Article: Introduction to Trading
This section provides an overview of trading the markets using a spread betting platform.
Both trading and investing are methods for making money from the financial markets.
- Investing - the accumulation of wealth by gradually buying and holding a portfolio of shares and other investment instruments.
- Trading - the frequent buying and selling of shares, currency pairs, commodities or other instruments.
The goal of trading is to generate returns that out-perform buy-and-hold investing. Unlike investing, trading typically involves both buying and short selling.
Spread betting is very similar to trading in most respects. It involves taking large long or short positions in the same instruments using leverage and attempting to profit from price movements. The most obvious difference between the two is that in spread betting the underlying instrument is never owned. You are simply 'betting' on the direction of the price movement. Because of this, spread betting is officially classed as gambling, so currently all profits are tax free. Due to the fact that the two are so similar, and given the stigma attached to the term 'Betting', I will use the term 'Trading' for the rest of this article although I am strictly speaking referring to spread betting.
I should point out that a great many FOREX traders actually prefer to use a spread betting platform for trading. The spreads are very tight these days and are comparable to those you get from a broker. Spread betting is simpler and also the profits are tax free. It is worth noting that the profits are only 'tax free' if you have another source of income which is sufficient to live off, otherwise you would be liable for income tax.
There are a number of important aspects to trading that can adversly affect the profits you are expecting to take for any given trade.
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Spread - The money you gain or lose from price movements is 100% yours. The broker makes all its money up front in the form of the spread associated with a trade. The lower the liquidity of the instrument you are trading, or the more costly the trade is initiate for the broker in terms of commission etc, the wider the spread will be. Major Forex Pairs and Indices have the tightest spreads.
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Margin - Each trade you enter will have a margin associated with it. That is the amount of money you are required to pay up front to secure the underlying asset, while borrowing the remaining amount. The margin is reserved and, although you are unable to trade with it, it is returned in full once the associated position is closed. Margin requirements are increasing significantly this year under new EU legislation.
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Slippage - When opening or closing a trade, whether you made a profit or a loss, you cannot guarantee the actual price you will get. The difference between the price you expected to get, and the actual price the trade executed at, is called slippage and must be allowed for in any trading strategies you formulate.
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Gapping - When entering a trade, you need to understand the underlying instrument as much as possible. Gapping is the situation where an instrument closed at one price, then opens at a different price when trading commences the following day. The can lead to serious losses if not sufficiently allowed for in your trading strategy.
- Forex - As the currency markets are generally 24/7, and due to the liquidity, you are least likely to have any gapping with the major currency pairs. Be aware though that minor pairs with less liquidity are more at risk.
- Shares - Shares are much more at risk from gapping, and any strategy involving them must take in to account the possibility of a sudden overnight shift in price, typically due to news associated with them.
- Indices - As indices are a basket of shares, although there is a slightly increased risk of gapping overall, the size of any gap will be much less as it is offset by the other shares in the basket (assuming they have not all suffered a gap at the same time!).
- Commodities - Similar to shares, commodities have a greater risk of gapping. They are however traded in high volumes, and the resulting liquidity makes them quite appealing to trade.
Trading can be emotionally exhausting. Each trade has a potential to lose you money, and it is important to realise up front that a fundamental part of trading is the knowledge that you will be losing money on trades - constantly. Each trade you enter into has a 50/50 chance of making or losing you money. The whole idea of a trading strategy is to improve these odds in your favour with an understanding of the markets. However good your strategy is though, it will lose money as well as make money. The actual amount of money you can expect to make overall is based on how well your strategy improves the odds.
For example, if you can improve the odds on each trade to 60/40, after 10 trades your profit will actually be that of just 2 trades (6-4).
With the knowledge that you will be losing money as well as making money, you will need a significant amount of initial funding to cover the losses. There is a basic rule to use when entering a trade - the loss associated with the trade should be no more than 5% of your current balance. This is an absolute limit, and it may be more appropriate to restrict your trading to 2% or 1% depending on your risk appetite.
- 10% loss per trade = 10 trades to lose all your money
- 5% loss per trade = 20 trades to lose all your money
- 2% loss per trade = 50 trades to lose all your money
- 1% loss per trade = 100 trades to lose all your money
For example:
- £10,000 funding, with a 60/40 profit/loss ratio and risking 5% loss per trade = £1000 profit for every 10 trades
- £40,000 funding, with a 60/40 profit/loss ratio and risking 4% loss per trade = £3200 profit for every 10 trades
- £100,000 funding, with a 60/40 profit/loss ratio and risking 3% loss per trade = £6000 profit for every 10 trades
Note that the £6000 income from the third example above is tax free and if it was all you made each month, it is the equivalent to a £115,000 a year salary!
To start trading with a small amount of initial capital is only worth doing if you will be trading multiple times every working day.
At the very top level there are two different approaches to trading.
- Fundamental Analysis - The analysis of news reports and company data such as financial statements and earnings to uncover mispriced securities.
- Technical Analysis - The analysis of price charts, looking for patterns to identify trends and make predictions.
As fundamental analysis is used more often in longer time scales it may not seem relevant to you, especially when writing an automated trading system. However the release of certain national fundamental statistics such as nonfarm payrolls in the US, can be invaluable in timing entry to or exit from a trade. Whatever instruments you are trading, it is helpful to research when major statistics are released concerning those countries or companies and analyise how the market typically reacts. The basis of an automated trading system however is technical analysis. Strategies are typically built on one or more technical indicators to time entry to and exit from a trade. There are a number of markets on which you can perform technical analysis There are two aspects to technical analysis:
- Patterns - Actual patterns formed by the price candles on a chart.
- Indicators - Values derived from recent short or longer term price movement.
Before you start writing an automated trading system, you really need to study and become comfortable with a whole range of basic technical patterns. Which ones you decide to use will ultimately depends on your style of trading, however understanding each of the patterns and identifying them in historic market data will help refine your strategies.
- Triangle Pattern
- Rising / Falling Wedge Pattern
- Head & Shoulders Pattern
- Cup & Handle Pattern
- Flag & Pennant Pattern
- Double Top / Double Bottom Pattern
I do not intend to detail each of these patterns, however I will provide a recent example of my favourite: The Triangle Pattern.
A very common pattern is the triangle. It occurs in all time periods, whether looking at daily, hourly or minute candles and the more well established the triangle becomes, the better the probability of a sustained breakout.
GBP/USD Hourly Chart - Jan/Feb 2018
- Thu 11th Jan @ 1pm - The triangle formation began.
- Thu 22nd Feb - The triangle is clearly established and a (very minor) false breakout occurs.
- Thu 27th Feb @ 1pm - Breakout finally occurs.
In this case the triangle is very firmly established when breakout occurs. There are four consistent highs on the top of the triangle and four consistent lows on the bottom, allowing for the false breakout. I personally entered the trade just after the breakout started at 3 and made a tidy profit. Take note from this example just how accurately the triangle can be drawn against the points. It is uncanny and slightly unnerving how closely it fits! Only the major currency pairs typically have this level of accuracy. In case you think this is just a one-off, check the following charts out:
GBP/USD Hourly Chart - Tue 28th Nov -> Wed 27th Dec 2017
GBP/USD 4 Hourly Chart - Wed 21st Jul -> Thu 16th Nov 2017
All this being said, do not get so obsessed with one or more patterns to the extent you start seeing patterns where there are none or where they are only very weakly established. This is one of the many classic mistakes that cause inexperienced traders to fail.
Alongside patterns, technical indicators are a very popular way of predicting price movement. Many analysts are highly sceptical of indicators, saying that they typically predict a movement once it has already happened. This is to some extent true, so your use of indicators should be very well researched and carefully applied.
- MACD (Moving Average Convergence/Divergence) Indicator
- RSI (Relative Strength Index) Indicator
- OBV (On Balance Volume) Indicator
- Scholastic Oscillator
Indicators typically produce buy or sell signals, giving traders a hint at the likely direction the market will take at any given moment. There are a lot of indicators to choose from, although a great many of them are very similar. Keep it simple and backtest thoroughly to understand the benefits and possible issues with indicators.
A fundamental part of formulating any trading strategy is backtesting - that is applying your strategy to historic data for the instruments you are interested in trading. You will want to get access to data with as much granularity as possible.
- Tick Data - this is the best quality data, as it provides every individual price tick. This data is the most expensive to acquire and will consume the most disk space and/or memory in your software and take the longest time to apply to any strategy.
- 1 Minute Price Candles - this is still useful data, aggregating each minute of price activity in to a single price candle and much easier to get hold of. The downside of this data is that you will not know how many ticks occurred in any given minute so it can provide slightly inaccurate results when applied to your strategy. When working with anything other than tick data, you should always take a worst-case approach to processing the candle.
Data that is any coarser than this is almost certainly not worth using for backtesting. You really need to the finest level of detail you can get access to in order to guarantee the most accurate results from your backtesting algorithm.
I have read over and over that to become a successful trader you must invest a LOT of time in learning about trading and the markets. The majority of traders fail very quickly when they first start, some in truly spectacular fashion, because they simply have not put in enough effort to understand the markets and are burned badly.
- Understand how FX, Indices, Shares & Commodities differ and select just one category to study in detail before you even consider placing a trade.
- Don't bother with expensive courses, there is such a wealth of information out there these are just a waste of money.
- Read as much as you can about the instruments you will be trading, trying to find articles by genuinely successful traders (there is a lot of hot air out there) and experiment with any that catch your attention to see if they work and suit your risk attitude.
- Never believe any traders who are on to a sure thing or making incredible profits, by preference study strategies from those whom are making a modest profit overall as they are more likely the real thing.
- Try to understand what your trading style is. Fundamental or Technical? Risk taker? Emotional? Understand where you strengths lie and what your weaknesses are and do your best to compensate for these.