Getting StartedPsychologyTechnical Analysis

The Basics of Trading:Part 2

In part 1 of this article, I looked at some of the basic elements of trading, including chart reading and money management. In this second part, I will consider some other essential issues, such as the need for discipline in trading and the importance of practice and planning.

The Importance of Discipline

I have previously mentioned why it is important that you DON?T move a stop-loss to increase risk, and I wanted to go through the ?what if? scenario of letting a stop run.

We?ll take this example from Barclays from January 2003.

Chart

Here we have a nice double (or even triple) bottom on support, and a clean bounce up. You take this long entry with a tight manual stop at 360.

This is what happens over the days to come…

Chart

Brilliant, straight into profit and looking good.

The following week isn?t so promising though…

Chart

You hear yourself saying,

"Ok the price has gone through support, but it?s ok, it closed above support so it?ll be ok."

So you leave it for a bit, and this happens…

Chart

"Oh no the price has gone through support, ok it?s too late to sell now, I?ll wait until price gets back up to the support line."

Chart

"Now price has made a nice rounded bottom so the next move is up, I can let it run for a while longer as it?s bound to go through the resistance level."

and the next thing you know price does this…

Chart

"Time to sell out and accept the loss."

Well it?s good to know you cut the loss ? some 35 points or 10% below where you should have done.

It?s very easily done this, and I?m sure most traders have done this at some point in their trading career. This is why discipline is such a large part of trading. Always remember to move a stop to protect profits NOT to increase risk.

Now, we will look at putting in practice all that we have learned…

Paper trading

So far we?ve covered, the basics of support, resistance and trendlines, money management and the concepts behind risk and reward, price targets and stop loss placement. That is pretty much the basics behind trading, so the next step is to start putting this knowledge to use.

If you are looking at end of day charts, then the learning process of trading can be a slow one, after all you have to wait a complete day for a new piece of data.

The best way to practice is to go back over old charts and try to analyse it from there. I was once told: ?practice doesn?t make perfect ? but perfect practice, now that?s perfect.? So I would like to spend some time going over how I?ve analysed data in the past. This should really help the learning process along:

Take a stock or a chart that you don?t know anything about, and pick a time 2 or 3 years ago. This way you have no idea of what has happened in the past, and therefore you cannot cheat. You then analyse the chart you have, and then forward the data one day at a time. This will create a new bar and from that you will have another bit of data to decide whether to trade or act on.

If you?re using the Sierra Chart package then you can use the right arrow key to jump one day at a time. There is a function on ADVFN to view a set date range. From there what you have to do, is change the ?To date?

Lets have a look at this example: Barclays, 5 May to 5 Nov 1997

Chart

At this point I can?t see anything in the BARC chart that I like, so I?ll jump a day at a time until I see a set-up I like.

Chart

Ok, this has bounced between the downtrend and the uptrend, so there could be something to watch here

Chart

A couple of days later the downtrend has gone, so at this point I looking to buy and use the uptrend as support. ? I?ll wait another day to see if I can get a better entry.

Chart

Now the chart has tested the uptrend, I?m happy to go long. So I?m long at 362 with a stop below the trendline at 355 and a target of 400 (which is the support in October). This gives a risk / reward of 5.43:1

Chart

One bar later and the trendline is still holding price, so I need to go one bar at a time until I see something of interest.

Chart

Oh dear. The trendline was broken and I was stopped out for ?7 less any commission. Now I?ve got to look back at the chart again and see if there is anything I should have seen or done differently. In this case, I should have waited to see a solid bounce off the trendline before entering. I should have also seen the short-term downtrend which if broken would have been an indication that the price would be moving up.

And that?s how to practice trading. Simple really, but if you do it properly, you can practice as if in real-time without having to wait days for each new set-up.

Now we will look at building a trading plan…

The Trading Plan

Building and using a trading plan is an essential part of trading. Without a suitable plan of action, it is highly unlikely that you will be able to create consistency in your trading.

Your plan should be clearly written, so that at any point before, during and after a trade, you should know what to do. This will make trading a lot easier and a lot less stressful – there can be nothing worse than looking at a losing position and not knowing where to get out, or how big the loss is going to be.

There are a number of elements that make up a good trading plan and it will be different for every trader. Here are the most important elements:

Which markets?

It may sound obvious, but which markets are you going to trade and are you able to trade them? It?s no good deciding to trade the UK markets on a day-trading basis if you?re doing a full-time job during the day. You also have to ask yourself "What advantages does this market have over the other options I have available?".

Who am I going trade through?

How are your trades going to hit the market? Will you use a spreadbetting company, a CFD account or a traditional broker? Which has the greatest advantages and do they have the level of service you require? Some people might find that spreadbetting offers the best deal for trading, but it might not be best for everyone.

Entry criteria

This is where things have to be detailed:

  1. Are you looking to buy low and sell high (swing trading) or buy high and sell higher (momentum trading)? What will get you into the market?
  2. Are you looking for a test of support to hold price up, or are you happy to get in mid-move? What will be the factor that confirms whether you take the trade or not. For example, you might be looking for the general index to be moving higher, or might be looking for some sort of indicator to signal a move in your favour is imminent.
  3. Does the trade you are about to take have a good risk / reward ratio? I would be reluctant to take any trade with less than a 3:1 R/R ratio.
  4. How are you going to place your trade? Are you going to use limit orders or market orders to get you in?

% Risk of capital on any trade

I make sure I do not risk more than 1-2% of my trading capital on any single trade. Any more than that and you risk a large drop in your account if you hit a bad patch or drawdown in your trading. Are you prepared to have more than one position open at any one time? Having more than one position open can get confusing on a short-term basis but for longer-term traders it?s the most efficient way to trade.

Exit Criteria

As I mentioned earlier, there can be nothing worse than looking at a losing position and not knowing where to get out, or how big the loss is going to be. The exit criteria can take many forms:

  1. Are you going to set a stop-loss in the market or use a mental one? I would always advise using a stop in the market if you can.
  2. Are you going to use a trailing stop and lock in profits when you can or take them off the table when offered?
  3. Are you looking to exit at your price target or just tighten the stop?
  4. Are you going to scale the position out (selling out bit by bit) or take everything off the table in one go?
  5. How long are you looking to hold the trade open for? Are you looking to sell in hours, days, weeks, months or years from now?

What charting set-up

Which time-frames are you going to be looking at. This table will give you an idea of what charts you should be looking at:

Type of Trader

Holding Period

Chart to Trade Off

Tick Trader

Minutes

Tick / 1 minute

Day Trader

Less than a day

1-5 minute

Position Trader

Hours / Days

15-60 minute

EOD Trader

Weeks / Months

Daily

Long Term

Years

Weekly / Monthly / Yearly

Are there any indicators you look at?

Testing

Are you going to test the above strategy by paper trading, simulating or are you happy to go straight in and trade from the start. I would advise paper trading any strategy to make sure it works. Some look great on paper, but when it comes to actually trading they are not actually workable.

Time to change the trading plan

How long will you give the trading plan before you start to amend it? If you start changing a plan too early, you will risk not giving it a chance. Give it too long though, and you risk draining your account with a plan that isn?t working.

The question above are ones that you SHOULD WRITE DOWN. I?m sure you can think about them in your head, but when it comes to the crunch, you need to be able to look at a piece of paper that tells you what to do ? it shouldn?t need much thinking about. These questions are the minimum that I would have as part of a strategy, you might find that there are other areas that I haven?t talked about, but you still want them in your strategy. Great, the more detailed you can make it the better.

I?m often asked how long should you paper trade for? The answer is, it?s a balancing act. You are balancing the need for understanding a trading plan with the need to trade for real. There is no getting away from the fact that real trading is very different to paper trading, for a start the emotional difference is massive and the risk with paper trading for too long is that you can get into a comfort zone, which makes the next step to real trading significantly harder. How long is really up to you, but my advice would be that as soon as you are happy with the plan, plan a couple more trades and then start trading for real.

When it comes to trading for real, make sure you start small. As I?ve mentioned before, your aim in the earlier stages of your trading career should be to stay ?in the game?, there will be plenty of time to increase the stake size once you have traded profitably at the lower stakes for a time.

In Part 3 of the article we’ll look at a basic trading plan that I have successfully traded in the past.

Mark Williams (better known as FTSE Beater), is a veteran T2W member as well as a site moderator. He has been trading since the age of 14 and is a strong believer in helping new traders. His popular and active thread for beginners, ‘The Basics of Trading’ has been running for more than two years and had over 30,000 visits. He has a background in business studies, economics and accountancy and has traded full-time as well as worked for an accounting firm in London.

Mark Williams (better known as FTSE Beater), is a veteran T2W member as well as a site moderator. He has been trading since the age of 14 and is a str...

tulaine

Newbie
6 0
Excellent timing for me!

It's good to get confirmation of 'common sense' while I'm still gathering information and learning the ropes. Not sure I agree with the figures though. Setting a maximum risk at 2% of the bank and 1 open trade at a time means it could be ages before any significant profits are visible. Another advisor suggests 4% and 12 open trades, still risking less than half the bank at any moment. Of course exposure to risk is a personal thing, so no arguments can ever resolve such an issue. I may not be comfortable with 48% out, but I don't think 2% would satisfy.

Lets hope I see part 3 before my impatience with paper trading takes me into risking real money!
 

jimmy1jag

Active member
226 7
Timing is spot on for me too. I was seriously thinking about using a workbook by a guy called Vince Stanzione (see thread of the same name elsewhere on this site) costing £347. The info provided in this starters' guide does indeed confirm sense and the info/ links to other sources/ sites have saved me the fee.

Instead of paper trading, however, I have just opened an account with Finspreads, where, for the first 8 weeks you have the option to join their (from memory) "Trading College". If you sign up to the trading college, you can trade at as little as 1p per point (for the first 8 weeks), instead of the standard minimum of 50p per point. The minimum you can put into the account at start up is £100. So £100 max. exposure and an opportunity to put the theory into practice for a low initial outlay. But trading for real money.

Apart from the rabbiting on (!), my real point is that Ftse Trader's work is spot on, and I too am looking forward to part 3.
 

EdC

Newbie
1 0
This is really helpful. I'm coming back to tradng having traded equity options in the past. Good, common sense stuff that reminds me to get my charting knowledge up to speed before I get going
 

ale

Active member
108 1
A good follow on from Part 1.
I'd like to see more examples discussed in this way -both good and bad.
(Need to sort out the link on page 2 to Sierra - it sends you to the top of page 1.)
 

FTSE Beater

Experienced member
1,518 4
Thanks to all of you for your kind comments. They are very much appreciated and it makes the whole thing worthwhile :cool:

I believe that part the 3rd and final part will be published this week (all being well).

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Hi Ale

Need to sort out the link on page 2 to Sierra - it sends you to the top of page 1.
Thanks for that, I completely missed that one :eek:

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Hi jimmy1jag

Instead of paper trading, however, I have just opened an account with Finspreads, where, for the first 8 weeks you have the option to join their (from memory) "Trading College". If you sign up to the trading college, you can trade at as little as 1p per point (for the first 8 weeks), instead of the standard minimum of 50p per point. The minimum you can put into the account at start up is £100. So £100 max. exposure and an opportunity to put the theory into practice for a low initial outlay. But trading for real money.
Excellent. The Finspreads trading college was designed for this very purpose and well worth doing.

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Hi tulaine

It's good to get confirmation of 'common sense' while I'm still gathering information and learning the ropes. Not sure I agree with the figures though. Setting a maximum risk at 2% of the bank and 1 open trade at a time means it could be ages before any significant profits are visible. Another advisor suggests 4% and 12 open trades, still risking less than half the bank at any moment. Of course exposure to risk is a personal thing, so no arguments can ever resolve such an issue. I may not be comfortable with 48% out, but I don't think 2% would satisfy.
I can understand your thinking, however before you think about going above 2% risk, then please please make sure that you can trade profitably below this level before moving above it.

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mrjonestrader

Newbie
3 0
Thanks - very interesting, I use Proquote at work and was just wandering with regard to what you say about paper practice trading using historical data if you had any ideas on how to advance a chart on a day by day basis using this programme? It does not seem possible unless you know any better? Also I have started trading stocks (3-4 at a time) on the AIM that exhibit a high degree of short term momentum, (SBT etc) therefore support lines are steeply inclined and less consistant than in your barclays example, in such cases would you still recommend setting the stops just a few percent below the inclining resistance trendline?
Lastly and on an unrelated point what do you think of trading brand new issues?Tthe upside potential seems huge and obviously losses can be limited with stops, I saw one treble in value within 2 hours of market opening last week (forget the name now sorry). The lse website gives a list of forthcoming issues as does investors chroncle, but I cannot find anywhere that gives advance opinion on likely market reaction to the listing. Any ideas on this? Thanks
 

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