Getting Started Money Management Technical Analysis Basics of Trading: Part 1

The Basics of Trading

I've had a long running thread on the T2W boards giving an introduction to the central themes of trading. This series of articles has been adapted from that thread and will take you through all the areas you need to get a start in trading, from chart reading to defining a strategy.

In Part 1 I will look at:
  • Basic chart reading
  • Money management
  • Exiting a losing trade
  • Setting a price target

Part 2 will then consider:
  • The importance of discipline
  • Paper trading
  • The trading plan

And finally, in Part 3, I will bring it all together by taking you through a simple trading strategy.

Basic Chart Reading

Ok let's start with the basics of chart reading and deal with Support, Resistance and Trendlines. This really is the core basics of trading, and in my view is the foundation of a trading strategy.

How Candlesticks are constructed.

There are 3 types of bars that can be used for charting. A line chart (which connects the
closing prices), a bar chart and a candlestick chart.

A bar or candlestick chart will show the high, low, open and close for a set period (so on a daily chart, one bar represents one day). The high and low data is very important, so we can not use a line chart as this information is left out and only the closing prices are shown.

There is no real difference between a bar or candlestick chart - they both show the same data so it's personal preference. However, as you move further on in your trading career, you will find that candles offer more information, but for the moment, I'm dealing with the basics of trading.

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The above just shows how a bar or candle is created. The up candles have light or hollow "bodies", whereas down candles have dark or filled "bodies."

Ok, time to look at the more technical aspects of trading, support, resistance and trendlines.

Support

Support is a level on a price chart, that price hits and finds a large amount of buyers, and hence the price starts to rise again

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On the chart above of Cadbury's you can see that every time price hit 399 / 400, it found enough buyers to force the price up.

Resistance

Resistance is the level at which a price chart struggles to break above. When price hits a resistance level, the number of sellers is strong (as they know that the next move is down), and it takes a lot of buying pressure to get it above this level.

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On the above chart you can see that there were a large number of sellers at 423, which was too strong for the buyers to push through.

Trendlines

Trendlines are made by connecting 3 or more points along the same line. They either connect the tops of the highs together or the bottoms of the lows. Trendlines work because everyone sees them and know that the next time price hits that level, a reversal should happen, so they either rush to buy or sell depending if it is an uptrend or downtrend.

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On this chart I have connected the highs together to create the straight line (or trendline). This is a downtrend because the trendline is pointing down.

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On this chart I have connected the lows together, and as the lows are rising, it is in an uptrend.

...and that's pretty much the foundation to trading. I know it sounds simple (and many of you would all ready know this), but it works and that is the main thing.

Now we will move on to look at money management.

Money Management

At this point, I would like to show you the solution to trading. The hidden secret that will change your life forever, and this is it:

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Money Management

This is nothing new, but few new traders use money management wisely and get "killed" because of it. There is a myth among new traders that you HAVE to be right more times than wrong. This table is one that I've taken from "The Master Swing Trader" by Alan Farley:
%WinTradesAvg winAvg lossProfit
75%100£800£2000£10,000
50%100£800£600£10,000
25%100£800£133£10,000

What the table shows is that to be profitable, or more profitable, you can either work on being right more often, or reducing the losses. Most new traders will let their losses run and run, which means the trades that follow must be right to claw back the money they have lost.

This is a table that Chris Manning displays, and it really shows the importance of cutting your losers
% Loss% Gain needed to break even
10%11%
20%25%
50%100%
100%400%

It shows that the higher the loss, the significantly higher % gain it takes just to get back to square one.

The most effective way of controlling your trades is to look at the risk / reward ratio of the trade before you enter into it. This is done by setting a rough price target, and knowing the position of your stop. From this you can then work out the risk / reward ratio, for example

Current price = 100
Target = 109
Stop = 97

Reward = 9 points
Risk = 3 points (including commission).

Giving a 3:1 ratio

Knowing where to place the stop is a difficult thing, but the rule of thumb is that the stop is placed at the point the chart tells you "you are incorrect" Most people (including myself) rarely take anything less than a 3:1 ratio, especially for stocks. A 3:1 ratio means that you only have to be right 25% of the time to break-even.

Once you are in a trade, one of 3 things can happen. Either your stop gets hit, the price moves sideways or the price moves into profit. The first 2 you can't really do much about, but when a price moves into profit, then you move the stop to lock in some profit. This is an art form in itself.

The important thing is to make sure that at any one point, the risk should not be equal or greater than the reward. In the above example, if the price went to 105, and we didn't move the stop we would have this scenario.

Current price = 105
Target = 109
Stop = 97

Reward = 4 points
Risk = 8 points
Giving a 1:2 ratio

A 1:2 ratio is very poor. This is where moving the stop to lock in profits really comes in. If we move the stop to 102, we lock in 2 points worth of profit and have the following risk / reward

Current price = 105
Target = 109
Stop = 102

Reward = 4 points
Risk = 3 points
Giving a 1.3:1 ratio, which is a lot better than the 1:2 ratio we had earlier.

Moving stops, and stops placement is very difficult, but I will deal with this later.

Ok, so lets take a closer look at a real chart and see how the Risk / Reward profile can be used.

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Here we have a chart of AAL (Anglo American):

Current price = 874
Target = 930
Stop = 859

Reward = 56 points
Risk = 15 points
Giving a 3.73:1 ratio, which is good enough for me.

The other aspect of money management is the stake size. I know a few traders whose stake size is too large for the account they are trading. The important thing, especially when you are first starting out, is to make sure that you "stay in the game" as most of your learning will come when you're actually trading.

The accepted level of risk among the professional traders and the trading authors is 1% of your capital on every trade. I used to trade with 2% risk, but that was far too much, and it still scares me today to think that I actually had that level of risk!! When your risk increases, any bad run that you have will be magnified beyond your control. To make sure you stay within your risk profile, work out how many points you are risking, how much 1% of your trading capital is and from that work out the stake size, so that if your stop is hit, you will only lose 1% of your trading capital.

Now we will move this one step further and look at exiting a losing trade.

Exiting A Losing Trade

As demonstrated from the table above, cutting a loss is really important, to do this we will use a stop-loss. Knowing where to place a stop, is one of the hardest things to know. There are so many factors that come into play, like the volatility of the instrument that you are trading, your risk tolerance...etc

Stop-losses are an important part of trading. I've said it before, when you are learning to trade, the important thing is that you "stay in the game" long enough to put what you have learnt to good use. Stop-losses save you money, they don't make you money. There will be many times as a trader, your stop gets hit, and your closed out of a trade only to look back later to find that you would have made an absolute fortune. This happens in trading, and at times like this you must remember that the stop loss is there to protect your capital.

The point at which you are incorrect.

The general acceptance is that your stop is placed at the point at which you are told that you were wrong / incorrect. Most of the time it will be a break in a trendline, or a point of support / resistance that has broken.

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With this example of SDRC, the support was at 450, and the natural place for the stop-loss was about 445. The support failed, the stop got hit and the price carried on lower. At 445 the price has violated the support line, so you would expect the price to fall further, which is what happened in this case.

The trader versus the market makers.

The unfortunate matter is that the market makers know where the stops are. They know because most people trade the same way. There are plenty of occasions when a market maker will go "gunning" for stops. What I mean by this is that they drop the price below support, to get the stops hit and then the price carries up, up and away.

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This GKN chart shows how the price fell below support at 197, hit 195 and then reversed. If you had placed a tight stop at 196, you would have been stopped out.

The only way to combat this is to allow the price a bit of room to move once the support / resistance / trendline has been broken, that way any stops that get gunned won't be yours. How much you let the price move around is down to personal preference, but YOU MUST KNOW THE POSITION OF YOUR STOP BEFORE YOU ENTER the trade, this includes the room for manoeuvre, and should be part of the risk calculation that we talked about earlier.

Mid-trade stop-losses.

I talked earlier about moving the stop-loss so that at any point in the trade, the risk does not exceed the reward. Moving your stop during a trade must only be used to lock in profits. If you move the stop loss to increase your risk, you are asking for trouble.

Moving a stop to protect your profits, the stop should be placed under the last support for a buy or last resistance for a short. On an end of day chart you might look for the last low to act as the support, or the last high as the resistance, for example.

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If we enter this Corus trade, short at 59, with a stop-loss at 64 and a price target of 45.

Risk = 5
Reward = 14
Reward / Risk ratio = 2.8:1

Now if the chart does this...

image11.gif


At the current price of 52, and leaving the stop where it is, we would have this scenario

Risk = 12
Reward = 7
Reward / Risk ratio = 1:1.7

At this point we have more risk than reward. So the logical place to put the stop is at 57, as this is the last significant high, giving...

Risk = 5
Reward = 7
Reward / Risk ratio = 1.4:1

Which is better than the 1:1.7 ratio.

Moving stop-losses to protect profits is just that, taking the profits that are on offer.

Stop loss placement is difficult and takes time to master, but as long as you remember the fact that stop-losses protect your capital, the emotional side of trading should be easier to follow.

Next we will look at setting price targets.

Setting Price Targets

We've already looked at stop-loss setting and risk / reward analysis. The other part is of course price target setting.

Your price target (as with the stop-loss) is governed by the time scale you're trading in and how long you expect to hold the shares.

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This ALLD has 3 levels of resistance

322 - January support
363 - October and December support
420 - High of January and also resistance in early September and back further.

The short term target is 322, which as I say is the January support. It's the short-term target for 2 reasons, 1) It's the closest to the current price and 2) There is enough resistance to hold it on a short-term basis (the resistance was only valid for a week), and for a short-term trade, we would expect it to get there pretty quickly.

he medium term target of 363 would take longer to get to than the short-term target, but that's what you would expect. For 363 to be hit, it will have to take out 322 and although you would expect price to stop there, it wouldn't hold it back long enough to be a problem.

The long term target will have to get through both the short-term and medium-term resistance, but as we are prepared to hold it in the portfolio for a while, that is not a problem.

Target setting comes down to how strong you think support and resistance is at the various stages. The text books say that the more often a level is tested and the longer the period it is tested over, the stronger it becomes.

Choosing how long you are going to hold shares for, is a very individual thing and take many years to figure out what suits you best. Having an idea of how long you're planning to hold your shares though should decide your target.

That is pretty much it for target setting. The only other thing to realise is that changing the target is no different to changing a stop-loss. There must be good reasons for doing it and it can be adjusted as time goes on and the chart develops. Just remember that a stop-loss MUST NOT be changed to add risk, but to protect profits where suitable.

Read part 2 of this series.
 
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Hi,
yes, SB sites have dummy accounts - they'll let you play with a pretend £X000 account while learning the ropes, some (I think Finspreads is one) will also let you start off very small for a month or two, betting 1p a point (the share price moves 1c, your bet wins or loses 1p... the 'norm' is £1 for each movement, ie win or lose £1 for every 1c a US share moves, or (I think - I trade US) per penny of UK stock price moves. UK prices seem rather sedate compared to US. Needless to say £1 a point is much more common, the odd SB company trades down to 50p a point but £1/pt minimum is the norm.

This means you can win/lose a lot very quickly - it also means an overnight gap can kill you... some shares can drop $10 overnight, that's £1000 change in your account - UP £1000 is pretty good, but imagine if your bet dropped that much overnight - and stop losses won't save you, that sort of drop DOES occur and you are locked into the loss up to the SB company's opening time. A common misconception is that stop losses allow you to set a limit at which you exit - they do SOMETIMES, but sometimes you can't get out until the drop has finished... you need deeper pockets, in SB, than appearances suggest.

SO... DO make use of the 'pretend account' (known as 'paper trading') if you look at SB, use it particularly to find out how to use things like limit orders, figure out the margin issues, and so on - the average 'paper trading account' has a large balance, when you play with a smaller one you discover you can't have 3-4 on the go at once, the margin requirements for each bet determine the total you can have in play at a time.

Getting the direction right is only part of it, a small part - I would think a good few SB players have lost noticeable amounts due to not understanding the margin requirements, or through not realising that what you can 'afford' on a paper account doesn't match what you can afford in real life using a smaller sum - you might happily hold overnight and show a profit, using your paper account of £10,000 - using your 'real money account' you discover a small opening gap creates an automatic close of the position at a significant loss. (You'll get a 'margin call' - but not much time to stump up the amount you have unexpectedly lost).

The thing is - the paper trading account can weather bigger 'drawdowns' than your real one - so play the paper account as close to reality as possible.

Given your experience so far I figure (A) with less than £3k on the go you aren't going to get rich in stocks, (B) SB if you do it really well might well generate a few bob, £3k in stocks won't, and don't let anyone tell you otherwise. (C) Trading is not easy, whilst I would not attempt to put you off this somewhat odd hobby, your chances of turning 3k into a a sizeable pot are limited, and if you are as new to this as your post suggests I would spend the next 2 years at least learning about trading and playing on paper.

Meanwhile... there are loads of websites with useful stuff on them, you don't need to buy anything. Your £2700 could go very quickly otherwise - keep it intact until you understand the game a bit better - the market will still be here when you are more up to speed. Websites are useful for teaching yourself how to spot setups, how to manage your trading, all sorts - generally speaking it's all well meaning stuff from people who are optimists but not making much from the markets. Do not, for heaven's sake, try trading a 'strategy' copied off a website - you really have GOT to read loads, develop critical skills for trading, try ideas out (paper trading) and find what works and what does not - very very little on the web is right as often as a coin toss, and it will take a good while to decide where the nuggets actually are. How 'nice' the author is should not be used as a guide, some very well meaning types will tell you a load of old rubbish simply because it's all they have and they're desperate to please you... the sad truth is that whether a tactic makes money or not is largely down to it being at least vaguely useable and (more importantly) the psychology of the trader - crap tactics and good trading will probably break even or close to it, brilliant method of selection and lousy trading = losses every time.

Have fun, it IS fun, and I'm not trying to put you off... but it's very easy to lose money in 3 ways - 1 is picking bad trades, the 2nd is not understanding the ins and outs of the trading method... you need to get both right, and that is far from easy, 3rd is making a pigs of it because your head is where the monkey (allegedly) sticks his nuts....
... welcome through the Looking Glass <g>
Dave



It should be
 
millsy500 said:
Hi FTSE
Thanks for the reply. A quick one regarding risk. I've been looking at us stocks because its easier for me doing eod and from what i can gather from on here they're more volitile and therefore more profitable especially the software stocks etc. The problem is even on the small ones they require around a 300 p stop so if your risking 1% then you need £30000 pot. Is this correct? On a pot of around £3000 is this too risky?
Many thanks regards Millsy
Hi Millsy

Your calculations are correct, however - what do you plan to trade with a 300p stop? :eek:
That's a large amount!!

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Hi Dave,

Great post :cool:
Does that answer your question Ale?
 
FTSE Beater said:
Hi Millsy

Your calculations are correct, however - what do you plan to trade with a 300p stop? :eek:
That's a large amount!!

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FTSE

I've been looking at companies like microsoft on the nasdaq,using spread bet companies.
Is this a bit risky?

Millsy
 
millsy500 said:
FTSE

I've been looking at companies like microsoft on the nasdaq,using spread bet companies.
Is this a bit risky?

Millsy
Hi Millsy

No, these companies are fine to trade. MSFT gets thrown about a lot in the day, but on a longer term basis this is fine. Could you give me a chart or an example (with dates and prices) of where you would consider using a $3 stop.

Thanks
 
FTSE Beater said:
Hi Millsy

No, these companies are fine to trade. MSFT gets thrown about a lot in the day, but on a longer term basis this is fine. Could you give me a chart or an example (with dates and prices) of where you would consider using a $3 stop.

Thanks

Hi FTSE

Heres an example. I've been short on ADBE since 18/2/05. I opened on 6310 with a 5% of price stop (IG index). I went into this trade because of software signal, a reversal to go short and because of negative ADBE news can't remember where i got the info tho.

Millsy
 
A very good article.
It concentrates on the essential core elements that any beginner should absorb if they wish to have any chance of survival.
 
Chart please

millsy500 said:
Hi FTSE

Heres an example. I've been short on ADBE since 18/2/05. I opened on 6310 with a 5% of price stop (IG index). I went into this trade because of software signal, a reversal to go short and because of negative ADBE news can't remember where i got the info tho.

Millsy

Can you post a chart ?
 
Well done Mark this is the best article on the trading for beginers like me so far, I have better understanding now the principals and hope you keep posting more similar articles to help us the beginers to grasp better trades, you are the man... tks
 
It is people like you Mark, who make trading more simple and most enjoyable. Thank you for your efforts.
 
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