Investing and Trading are two very different methods of attempting to profit in the financial markets. The goal of investing is to gradually build wealth over an extended period of time through the buying and holding of a portfolio of stocks, baskets of stocks, mutual funds, bonds and other investment instruments.
Investors often enhance their profits through compounding, or reinvesting any profits and dividends into additional shares of stock. Investments are often held for a period of years, or even decades, taking advantage of perks like interest, dividends and stock splits along the way. While markets inevitably fluctuate, investors will "ride out" the downtrends with the expectation that prices will rebound and any losses will eventually be recovered. Investors are typically more concerned with market fundamentals, such as Price Earning Ratios( P/E) and management forecasts.
Trading, on the other hand, involves the more frequent buying and selling of stock, commodities, or other instruments, with the goal of generating returns that outperform buy-and-hold investing. While investors may be content with a 10 to 15% annual return, traders might seek a 10% return each month. Trading profits are generated through buying at a lower price and selling at a higher price within a relatively short period of time. The reverse is also true: trading profits are made by selling at a higher price and buying to cover at a lower price (known as "Selling Short") to profit in falling markets. Where buy-and-hold investors wait out less profitable positions, traders must make profits (or take losses) within a specified period of time, and often use a protective stop loss order to automatically close out losing positions at a predetermined price level. Traders often employ technical analysis tools, such as moving averages and stochastic oscillators, to find high-probability trading setups.
A trader's "style" refers to the time frame or holding period in which stocks, commodities or other trading instruments are bought and sold. Traders generally fall into one of four categories:
- Position Trader – positions are held from months to years
- Swing Trader – positions are held from days to weeks
- Day Trader – positions are held throughout the day only with no overnight positions
- Scalp Trader – positions are held for seconds to minutes with no overnight positions
Traders often choose their trading style based on factors including: account size, amount of time that can be dedicated to trading, level of trading experience, personality and risk tolerance. Both investors and traders seek profits through market participation. In general, investors seek larger returns over an extended period through buying and holding. Traders, by contrast, take advantage of both rising and falling markets to enter and exit positions over a shorter time frame, taking smaller, more frequent profits.
Good Rules for Trading
- Don’t allow emotion to rule
- Check your shares every day
- Learn, learn, learn – knowledge is power
- A disciplined trader is a successful trader
2. Protect Principal
3. Protect Profits
- Always ensure to lock-in your profits while minimising your risk
- Let your profits run and cut your losses short
- It is more difficult to recover from loss than to make a gain
4. Money Management is More Important than Entry Strategies
- While you may buy the right share at the right time, if you don’t know when to sell you could lose your profit and part of your principal
- Invest no more than 5% – 10% of your investment capital into any one share or trade in order to reduce your risk and maximise your potential profit
5. Always use a Stop-loss
- Either a mental or physical stop-loss – know what you are going to do when a security reaches this level
- A Stop-loss protects you. They lock in your profits and minimise your risk, allowing you to let your profits run and cut your losses short
6. Trade in the Direction of the Trend
- Buy only shares that are rising. Sell only shares that have started to fall
- The market is much bigger than you are. Don’t fight the trend
- Don’t guess when the trend is going to turn – it won’t
- The trend is your friend
7. Don’t get Caught up in Impulse Trading
Impulsive trading is often reported by part-time investors who have excessive distractions. Without a defined structure to their investment activity, investors may easily fall victim to their emotions, trading on whims and poorly thought-out strategies. What often starts out as disciplined and well planned investing, often turns into impulsive trading ("churning") by watching the markets too closely and becoming confused about investment objectives.
8. Knowing When to Sell
- Major negative fundamental event
- When your system sell triggers are reached
- Follow your own Trading rules
9. Don’t Lose your Long Term Perspective
Many people prefer small short-term gains over greater long-term rewards. This preference for instant gratification is a biological part of us; it is greater in some than in others. It is especially a problem after we check our investments and see that they have moved strongly in either direction. Strong moves inspire us to check the investments more frequently. More frequent checking makes us more vulnerable to abandoning our plans. Many investors find themselves watching minute-by-minute price movements.
10. Cutting Winners Short
Most people cut their winners short - selling out of winning investments prematurely. There are several reasons why this occurs. Some investors want to take home a real gain, forfeiting the investment's future potential, in order to feel proud of their profits in the short-term. Other investors are obsessive, watching their investments closely. When they feel that their paper profits might be in danger, rather than carrying through with their plan, they quickly sell out and capture profits (to avoid the possibility of losing their paper gains). This is related to one's level of "obsessiveness".
11. Don’t Trade Markets About Which you Know Very Little About
This is not to imply that you have to be a fundamental expert on every market you wish to trade. However, you should know about what fundamentals are impacting, or could impact, a market you are contemplating trading. For example, a person who has only traded the stock market would not want to jump right into a 3-year Bond futures trade without first doing a bit of homework on how the bond market trades – price increments (dollar amount per tick), trading hours, on what exchange the market trades, etc.
A trader could pick up a Financial Review and read the “Bonds” section for a week or so to become familiar with fundamental factors that influence the bond market. Also, consider this: Most traders enjoy the process of trading. If they did not, they would likely just hand their money over to a “fund manager” and give the manager control over their money. Learning and knowing what fundamental factors are impacting or could impact a market that a trader plans to trade is part of the process (enjoyment) of trading.
12. Don’t Trade Hot “Tips.”
You may trade for 20 years and never hear a good trading tip. Reason: There aren’t any . . . at least not any that are any good for regular individual traders. Markets are way too big and too tightly regulated to be impacted by any tips or inside information. Any legitimate “early information” has almost certainly already been factored into the market price structure by the time most individual traders could ever benefit from it.
Don’t confuse tips with rumours. Markets do move on rumours more than just occasionally. Rumours are a part of trading but still fall into the category of “not much use”. Besides, many rumours are never confirmed as fact and are often self-serving to those who try to start them.
13. Don’t Get too Fancy with your Market Orders
Entering a trade “at market” with a market order may be the best way to enter a trading position especially in markets that are liquid (have high open interest). It’s certainly the easiest way to enter. Fiddling around with limit or stop-limit or other multi-step orders to save a tick or two or three can cost a trader a good entry point or even a missed trade altogether.
It’s certainly easy to be guilty of this offense because every trader is always trying to get just a little better price. This doesn’t mean that limit or stop-limit or other types of orders are not useful in certain circumstances because they are. However, most trade entries are best made “at market.”
14. Don’t Form a New Market Opinion During Trading Hours
This rule goes hand in hand with the rule that says you need to stick to your trading plan of action. Day-today market “noise,” or the minor up-and-down price fluctuations of a market, can be at least distracting to a trader and at most prompt the trader to make a hasty and poorly founded trading decision.
15. Don’t Force Trades; If you Don’t See a Trade, Stand Aside
Don’t chase a market just to put on a trade. Try to exhibit patience and discipline in trading – easily said but hard to follow. Patience and discipline are not easy virtues for any trader to learn because a typical trader has a “Type A” personality with a competitive nature who hates to wait in lines. However, to have even a chance at success in trading, you have to control your impatience. If you happen to miss a trading opportunity because you waited too long, other trading opportunities will come along.
A good trade is usually profitable right from the beginning. If the market price moves “your way” in the first couple days after you’ve executed the trade, then odds are significantly higher that your trade will be a winner if you have waited patiently for the right position.
This rule reinforces the notion that tight protective stops are an important part of trading success. But there is a time to be impatient: If a straight trade is under water after two or three days, more times than not it’s prudent to take a small loss and move on. Do not be patient with losers.
16. Use Inter-market Analysis to Spot Trading Opportunities
No market trades in isolation but is influenced by what is happening in a number of related markets. Don’t focus on just one market as much of today’s single-market technical analysis does. Instead, take into account developments in other markets that are likely to affect prices in your target market. If you trade stocks, you have to be aware of what is taking place in interest rate, currency and commodity markets such as gold. The price of a market you want to trade may be the sum of what is happening in ten or more interrelated markets.
17. Watch Open Interest Statistics, Especially in Options
When you are contemplating trading any contract, make sure to first check the open interest for that specific contract or strike price. If a futures contract or options strike price has a low open interest total, it is probably best to seek out a more liquid contract. Fills on both entry and exit can be tough and may produce more slippage than is desired. When you get into a position, be sure it is liquid enough so you can get out on favourable terms.
18. Know What you can and Cannot Control
You can control the market you want to trade. You can control the type of market order you want to give your broker. You can control when you want to enter the market. You can control the amount of contracts you wish to trade. You can control when you want to exit the market.
But you can’t control the market, which often has a habit of doing unusual and unexpected things. Knowing and prudently managing the market factors you can control and knowing that you cannot control the market gives you a trading edge.
19. Make the Market’s Action Confirm your Opinions
If you have a particular market on your “radar screen” for a trade, don’t just jump in based on a hunch or a “gut feeling” or because you want to get a fill right away. That’s when a market order advised above may not be in your best interest. Make the market first confirm your opinion. Make the market show you some strength if you want to be long, or make it show you some weakness if you want to be short.
20. Do not Overtrade
Trying to trade too many markets or too many positions in one market can create problems for an undercapitalised trader. There is no set rule for how many markets a trader should trade at one time. Some traders can trade many markets at the same time and not have a problem. However, if you are feeling stressed about a position you are carrying or can’t keep up with what’s going on in all the markets you are trading then you are likely over-trading.
For those traders who are really not sure how many markets to trade at one time or how many contracts to trade for each position, it’s always better to take a conservative approach. Step in slowly until you become comfortable trading in a larger size or in multiple markets.
The Costs of Trading
Opening an Account
To open a trading account you will need to complete an application form. Some companies will also offer the facility of completing an online application form and providing your identification information through the same process.
The size of the application will depend on the type of account that you will be opening (personal, company, family trust, superannuation). All trading account applications will be accompanied by a PDS (Product Disclosure Statement). It is a requirement of ASIC that any company providing financial advice or financial products provide this statement to their clients prior to opening an account or obtaining advice. The PDS will clearly outline the services that you can expect to receive and the cost associated with each of those services.
Every Broker or Brokerage House charges a different price (called the commission or brokerage fee) to trade. The price is usually indicative of the service, so cheaper isn't always better.
Stock Market Data and Information
To access stock market prices you will need an ASX data feed. You need to be sure that the quotes are not delayed, and in the case of CFD providers, that you are preferably getting direct market access prices.
If you are a frequent trader you should be able to get data for free, otherwise expect to pay between $30 and $100 per month depending upon the functionality included. If you are a less frequent trader it is possible to obtain end of day charting for free.
Companies in Australia do not charge their clients for data to make a profit - the ASX charges a fee to everyone who wants to obtain live data. The majority of brokerage houses only charge their clients the exact fee that the ASX charges for the data.
Traders can sometimes expect additional fees for allowing a broker to manage their investment or portfolio.
Some of these fees include:
- Fees for transferring assets both into and out of an account
- Account maintenance fees
- Interest on margin loans
- Sales charges on certain securities (e.g. loans on mutual funds)
A Checklist for Trading
There are many things to consider when planning your environment for successful trading. It is better to start with the basic building blocks so that you can create your future trading lifestyle. Ask yourself questions such as; "Do I need to be limited to working at my desk"? The better the planning the less distractions you will have, leaving more time for the important things in your life.
Trading requires a lot of paperwork, amongst other things you may need to set-up broking accounts, bank accounts, cash management trusts or CHESS accounts. You will be asked for your Tax File Number, ABN (if trading as a company or SMSF) driver's license number and a myriad of other personal details. Get into the habit of creating a separate file for each trading account and be thorough in filing your paperwork. If you have a scanner, create digital copies of all your important documents and store in a safe place.
This can be broken down into 2 essential components, a phone and a computer. We suggest an SMS-capable mobile phone and a reliable computer that is connected to the internet, preferably on a broadband connection although dial-up is sufficient. Even a notebook computer with a GPRS card is adequate (It will also allow you to trade from the beach!).
If you are a frequent trader we suggest you have a back-up plan, think about what you would do if there was a power cut or you are in an area with no mobile phone service. At the very least you need to have telephone contact with your broker or CFD provider.
We recommend that you utilise a separate e-mail account for your trading activities, a work e-mail account may not be secure and do you really want your co-workers to have access to your personal details? There are many free web based e-mail accounts such as Yahoo, Hotmail, MSN and G-mail that provide adequate storage for attachments. You can access these accounts from any computer with an internet connection and also download onto your local mail server. It is a good practice to ensure you back-up your files regularly. There are some very cost effective solutions available that can include off-site storage for all your data files, trading records etc. Consult with your ISP to see what they can offer.
To access stock market prices you will need an ASX data feed. Many of the on-line brokers & CFD providers include data and charting packages in your account. Just be sure that the quotes are not delayed, and in the case of CFD providers that you are preferably getting direct market access prices.
Basic Tips for Share Trading
It is often said that markets are driven by greed and fear. In 2005 it was greed’s turn to take the wheel and steer the Australian stock markets to good returns from January to September. October marked an abrupt U-turn. The market declined nearly 7.9% in three weeks as fear grew about what was coming next. Anyone actively trading the market in October became dazed by the volatility and the unpredictability. For beginners to the world of trading, it induced fear and dread. This "fear factor" can be a huge obstacle to success.
Dreams of wealth from trading shares and derivatives are often spoken about but never acted upon; the main reason being the fear of losing money. In this lesson we will discuss some of the better known and effective ways of overcoming this well-documented fear toward trading. When it comes to trading there are four basic common-sense rules that apply to every beginner: always paper trade before putting in your own money; only trade with money you can afford to lose; identify you risk threshold and lastly; diversification.
The first thing a new trader should do when trying to deal with the fear factor is to paper trade. There is no better way than this to learn the trading business. No money is at risk, but you experience the entire trading process-short of calling your broker, sending in your money and making it official. Virtually any stock can be tracked online or in the newspaper, making it quite easy to see if the stock is moving in your direction or not. The bottom line is that by trading stocks, CFDs and options on paper, you become comfortable with the markets before risking any money. And the best part is that it reduces fear.
Only Trade With Money you can Afford to Lose
The next step to reduce fear in your trading is to trade only with money you can afford to lose. Never trade with funds that are used to meet your basic living needs, such as food, rent, utilities and other necessities.
Sleep at Night Factor
Get to know yourself! This sounds trite but it is a fundamental building block for the long-term successful share, CFD or option trader. Each trader needs to identify his or her own personal risk threshold. If this threshold is exceeded it leads to fear, which impairs the trader from making clear decisions. This all depends on the individual trader's personality. For example, if you are a risk-adverse, conservative person, trade carefully and frugally. If you are an individual that is risk prone, then by all means take "considered risks. Just remember never to exceed your individual fear threshold, whatever it may be. A fearful trader is not a calm, logical trader. When the market goes against your trading, you need to be level headed and have clear precise exit plans. Thus it is extremely important to stay cool and implement your trades with logic and common sense.
Let’s Gains Run Their Course, Cuts Losses Short
This is a necessary element for any good plan of investing, especially the part about letting gains run to their full potential. As long as a portfolio is well-diversified, you can probably afford to make the mistake of holding onto your losers, but you absolutely must not make the error of prematurely cashing in your winners.
As the saying goes, never put all of your eggs in one basket. It is important to diversify your positions as another way of managing fear. The idea is not too buy CFDs, options or shares all within the one industry. Many novice traders in the first couple of years often buy a couple of bank or resource CFDs, Options or stock simultaneously. This is not diversification. This is great if they in your direction, however they can all move against you. The key to achieving large and consistent profits in trading is to diversify your strategies and approaches so you are able to absorb losses and be confident that any one loss won't push you into financial trouble.
Trading the Indices
Investors and traders are obviously familiar with the concept of picking a share that will rise in value and benefiting from that increase in value and likewise, being able to pick which stocks will fall in value so they can short the stock to profit from that move. But what if you have a general view of the market but didn't want to pick out a particular stock to base your opinion on? You will be pleased to hear that you can trade Indices with Options, Warrants, Futures and CFDs.
What are Indices?
Indices are a broad index based on a set number of stocks within any particular market sector. The most important local index is the S&P/ASX 200. There will always be a fixed number of companies, 200, in this index. When a stock is removed, its position would be immediately replaced by another. The S&P/ASX 200 Index represents approximately 90% of the total market capitalisation of the Australian market. Indices provide investors and fund managers with an effective benchmark for equity performance, yet with an emphasis on broader representation.
A stock index is a hugely important part of our financial world, but it is nothing more than a number representing the top shares from a particular exchange.
For example, the FTSE 100 represents the largest 100 companies traded on the London Stock Exchange. If, on average, the share price of these companies goes up - then the FTSE 100 will rise with them. And if they fall, it will drop.
Other examples of stock indices include:
- Dow Jones, Nasdaq and S&P (US)
- DAX and CAC (Europe)
- Hang Seng, Nikkei and ASX (Asia-Pacific)
Most of these are calculated using a capitalisation-weighted average, which means the size of each company is taken into account. The more a particular company is worth, the more its share price will affect the index as a whole.
However, the Dow Jones and Nikkei are price-weighted indices, where shares with higher prices have more influence. This means a stock trading at $100 is given 10 times more weight than one at $10.
The Benefits of Indices
1. Stability or Less Market Shock
Due to diversification within the broader national Indices, they have inherent stability as no one stock can completely influence the index. As such, one-off dividend announcements or general market announcements have little to no effect upon the index.
2. Liquidity Benefits Options and Warrants
There is a lot of activity on the indices which equates to liquidity. This allows more choice, either in the expiration date and/or the strike price of Index Options, and warrants. It also allows the trader/investor to enter and exit the index market more easily.
3. Greater Leverage
The instruments you use to trade Indices offer a greater leverage than they would on an individual stock. However, it must be noted that, as always, this brings greater risk as well as more profit potential.
How to Trade the Indices
There are many Indices that you can trade on; in fact you are able to trade 24 hours a day on the respective global indices. Each Index has its own patterns, volatilities and peculiarities and it is worthwhile ensuring that your trading style fits an Index before committing money to it. The following short paragraphs on Index Options and CFD's is based upon the Australian Index, called the XJO. Please note that you can also use Futures to trade the XJO and warrants for the XAO.
Although similar in concept to Equity Options, XJO options only have Quarterly expirations (March, June, Sept, Dec). Also, Index options are European, which means they may only be exercised at expiry, whereas share options can be exercised at any time. They are also cash settled (as opposed to security settled for ETOs on equities). Moreover, the strike price is expressed in points, as is the premium. (1 point = $10. The strike price is at 25 point intervals)
CFDs allow you to use leveraging to increase your exposure to the underlying movement in the Index. The main difference to CFDs on a stock is the level of leveraging; up to 100 to 1. This brings with it a large degree of risk which you should discuss with your financial adviser and be fully aware of before entering into a CFD agreement. Unlike Options, which allow you the right but not the obligation to the Option, CFDs are a binding financial contract.
As long as money has existed, risk-takers have multiplied their efforts through the use of other people's money. There is probably no place where the use of other people's money can be used to such advantage (if you have a well-thought out plan) or to court disaster (if you don't have a plan) than the stock market.
In real estate, for instance, you can borrow money, but there will be a banker there to make sure you don't make too bad a deal and thus put the bank's loan in jeopardy. In the stock market there are few such safeguards. You are free to lose all of your money (and more) if you are not judicious in the use of debt leverage.
In the stock market, it is possible to easily borrow money, using the value of the stocks you own as collateral. By using margin, you now magically have the same number of dollars in your account, but more stock than you had before. This practice is called trading on margin. Does it sound risky? You had better believe that it is, if it's done in an uncontrolled fashion.
When using margin the need to have an airtight plan and the discipline to follow that plan is doubly important. Even then, people can and do lose money trading on margin, because you can never tell what will happen in the stock market. However, if you do have a reasonable plan and discipline, you can obviously make a lot more money in stocks than you can by trading from a 100% cash position. If you try trading on margin, you can lose a lot more money than you could on a cash-only basis. So, be aware of the risks of margin as well as the potential.
To effectively use margin, the first, most important rule is that you never borrow money in order to add more shares to a losing position. If you are carrying a losing position on anything, it is by definition trending downward at least from your entry point. We already concluded that we didn't want to buy into down trending stocks even when trading from a cash position. We certainly don't want to add to any losing position, and with the ability of margin to magnify gains and losses we must be especially careful not to add to a losing position when we are borrowing to do it.
Plus the use of the maximum allowable amount of margin leverage also means that if the position moves against you, you are likely to lose a huge amount of your account equity, in other words the part of the account you actually own. In fact, with margin you can actually end up losing more than all of your money, under the most extreme conditions.
So, our rule for use of margin will be: To control our use of leverage, we will choose our initial position size in a stock so that we will always have enough cash on hand to make our initial purchase and half of our second purchase, without borrowing anything.
How Do You Trade CFD's?
CFD’s are an alternative to conventional trading.
The concept of CFD trading is simple. If you think a market is set to rise you buy at the top end of our quote (the offer price), or if you think the market will fall you sell at the bottom of our quote (the bid price).
Your position is a contract: you never actually own the instrument you are buying. The important fact is that when you buy you want the price to go up, and when you sell you want the price to drop.
Please note that trading CFDs is a leveraged investment strategy, which can carry a high risk to your capital. We recommend that you only trade with money you can afford to lose, that every trade must have a stop loss and that you do not invest any more than 20% of your capital in any one trade. Please refer to our Risk Disclosure, Disclaimer and Financial Services Guide prior to trading this financial product.
Short Trades (Short Position)
How do you Place a Short Trade?
We think that the share price is going to fall therefore we go short and sell XYZ shares. We decide to sell 1,000 CFD shares for the XYZ Company which is currently trading at $12.75.
1,000 CFD shares at $12.75 gives us a total position of $12,750 (1,000 x $12.75 = $12,750).
As the margin requirement for the XYZ Company is 10%, we only need to allocate 10% of the total investment from our trading account as a deposit. Therefore 10% of $12,750 is $1,275. Our total contribution towards this CFD trade is $1,275.
How to Close your Short Position
The share price for XYZ Company falls to $12.05. We exit the trade and take our profit. We buy 1,000 shares at $12.05 and close our position. To calculate our profit we need to multiply the total number of shares purchased by the profit achieved from the trade. We have achieved a $0.70 profit ($12.75 - $12.05 = $0.70). 1,000 shares multiplied by $0.70 equals $700. This represents our gross profit for this trade.
Please note: The example does not include brokerage or interest charges. For information on brokerage & interest rates please contact your broker. To calculate your net profit for the transaction you would have to deduct the brokerage and interest charges from the total profit shown above. Please note that trading CFDs is a leveraged investment strategy, which can carry a high risk to your capital. We recommend that you only trade with money you can afford to lose, that every trade must have a stop loss and that you do not invest any more than 20% of your capital in any one trade. Please refer to our Risk Disclosure, Disclaimer and Financial Services Guide prior to trading this financial product.
Short Trade - Total Investment in the Trade
Share Price x Number of Shares Purchased x Leverage Amount
Short Trade - Calculating Gross Profit/Loss in the Trade
(Entry Price – Exit Price) x Number of Shares Purchased
Long Trades (Long Position)
How do you Place a Long Trade?
We think that the share price is going to rise therefore we go long and buy XYZ shares. We decide to buy 1,000 CFD shares for the XYZ Company which is currently trading at $12.75.
1,000 CFD shares at $12.75 gives us a total position of $12,750 (1,000 x $12.75 = $12,750).
As the margin requirement for the XYZ Company is 10%, we only need to allocate 10% of the total investment from our trading account as a deposit. Therefore 10% of $12,750 is $1,275. Our margin contribution towards this CFD trade is $1,275. This is the amount that will be deducted from our trading account.
How to Close your Long Position
The share price for XYZ Company rises to $13.65. We exit the trade and take our profit. We sell 1,000 shares at $13.65 and close our position. To calculate our profit we need to multiply the total number of shares purchased by the profit achieved from the trade. We have achieved a $0.90 profit ($13.65 - $12.75 = $0.90). 1,000 shares multiplied by $0.90 equals $900. This represents our gross profit for this trade.
Please note: The above example does not include brokerage or interest charges. For information on brokerage & interest rates please contact your broker. To calculate your net profit for the transaction you would have to deduct the brokerage and interest charges from the total profit shown above. Please note that trading CFDs is a leveraged investment strategy, which can carry a high risk to your capital. We recommend that you only trade with money you can afford to lose, that every trade must have a stop loss and that you do not invest any more than 20% of your capital in any one trade. Please refer to our Risk Disclosure, Disclaimer and Financial Services Guide prior to trading this financial product.
Long Trade - Total Investment in the Trade
Share Price x Number of Shares Purchased x Leverage Amount
Long Trade - Calculating Gross Profit/Loss in the Trade
(Exit Price – Entry Price) x Number of Shares Purchased