enjoys the fruits of profit.

In the above example, Trader A has kept his position sizing to two contracts and he maintains this position sizing consistently. At the end of five trading days, he manages to earn Rs 2,000 through a systematic position sizing approach. 

In the above example, Trader B picks up a random number of contracts as he has not planned his position sizing. At the end, he suffers a loss of Rs 6,000. Both the traders follow a similar trading pattern but the only difference is in position sizing. So it gives us a clear idea that along with analysis, position sizing (money management) plays an important role in successful trading

Here are some of the issues addressed by money management or position sizing:

• How much capital do you place on each trade?

• What is the frequency of your trading?

• When must you take a loss to avoid larger draw-down?

• If you are on a losing streak do you continue to trade in a similar manner?

• How is your trading adjusted with accumulated new profits?

• How must you prepare if trading both long and short positions?

• How is volatility handled?

• How do you prepare yourself psychologically?

TRADING PSYCHOLOGY AND DISCIPLINE

Psychology is the study of human behavior and thinking. It is important because it helps you to understand yourself better. It also helps you to understand other people. If you understand psychology, you can change your own behavior and help other people to change theirs. You can also predict how other people are going to react to things. There are a number of characteristics and skill-sets required by a trader in order for him to be successful and consistent in the game of trading. These characteristics include the ability to determine the direction of the trend; identifying proper chart patterns; and selecting the right stock. However, not one of these is as important as the ability to contain emotions and maintain discipline. Most of the successful traders believe that trading is 75 percent psychological and 25 percent analysis. However, measuring the percentile is a bit

difficult but it’s true that trading is more of psychological work. The psychological part of trading is particularly important and the rationale for that is fairly straightforward since a trader is often darting in and out of stocks on short notice, and in this process, a trader is forced to make rapid decisions. To accomplish this, a trader needs a certain level of presence of mind. Traders also need discipline so that they bond with previously established trading plans and know when to book profit and when to get out of a trade. When traders lose money, they often attribute it to the day not being one of their lucky ones. Such a lack of consistency, however, is actually the result of a lack of discipline or some psychological error. Traders lose discipline with trading for the same reasons that dieters lose discipline with dieting or people getting in shape lose discipline with exercise. Quite simply, our mood, needs, and mind tend to avoid short-term discomfort at the expense of our final goal.

Here are some common reasons why traders lose money in a stock market:

Not having a clearly defined trading plan or strategy in the first place:

In the ‘Mahabharata’ Abhimanyu knew how to enter the ‘chakravyuh’ but didn’t know the way out, thereby losing his life. The same goes for traders. Most of the traders are aware of entry points but very few follow a proper exit strategy when they suffer a loss. It was this situation in 2008 when many traders entered into the trending mid-cap stocks at a higher rate in anticipation of making quick money but were forced to maintain a lifelong relationship with some stocks because of the lack of a proper exit plan.

Environmental distractions and boredom cause lack of focus:

All of us have limits to our attention span and when the market is quiet we shift our focus from the market to some other stuff like news channels or mobile games, etc. This leads to lack of focus and can cause serious problems for a trader.

Unwillingness to accept losses:

This leads traders to amend their trade plans after trades have gone into the red, turning what we're meant to be short-term trades into longer-term trades and transforming trades with small size into large trades by adding losers. As a market analyst puts it, “When trades go against the traders most of them get adamant and hold on to their positions in the anticipation that sooner or later this would move in a favorable direction. One should move out of positive trade when the stock is reaching its resistance or desired percentage returns have been obtained or by revising stop loss to higher levels.”

Overconfidence follows a series of successes:

It is common for a trader to attribute success to skills and failure to situations. As a result, a series of even random or unintentional wins can lead traders to become overconfident and bend from trading plans.

Inconsistency:

Most traders disobey trading signals as they don’t trade on every signal generated by the trading system. You can’t tell ahead of time which trade will be a winner and which won’t. Thus, as a trader, you need to obey every trading signal that a system gives you.

Situational performance pressures:

This includes financial pressure and stress outside of trading. Sometimes trading does not go according to the plan or you get a period of draw-down that might be extended in time or deep in cost. Likewise, sometimes life outside of trading presents challenges that can have an impact on you. When such incidences take place, your mindset can often be affected and as a result, your behavior can become less disciplined. A typical example is where traders have financial difficulties either in their trading or personal life and thus start to get into a mode of desperation. Their sole goal then is to make money in a quick time and this moves them away from the discipline of sticking to their plan.

Taking on too much risk:

High risk creates higher stress and higher stress creates stronger anxiety and worry so that all this weighs down badly on a trader’s decision-making ability. This leads to huge painful losses that no one wants to take.

A simple piece of advice to most of the traders who are struggling with their trading would be to trade tested systems or patterns and trade them systematically. If you look at highly successful business organizations such as McDonald’s, Dell, or Wal-Mart, you will find them doing the same thing the same way every day with a high degree of consistency and discipline. They have come up with a winning formula, which is half the battle won, but they execute that formula with a high degree of faithfulness, and regularly. That is how a trader should go on in trading as well.

IDENTIFYING THE TREND

In short-term trading, it’s important to identify the trend. There is a famous saying on the street – “trend is a friend”. It means a trader needs to make trend his close accomplice and with this, he can maximize wealth. A million-dollar question that arises here is: How do you spot a trend? It’s difficult, as the market never moves in a straight line.

Following are some of the methods followed by professional technical analysts and traders to identify trends:

Moving averages:

A moving average is the average price of a stock over a specific period of time. The most common time frames are 15, 20, 30, 50, 100 and 200 days. The overall idea is to see whether a stock is trending upward or downward. A good long candidate stock will have an increasing moving average that is moving upward. If you are looking for a good short candidate you need to find a stock with flattening out or declining moving average. One of the widely used tools is the 200-day moving average. You need to simply plot the 200-day moving average on the price chart. When the price of the stock moves above the 200-day moving average line indicates an uptrend and when the stock price falls below its 200-day moving average line it’s in a downtrend. One can also look at the 50-day moving average or 20-day moving average for short-term trades.

Below is a chart of JP Associates wherein we have plotted a 50-day simple moving average. One can see in the chart that as soon as the stock price sustains below the 50-day simple moving average, the stock enters into a deep correction from levels of 70-odd levels to 32-odd levels and this gives us a clear idea about the trend of the stock. Price Cutting 50 DSMA On Closing Basis

Moving average convergence divergence (MACD):

This is a very important tool used by short-term traders. You just have to select the MACD and plot it on a chart. The MACD comprises two lines, fast and slow. The last line is the difference between the 26-day exponential moving average and the 12-day exponential moving average. The slow line, also called the signal line, is the nine-day moving average. When the fast line crosses above the slow line, it’s a buy signal, and when the slow line crosses the last line it’s a sell signal.

Trend lines:

Trend lines are the simplest form of technical analysis; it’s one of the essential tools used by all the technical analysts for their studies. A trend line is a line drawn between at least two points on a stock chart where the price has previously found support or resistance. The more the point touches a trend line, the higher is the importance of that trend line.

Below is an example of how to use a trend line to define the trend. We have plotted a simple rising trend line on the stock of ITC. The trend line support was best to buy this stock and the stock kept moving higher as the stock never breached its upward trend line support.

Ichimoku:

Ichimoku is a technical or chart indicator that is also a trend trading system in and of itself. The creator of the indicator, Goichi Hosada, introduced Ichimoku as

a “one glance” indicator so that in a few seconds you are able to determine whether the trend is up, down, or sideways. In Ichimoku the cloud helps us to find the trend. The trend is upward when the price is above the cloud. The trend is downward when the price is below the cloud and the

the trend is sideways or flat when the price is in the cloud.

Below is the chart of Lupin wherein it is evident that once the stock has moved above the cloud at around the level of Rs 978-981 it is trended one way up to the

level of Rs 1,400. Such trending stocks can be identified with the help of Ichimoku. There are a number of studies and tools available in technical analysis that help to identify a trend, but we have handpicked some of the best studies and tools which will help you to identify the trend.

BEST SHORT-TERM TRADING SET-UPS

Box Trade:

For short-term trading this is one of the most valuable set-ups. We have seen technical analysts place undue emphasis on some complex trading set-ups, which of course sounds good, but such highly complex patterns create confusion and too many questions in novice traders’ minds. However, if we practice simple things with conviction and proper money management it will give optimum results in trading. This trading set-up is helpful for new traders or traders who have been trading over many years.

To fully understand the methodology behind the set-up, we need to first understand how the markets work and what I am sharing with you is true for all the markets. Markets trend and they consolidate; they expand and contract. It’s typical nature of all the markets, and it has been as long as man began trading goods. When a market is trending or expanding it makes higher highs and higher lows. It’s during such a period that traders make chunks of money because the moves are big. However, trending markets only occur during a small percentage of the time. The rest of the time the markets consolidate and it’s during this consolidation time that traders must be prepared to catch the next big move. This trading setup is suitable for momentum traders or traders who want to make quick money.

Below is an example of box trade:

The above chart is of Mastek. The stock had witnessed strong consolidation for more than two months and was trading in a box and once the stock moved out of the box range it had a decent rally of Rs 100; in percentage terms 45 per cent in no time.

Andrew’s Pitchfork:

This technical tool was invented by and named after renowned educator Dr. Alan

H. Andrews. Andrew’s Pitchfork, otherwise known as median line, studies or utilizes the concepts of support, resistance and retracements. It consists of:

• Handle

• Resistance trend line

• Median line

• Support trend line.

There are a few steps for creating a pitchfork.

The first step in drawing a pitchfork is to identify a significant high or low that has previously occurred. This will typically be a high in the case of a down-trending market and a low in case of an up-trending market. The initial selection of the A point will determine the direction of the fork. The remaining points (high and low) will alternate; thus, if the A point was a low than the B point will be a high and the C point will be a higher low. The following chart which shows an up-trending Andrew’s Pitchfork clearly illustrates the construction of the same.

The above chart is of Bajaj Auto and on this chart we have applied Andrew’s Pitchfork wherein you can see the stock has moved about 250-280 points from point C i.e. Andrew’s Pitchfork’s lower line support. This trading set-up is suitable for swing traders and traders who prefer better risk-reward ratio i.e. low risk and high returns.

NR 4 and NR 7:

This trading set-up is quite popular with short-term traders. An NR 4 pattern would be the narrowest range in four days, while an NR 7 would be narrowest range in seven days. The philosophy behind the pattern is similar to the Bollinger

Band Squeeze; a volatility contraction is often followed by a volatility expansion. Narrow range days mark price contractions that often precede price expansions.

Bull Set-Up:

• Identify NR 4 i.e. the narrowest range of four trading sessions or NR 7 i.e. the narrowest range of seven trading sessions.

• Buy if the price of stock moves above the high of narrow range day high i.e. high of the fourth trading session in case of NR 4 and high of the seventh trading session in case of NR 7.

Bear Set-Up:

• Identify NR 4 i.e. the narrowest range of four trading sessions or NR 7 i.e. the narrowest range of seven trading sessions.

• Sell if the price of stock moves below the low of narrow range day low i.e. low of the fourth trading session in case of NR 4 and low of the seventh trading session in case of NR 7.

Example of NR 4 Trading Set-Up:

The above chart is of Reliance Industries. The last candlestick which is marked in the red circle indicates a narrow range of four trading sessions. The next day, as soon as the stock price moved below the low of NR 4, the candlestick stock saw a good correction.

ITINERARY TO LEARN STOCK TRADING

New traders taking their first baby steps towards learning the essentials of this game called trading should have access to several resources of excellence education. So for a new trader wanting to take his or her first steps towards trading here is the answer to the simple question of how do you get started?

Open a stockbroker account:

Find a good online stock broker and open an account. Become familiar with the online trading portal layout offered by the broker. Trading online is the best thing to do when you have large capital exposure for trading because you need to have the right information which is required by a trader in order to execute to trade. In online trading you are the sailor of your own ship; your orders are directly sent to stock exchanges rather than a stockbroker. This makes the execution of a trade prompt. Some of the brokers even offer virtual trading which is extremely beneficial because you can trade with virtual money.

Consider paid subscription:

A full-time trader can allocate his whole time to the process of trading that involves tracking stock prices, chart patterns, and entry-exit prices, but traders who don’t have the time to track market movement need professional guidance to trade. Therefore, they can opt for a paid subscription. Paying for research and analysis can be both educational and useful for maximizing wealth. Traders may find watching or observing market professionals be more beneficial than trying to apply newly learned lessons themselves.

Market timing is most crucial in short term trading and paid subscription helps traders to identify proper entry timing and exit points. There are a number of services offered by advisory firms like Intraday, Positional, Swing and BTST/ STBT. One can select the product which suits your trading style.

Go to seminars:

Seminars are one of the best ways of learning as they offer the first-hand sources of information. Seminars provide valuable insights into the overall market scenario and specific investment types. In a seminar, speakers will discuss how they have found success utilizing their own strategies over the years.

Read financial magazines:

Financial magazines provide a wealth of information and are usually easy to understand and follow. In a magazine you get an update of the current economic environment, in-depth stock analysis, expert interviews, and advice.