Trading – The art of scientific risk management
“In this business if you are good, you’re right six times out of ten. You’re never going to be good right nine times out of ten”- Peter Lynch
In our previous blogs, we learnt about investing, various asset classes like stocks, bonds, gold, real estate and cash, went in depth into stocks and bonds and learnt about derivatives like futures and options. What do we do with all this information? We use it, of course. We use all that we have learnt and put it to practical use in trading and investing. In this blog, we learn about the various types of trading and some more information on the two ways of determining how, when and what to trade or invest in.
Trading at a fundamental level is simply buying and selling of an asset or commodity, in this case stocks, bonds or derivatives. You trade in the anticipation of making a profit. For that you must buy at a lower price and sell at a higher price. In case of stocks, we can short sell as well allowing us to sell first and buy later but it works on the same principle. In short selling, you sell higher and wish to buy lower to make a profit. That is all there is to achieve in trading. While it sounds simple, in reality, trading can be quite complex and complicated. Experience however trumps all theoretical knowledge. So if you are looking to learn trading, try opening an account with We Bull or Robinhood. Deposit a small amount that you can afford to lose and get started right away.
So there are four types of trading methodology based on the timeframe in consideration and they are as follows:
Trades that take place in a matter of seconds to a few minutes
Day trading or intraday
Trades that take place in a single day. One enters and exits within the same day
Trades that take place over few days to weeks.
Trades that take place over weeks and months. Investment is a form of positional trading that takes place over years and decades.
Scalping is an extremely quick and rapid form of trading most suitable for experienced traders with access to high speed internet and advanced, powerful computers. It involves opening and closing trades in seconds to a few minutes in order to capture small differences in stock prices. For e.g. a scalper may place a buy order on Apple at $130 and exit it a couple of minutes later when it reaches $130.5. Similarly, if the stock goes against him/her, he will be quickly booking losses as well. In this case, if the stock moves to $129.5 the scalper will quickly close the position even if Apple were to go back to $130 a couple of hours later.
Scalpers take this kind of trades numerous times throughout the day, every day. Due to them capturing small movements, they need the difference between bids and offers to be extremely small which is possible when the stock is liquid. (Liquidity in stocks means lots of buyers and sellers for it along with lots of market activity. Apple being a large and popular company will have a lot of liquidity as compared to John Wiley & Sons which are not as popular and thus less liquid).
Since scalping takes place in matter of few seconds to minutes, the amount of time spent in the market is very less thus reducing exposure to market risk. They will be saved from erratic market movements or volatility as it is known as scalping is akin to simply dipping your feet in the sea while sitting in a boat and pulling them back up once they are wet. You don’t get exposed to the waves. Also scalping relies on smaller moves which are often easier to obtain. Doing this multiple times adds up profits.
The high frequency of trading increases costs. When trading, there are costs associated which include brokerage, spreads (difference between bid and offer), taxes on trading and various transaction charges. These eat into the profits leaving behind much less than what you thought you had earned. Also the costs and charges are deducted irrespective of loss or profit. So not only do you lose money on your profits but your losses are magnified by the added costs. Also sometimes, although rare, it is easy to fall into the sea while simply trying to dip your feet. Similarly, it is possible to get caught in a sudden market movement, where liquidity dries up and one is unable to exit. That is why the focus on highly liquid stocks.
Nonetheless scalping remains a preferred mode of trading for those with access to the resources and today we have High Frequency Trading firms capitalizing on lighting fast speeds to make millions of dollars.
Day trading is a trading method where one opens and closes trades within the span of one trading day. USA requires a day trader to have minimum $25,000 in their account. Day traders like scalpers look to bank on quick movement in their traded assets but are willing to hold for slightly longer in order to capture a larger profit. However a larger profit comes with a relatively larger loss as well. For e.g. a day trader may place a buy order on Apple at $130 and exit in a few hours or end of day at $132-$134. However at the same time he may have to book a loss if price goes down to $128-$126. When to book a profit and when to book a loss are all defined by certain rules for management of risk. We shall look at some risk management rules in subsequent posts when we dive in depth about trading.
A day trader may take numerous trades during the day, every day but it will be relatively lesser in number than scalpers. Day traders too require liquid stocks in order to capture as much profit as possible without having to give it up in spreads. More than liquidity, what day traders require are stocks with lots of action in them. Stocks with events like results or some news announcements coming up will tend to move a lot and a wide movement provides ample opportunities for day traders. Day traders do not like stocks that are calm and silent. For e.g. a stock that moves $10 a day up and down is preferred to a stock that moves only $1.
Since day traders close their trades at the end of the day, they do not face any overnight risk. Overnight risk is the chance of loss incurred by adverse market movement due to any event that occurs after market hours. For e.g. say you decide to buy a pharmaceutical stock. In the night, the pharmaceutical company releases bad news about one of their drugs and that they are facing litigation. Now next morning the stock will open down and may continue to go down. There is nothing one can do before the market opens and one has no option but to take a loss. In the above example, you purchased the stock at $100. Due to the negative news, the next day the stock opens at $70 and goes down from there. So the $30 loss is the minimum loss you have incurred. If you don’t sell immediately, your loss might go on increasing. Day traders do not have to face these risks as they open each day fresh, taking trades only after market has moved.
Day trading requires much less capital than investing and other forms of trading except scalping. Brokers usually provide leverage which allows you to trade more than your account because they know that you will close the trade the same day. For e.g. with $25,000, one can trade assets up to $100,000. However we would once again like to inform our readers that leveraged trading is risky and may lead to loss of capital.
Just like scalping, day traders have to incur costs for the multiple transactions they do which tends to eat into profits. Also short term movements can often be erratic and volatile which often leads to one booking losses whereas the overall trend would have led to a profit. In order to succeed at day trading, it requires a total commitment to the trading screen for the market hours which a very few people can give either because they do not have the time or discipline or they cannot spare time from their day jobs. Finally day trading is a risky activity with extremely low chance of consistent success. Only 10% of day traders succeed, most of them professionally backed by large institutions. As a day trader, not only are you competing with other traders like yourself but also with large banks and institutions who are looking for an opportunity to make a meal out of you.
Day trading continues to remain attractive for all those entering the market but it is recommended to take this up after some experience investing and experiencing the markets.
Swing trading is a trading method where a trade takes place over several days to a week. Prices tend to swing from one point to another on longer time frame charts. For e.g. here is a chart for Amazon
The above chart is of Amazon’s stock and as one can see, price has moved from $3,350 on the higher side to $3,050 on the lower side and bounced between several times. A swing trader will try to short sell at $3,350 and try to exit it and buy more at $3,050 and again sell and short sell at $3,350. The trader is trying to profit off the “Swings” and hence the name swing trading. Swing trading is relatively easier than day trading as in one need not exactly time the market and a large profit movement allows for imprecise trading. The swing trader looks for larger profits as he has to take on larger risks and subsequently face larger losses as well.
Since a trade can last for several days, swing traders don’t need to trade every day. They can also trade less liquid stocks with ease since they are not affected by spreads nor do they need to take a large position at once.
The biggest advantage that a swing trader has on his/her side is time. Trades often need time to work themselves out. Prices don’t often move in a straight line or the way we wish them to. In scalping and day trading one is bound by the time in a trade and often has to exit, at a loss, those trades which if given enough time, would have worked in their favor. Because there is often no leverage in swing trading, one has to use their own cash which allows for a smaller sized position and thus smaller risk.
Swing Trading by the virtue of its nature involves holding positions overnight and thus exposes a trader to overnight risk. Since swing trading takes place over days, one can often miss out on opportunities in between because they are already in a trade. The number of trading opportunities are also limited and one gets less chances to put their money to use.
Swing Trading remains quite popular amongst beginners and veteran traders alike and those with large capital use it to compound their returns with proper risk management.
Positional trading is a trading method where trades take place over several weeks to months. In investing they take place over years. One holds for multibaggers (i.e. a stock price rise multiple times of its initial price) and the holding period can be variable and very long. For e.g. those that purchased amazon. For those that purchased Amazon on 1st February 2001 at $10 are now enjoying its price at $3376 as of 3rd February 2021. That is 300 times the price paid. $10,000 in Amazon in 2001 became worth $3.3 million today. However large profits also come with large losses and positional traders often face the risk of stock price going to zero.
Positional traders rarely trade every week, let alone daily. Trades often don’t take place for months. Sometimes, if the stock price falls, they might add some more quantities to their existing trades, but that is the extent of it.
In the long run, the markets have always gone up. No doubt about that. Positional trading puts one on the right side of the trend allowing for it to capture the market movement. Since the holding period is long, positional traders are not affected by small price movements and instead use those to get a better price on their positions. It is also conducive for a buy and hold strategy and those that wish to invest their money and forget it can adopt this style
This style of trading banks on time being in your favor and since it can take years for a position to succeed, it can mean years lost should the position fail. In case of our example on Amazon, if the stock had failed, that would be 20 years wasted, 20 years that people don’t have. Positional trading also has a serious risk of losing all your money since the stock can often go to zero as well. Finally positional trading requires deep understanding of the business one is looking to trade or invest in and that is not possible for a lot of people.
Now that we know the different types of trading styles in play, in our subsequent posts we shall look at various types of orders in the market as well as a post on the type of analysis required for each style of trading. To trade, one would need a brokerage account so if you haven’t opened an account yet, why not do it with We Bull and Robinhood who offer online account opening, superior connectivity and tons of analytical tools that will help you trade better.