‘Trading 101’

Trading…

Bull And Bear Street

  • Uses ‘Technical Analysis’ primarily to decide upon the suitability of any trade
  • Involves Short Term Positions i.e. anything from a just a few minutes upwards
  • Uses Leverage provided by a broker to facilitate control of far more of an asset to maximize profits
  • Uses Stop Loss Orders to limit losses
  • Means Going ‘Short’ As Well As ‘Long’ or in other words selling as well as buying
  • Uses Derivative Products to profit from price movements including spread betting, CFDs, and futures

Trading Uses ‘Technical Analysis’

Technical Analysis is the study of market charts and the patterns that form within them. These patterns can give traders clues as to the likely future direction of price, providing the information they need to place a trade.

Meanwhile traditional investors such as Warren Buffett, focus on company fundamentals (the numbers found in company balance and P&L sheets) using Fundamental Analysis to make their trading decisions.

Some traders may also use fundamental techniques alongside technical analysis.

Trading Involves Short Term Positions

Traditional investors typically take a longer term view, holding positions for months or even years. Trading on the other hand facilitates taking positions that can last anywhere from a just a few minutes upwards.

 

Trading Uses Leverage

Trading using leverage is little different to buying a property with aSilver Bull And Bear mortgage.

In the same way that you might purchase an expensive house by taking a mortgage out with your bank for the additional money, your trading broker will extend to you leverage to buy more of a stock or currency than you might otherwise be able to afford.

Whilst a bank requires that you provide a deposit of  typically 10-20% of the property value, your broker requires a much smaller deposit or ‘stake’, usually just 1% or maybe even less!

By putting down this deposit you in effect control the whole asset and when you sell the property/asset you also pocket any profit.

Example 1: Going ‘Long’ with leverage (stocks)

Stock BoardLet’s say we have a broker who is offering leverage of 100:1. Normally to buy 1 share of ‘Company A’ with a share price of 100p we would need 100p. However using our broker leverage we can buy 1 share of Company A with just 1p (the broker provides the other 99p). Therefore we are free to use our 100p to control 100 shares in this way.

If the share price rises to 200p then normally we would have made 100p profit from selling our 1 share, but because we used leverage to buy 100 shares:

Profit = 100 shares x 100p = 10,000p or £100!

We have used the same amount of capital (100p) but received 100x the profit!

Because the 100p rise in the stock price gives us £100 profit our stake for this trade was really £1 per point (1p provided by us with 99p provided by the broker i.e. 100% leverage).

However had the situation been reversed and the share price fallen to zero, then our leveraged trade would have resulted in a loss of £100.

Leverage whilst a powerful profit making tool is also a double edged sword!

Example 2: Going ‘Long’ with leverage (forex)

We wish to ‘go long’ or buy the EUR/USD currency pair by buying 100,000 Euros at the current market rate of 1.2130. At 100:1 leverage our broker takes just €1,000 worth of US Dollars from our account as the margin/deposit needed for the purchase, whilst he lends us the other €99,000 worth of dollars required.

Trade EUR USD
You buy 100,000 Euros at the market exchange rate of 1.2130 +100,000 -121,300
1 day later, you sell your 100,000 Euros back at the new market rate of 1.2210 (up 80 pips) -100,000 +122,100
Profit on the trade = $122,100 (sale price) – $121,300 (original cost) = +800

The table above shows that the exchange rate between the Euro and the US Dollar went up over night 80 pips and we sell at the new rate of 1.2210 giving us a profit of $800.

As in the stocks example, had the situation been reversed and the exchange rate fallen 80 pips before selling, we would have lost $800!

Leverage is a double edged sword and whilst leverage allows traders to make exaggerated profits, it has the same effect on losses too. Of course with outright asset ownership (e.g. buying shares) any loses are simply limited to the total price you paid for the stock i.e. if the share price slides to zero.

When using leverage therefore, it is critical that traders understand that it is possible that you can lose more than you originally staked on a trade. However, losing more than your deposit is generally reserved for where markets have a closed period and company/asset news released after market hours causes price to open at a very different level to that which it closed, called gapping.

Example 3: Leverage and gapping

The London Stock Exchange (LSE) is only open between 8am and 4.30pm, Monday to Friday. On Monday at 4.30pm Company A’s share price closes at 100p per share. At 5pm they announce to the market the loss of a major client and stream of revenue. On Tuesday morning at 8am Company A’s share price opens/gaps down 30% at 70p.

If you had bought this stock and had a stop loss at 80p it would not have been triggered as price never moved through this level. Consequently your broker would have closed the trade for you at the opening price of 70p, losing you more on the trade than planned for.

Serious gapping in the forex market is rare however due to massive liquidity and the fact that the forex market only closes at the weekends.

In conclusion, whilst capital protection mechanisms exist such as stop loss orders and broker margin calls, fundamentally no-one should ever trade with money they can’t afford to lose.

Trading Uses Stop Losses

Stop loss orders close trades that are going against you, protecting you fromStocks Down further loss.

As trading involves potentially large and unknown loses, every trade should incorporate a stop loss order placed at the same time as your entry order, i.e. a stop loss is never an afterthought and trading without one is tantamount to suicide!

Stop losses can’t protect you from gapping but remember that severe gapping is rare, can also work in your favour, and is partly avoidable by not trading when scheduled news is near or by closing trades before the market closes.

Trading Means Going ‘Short’ As Well As ‘Long’

Buy Or SellIn trading it is possible to profit from both downward as well as upward movements in price. In trading speak this is called ‘going short’ (selling) as well as ‘going long’ (buying).

If you buy a house for USD100,000 anticipating an upturn in the property market and consequently sell it next year for USD200,000, you have ‘gone long’. Alternatively if you believe the property market is going to crash and sell your house for USD200,000 only to be able to buy back an identical one later for just USD100,000, you would have ‘gone short’.

Profiting from buying stocks is easy to understand, but when profiting from short selling stocks it is simpler to understand how it works by thinking of  it as ‘borrowing stock from a shareholder to sell, with an obligation to return it at some point in the future’.

Example 4: Short selling stocks

Company A’s share price is currently 100p but we believe it will fall. Through our broker we ‘borrow’ 100 shares from a shareholder and sell them at 100:1 leverage. Sure enough the stock price has falls to 50p and we buy them back and return them to the shareholder. The shareholder has his shares back and our profit = 100 shares x 50p = £50

In forex however, it’s not actually possible to ‘go short’ as every currency transaction must involve selling one to buy another. For example going short on the EUR/USD pair (selling Euros to buy US dollars) is identical to going long on the USD/EUR pair. In reality though most currency pairs are expressed in a standardised way i.e. it’s nearly always referred to as EUR/USD, hence the going long or short simply states the direction of the trade.

Trading Uses Derivative Products

Whilst it is possible to trade by making outright purchases of assets e.g. shares, trading really comes into its own when using leveraged products such as Spread Betting, Contracts For Difference (CFDs) and Futures.