Best Thread The Basics of Trading

[FTSE Beater]

The Secret to Trading

Hi all

I thought it was time 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,

Money management is king. In the land of the trader, money management has ruled and killed all the traders who don’t believe in it.

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:

<table border="1"> <tr><td>%Win</td><td>Trades</td><td>Avg Win</td><td>Avg Loss</td><td>Profit</td></tr> <tr><td>75%</td><td>100</td><td>£800</td><td>£2000</td><td>£10,000</td></tr> <tr><td>50%</td><td>100</td><td>£800</td><td>£600</td><td>£10,000</td></tr> <tr><td>25%</td><td>100</td><td>£800</td><td>£133</td><td>£10,000</td></tr> </table>

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

<table border="1"> <tr><td>% loss &nbsp  </td><td>% gain needed<br>to break even</td></tr> <tr><td>10%</td><td>11%</td></tr> <tr><td>20%</td><td>25%</td></tr> <tr><td>50%</td><td>100%</td></tr><tr><td>80%</td><td>400%</td></tr> </table>

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 your 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

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 hopefully find someway of explaining it next week.

If we have a look back at the chart of AAL from last week, we can see that at the close on the 24th January we would have had this risk profile.

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 who’s 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 your actually trading.

The accepted level of risk amongst 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 risk!! When your risk increases, any bad run that you have will be magnified beyond your control.


The chart I would like everyone to look at this week is BAY (British Airways) over a 6 month period on a daily chart. The advfn.com url is http://www.advfn.com/cmn/chrt/chrt_...0&ind1_2=&ind2_2=&ind_type3=0&ind1_3=&ind2_3= and if you need help posting up a chart, then this thread should help you. http://www.trade2win.co.uk/boards/showthread.php?s=&threadid=4624

As with the AAL chart, please draw in any support, resistance or trendlines that you think are relevant, and give a breakdown as before with,

An explanation of the trendlines drawn.
Trade : Buy now, Sell now, Buy at x price, Sell at x price or stay away
Risk profile with: Entry price, Target, Stop-loss and the Risk / Reward Ratio.

As always there is no wrong or right answers and I would love to see your analysis.

Take care,

 

[JonnyT]

I'd be looking for some short term strength...

JonnyT

 

[ChartMan]

Here's my take on BAY. I haven't done TA on EOD stocks for a long time so don't take this as gospel, but follow the reasoning..... Firstly, one of the powerful TA formations is Negative or Posative Divergence- go look this up in the archives if you don't undertand the terminology.
Secondly, there is a rule that says 'history repeats itself, and each instrument has it's own characteristics'.
So here we have BAY showing Positive divergence in the price. NOW go back in time and see if the price responded in the past to Positive divergence. Answer, yes it did on at least one occaision.- Around Nov 1999 - look back further at your leasure. Notice also there was a responce to Positve Divergence in July 2000.
OK so now we have that bit done. We can assume that the price is now more likely to go up than it is to go down ( Is that a wise assumption in this climate?). OK let's go long, but what about the R/R? The risk is a drop below 100, so that's 14p. Give yourself some breathing space so say 95p....19 p away from 114p. The reward is , worst case, is 141p- downtrend resistance. You CAN'T assume the price will go beyond this value. That's a reward of 27p. So the R/R is 1.5. That's just no good at all , especially as you have a potential BIG drawdown of more than 10% to get to support.
Now here's the crunch. Patience.Why not put it on your "watch list" for a price of 145p? There is a triangle formation that may break to the upside through 150p. At this point we have a viable trade. The risk will be the value of the downtrend resistance line, which after the breakout will become support! This will be in the order of 140p. The reward will be around 190p, horizontal resistance, as drawn. This gives a R/R of 4:1. 10p down , 40p up.
You may think this is tedious, but it will win hands down over the "pin the tail on the Donkey"
An alternative possibility. Go long now, on the basis that the price IS at support, on a minor uptrend. Stop at 105p R/R is 2.5 :1. Not my cup of tea .)
If you didn't read it, take a look at my Dow analysis on Friday under Indicies. The Dow had a nice R/R 8:1 on a triangle breakout.

 

[FTSE Beater]

Hi all.

First things first. Chartman, I can tell it’s been a long time since you traded EOD. Line charts are fine for 1 minute data, but useless for EOD charts - Unless your one of these newspapers who enjoy doing a dot to dot chart on the FTSE 100 to show all the people in the street what has happened

Hi Splurge

Thank you for your kind comments, and for any new traders out there, I think Splurge sums up how important this subject is.

Hi Fluke.

What JonnyT is saying is that the price has dropped quite a way and eventually the selling pressure runs out and people start buying it back up again, and after a major sell-off, you don’t want to be shorting because it could turn at any time. In the short-term it looks like it might bounce, and as Chartman pointed out there is some divergence. Which is something I will be looking at in a couple of weeks time.

Chartman makes a very good point. As I just said, we can’t really go short, and as Chartman says, the risk is too high to go long. We can’t trade BAY at the moment, so we look for a “Safe entry” or a point at which the risk / reward ratio comes into our favour. This is where the waiting comes in, it could take weeks for the price to enter a safe trading zone, but then the markets reward good safe entries, and not the gun-hoe approach.

My personal view on the chart is this.

The support level (Which now becomes resistance) is at 130. So say the price hit 130 and started to fall again, to say 125. If you short at 125 then the risk / reward profile looks like this:

Entry Price: 125
Target: 100 (the last low)
Stop-loss: 133 (3 points slippage to give the price space to move around).

Reward: 25
Risk: 8
Giving a ratio 3.125:1


Getting to grips with Risk / Reward is hard, and its something that is not learnt overnight, so if anyone wants help with Risk and Reward, then post up a chart with your view on the risk and reward, and I’m sure someone will have useful comments to add. Remember we are all here to help each other.

Fluke, try your hand at the chart for BOC over the last 7+ months. Post a chart up, and we’ll see how you get on. Remember there is no wrong answer. If you would rather not post up a chart (and this goes to everyone) then feel free to email me at [email protected] , but if you can post a chart up, then others can learn from it as well

 

[Bill G]

BAY

It's interesting to note my first resistance lines on the first chart
line up with the Fib lines on the second chart.
It looks like a reversal is taking place possibly on the strength of the positive survey carried out by Opodo ,an online travel service,
Bill

 

[Bill G]

BAY

and the second chart
Bill

 

[ChartMan]

Ftse, I agree about the line/candle, but I wanted to show the Divergence in Nov 99 and line charts give a cleaner look....

 

[Fluke]

Hi FTSEB.
I cant thank you enough,I have understood you explanation,this is exactly what i need to get my head round. I will look at the BOCchart and come back to you.By the way,I thought the 130 level was resistance,you said it is support. Im not criticising you,just making sure I understand how you work.

 

[FTSE Beater]

DOH!!!!!

Yes I meant Resistance. If something is old support which gets taken out (as it has on the BAY chart), then it becomes resistance when tested.

I've edited the post now

 

[monarch]

Thanks to FB this is really good stuff.

I think one important lesson to come out off the last series of postings is the fact that not trading is sometimes hard to do.
I wonder how many people studied your chart and were desperate to find an excuse to trade it.
Beware of trading for trading's sake. I think the post by chartman highlights this, we all need to sit on our hands sometimes and wait and watch.

Nick

 

[monarch]

FB this is good stuff, thanks.

I think one good lesson that has come out of the last series of postings about BAY is not to over trade.
I wonder how many people looked at your chart and tried to make a trade for tradings sake. Sometimes we need to sit on our hands and just watch and wait for positive signals to trade and not make the chart fit our desire to trade.
Avoid overtrading.

Nick

 

[FTSE Beater]

Hi Monarch

The overtrading aspect of risk and reward is something that I hadn't actually thought of.

Risk / Reward really shows when to get in and when to stay out. Most of the time as traders, your watching a stock to set-up and being patient enough to allow the trade to come to you is something that new traders struggle with

Thanks for pointing that out Not sure it was important enough to post twice though

 

[iSquared]

Now I've worked out how to get screenshots of an acceptable size here is my attempt at analysis. I did the homework when requested but haven't posted it till now. Seems an excuse just like I'd use at school ;-) .

Looking at the chart now I wouldn't personally consider it as an entry yet as it is still too far from the trendline and as a result a logical stop the other side of it.

Cheers.

Andrew.

 

[iSquared]

For BOC: Large descending triangle broken to the downside. I'm undecided whether a pulback to R has occured. As such for now I'd pass.

However I would wait for a pullback and a potential 'High Swing Point' If the high touched 790-800 I'd enter a limit short at the low of the previous day ... so if the price made a new low I would have entered a short with a stop at the low of the previous days 'high swing point'. The triangle target is problematical due to the dreaded FA. Normally it is the height of the triangle which in this case is about 1100 less 800 = 300 taking the price to 500 (EPS is forecast about 58p Div 38p so that would give a PE of 8.6 and a Yield of 7.6%). It is not beyond possibility (but might be the end of the Bear!) but is something I like to check to see when the value players might start sniffing. Anyway given that, if I could enter on a bounce from 800'ish I'd have a target of 730. If the triangle was entered again I'd wait for a 'high swing point' from the trendline - same target - closer = higher probability.

Note to any readers - this is not the sort of trading I normally do. I might know the terminology but I haven't got the experience.

Cheers,

Andrew

 

[FTSE Beater]

Hi ISquared

Your analysis of both BAY and BOC are excellent.

The Funndimental side of things went straight over my head, but the TA I could understand

 

[TBS]

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.

Sorry Mark, but this is completely wrong.

A trendline requires two points (not three) the first point should be a reaction low if looking at a bull trend or a reaction high if looking at a bear trend.

The second point is ideally a second reaction high or low, but not necessarily, it may also be a level of support or resistance.

This is used particularly on breakouts, when the price charges up (or down) at an unprecidented and unsustainable rate (and thus is more likely to retrace than anything else). In this situation the trendline is linked from the high or low to a point along the broken support or resistance level, in line with the price action. The reamina like this until a second more established point is made.

Trendlines do not 'work' because 'everyone sees them', I've never read such rubbish!

They are an ever-changing level of support or resistance, points at which the buying pressure or selling pressure is sufficient to hold the price action - giving you your next points in the trend, not the other way around.

 

[Mr. Charts]

There is endless talk on risk/reward in trading/investment literature and forums.
That's fine, but let's think for ourselves here.
All risk/reward sums are without merit other than in spread and option trading.
Why?
Where is probability in this?
You might say you are trading 1000 shares with a take profit target (reward) of $1 and a stop loss (risk) of 25c.
Fine you say, 4:1
Sorry, simply not so.
The calculation is incomplete, totally meaningless in fact, without considering the probability of the two events occurring within any set time frame.
If the probability of the $1 gain is only 20% say, and the probability of a 25c loss is 80%, that rather messes up the maths, doesn't it? Messes up the trade actually.
So if we trade on the basis of R/R we are being self delusional, are we not? ;-)

Mr. Charts

 

[FTSE Beater]

Hi Mr.Charts

I totally agree with you, but as a starting point, you have to understand the risk / reward ratio and the support, resistance and trendlines that put the probability of a winning trading in your favour.

Remember everyone, this is a beginners guide. Nothing more.

 

[Mr. Charts]

Yes, you're right ftse-b, but if people simply follow basics they won't succeed long term. It just isn't as straightforward as that otherwise most would become winning traders and in the real world most fail. But yes, sorry, this was not the most appropriate thread and you do need to learn to walk before you run.
Funnily enough I remember writing a similar series of articles on TA for ESI (which later became E*Trade) many years ago!
I've always found in my coaching that clients need to be taught to think for themselves and think laterally so they can learn to spot the opportunities before the rest of the crowd.
Learn to think and see and understand the forces under the surface - and learn just why most fail at this business so you avoid the pitfalls.
Oh dear, I've gone on for too long again.

 

[FTSE Beater]

Hi Mr.Charts

This really is just the walking stage (if that), but I think it's a good start to trading.


I hope the new traders will realise that this is only a basic guide, and to move onto the really profitable stuff, then you really have to do one on one courses, and learn from the masters