So, you’re yet to take your first cautious steps into the world of trading. You’ve been saving your money and reading articles for a while but rather than clarify your initial course of action you’re more confused than ever. What do I do first? How much money do I need? Is now a good time to start? What are the risks? How much time will it take? These are all good questions. Let’s outline some of the main things you’ll need to have sorted to get you started on the right path.
1. Trading capital (money to invest)
You may have seen those ads for investing in property where you can buy with “no money down”. Well, that’s not going to work here. You’ll need some capital behind you to get started. The most conservative way to get a ‘trading float’ together is through old-fashioned saving. Don’t underestimate the power of saving as a wealth creation tool – just don’t make it your only wealth creation tool.
A question I regularly hear is ‘How much money do I need to get started?’ I think what is really being asked here is ‘How little can I start with?’ The problem with starting with a small amount of money is that your ongoing costs, e.g. brokerage etc. will cut into your profitability much more than if you have a larger amount of capital. For example, if you purchase a parcel of shares worth $3,000 your brokerage could be $19.95 (online brokerage rate) to buy and another $19.95 to sell. This represents 1.3% of your total trade value in costs. But if your parcel of shares was $20,000 your costs in and out would only represent 0.25% of your total trade value ($24.95 buy and $24.95 sell). This may not seem like much, but if you are turning over a lot of trades it all adds up.
Other costs such as guaranteed stop-loss orders are often also set fees regardless of trade size. Another problem with a small amount of capital is you are restricted as to how many positions (parcels of shares) you can hold. This, in turn, makes managing your risk more difficult. So to begin trading with, say, $10,000 is actually more difficult than beginning with $50,000 or $100,000. “But I’ve only got $3,000 saved.” Well, wait until you’ve saved up some more. In the meantime you can educate yourself so you’ll be in-the-know when you’ve got a decent stake together.
To buy and sell shares, you’ll need a broker. There are two types of stock broker (or share broker), full service and discount. I prefer using a discount broker which usually means you can do your trades online without talking to a human. It’s also much cheaper – full service brokers can charge 3 or 4 times the brokerage fees of an online discount broker.
Being able to trade without talking to a human broker also avoids you having to hear their opinion about the actions you are taking and therefore affecting your own psychology.Before online broking was available, my broker was on strict instructions from me to take my buy or sell orders without making any other comments about my trading choices. Mentally, I tried to imagine him as an order-taking robot (with cool lasers for eyes…) To see who we recommend to be your broker, click here.
3. Charting Software & Data
Before jumping in with your first buy order, you’ll need some way to analyse and search for trading opportunities. There are generally two types of analysis you can employ – fundamental and technical.
Fundamental analysis involves looking at announcements, company balance sheets and profit/loss details. Technical analysis involves reviewing actual share price and volume data on a chart of the stock’s price history to determine the likely direction of subsequent share price action. I am an advocate of technical analysis. I usually ignore all fundamental analysis as it is unclear what actual effect the often subjective fundamental information will have on the share price.
Also fundamental data is notoriously difficult, if not impossible, to quantify when comparing different stocks. Technical analysis, on the other hand, relies on looking at what is actually happening now and can give insight into the market psychology that is occurring. To scan the market for buying and selling opportunities from a technical point of view you will need a charting program for your computer and a source of share price data. For Louise’s recommendations on how to choose charting software and data, click here.
4. Record Keeping
You’ll need to keep a record of your trading activities. You could use something as simple as a spreadsheet program on your computer or an off-the-shelf record keeping program such as Trade Trakker.
Having good record keeping lets you know where you stand at any given moment and also helps your accountant at year end work out your situation with regards to tax.
5. Trading Plan
I was watching a bit of late night TV and there was this show called Dragons’ Den. The premise is that several entrepreneurs (or wannabes) pitch their business ideas to five wealthy investors to gain financial investment in exchange for a stake in their fledgling companies. As I watched, a distinct pattern emerged. Those who had a hobby or interest they thought they should be making money from fronted up asking for financial help but most often had flimsy, pie-in-the-sky figures, no research and a lightweight business plan.
They were usually sent packing as each ‘dragon’ scoffed at their idea and lack of preparation. Then there were the (fewer) true entrepreneurs who had a solid business idea, a well thought out business and marketing plan, robust research and a sound grasp of their finances. In almost every case where this was demonstrated one or more of the wealthy investors took a stake in the enterprise. If you want to be successful as a trader you will need to have a written trading plan. By mapping out what you want to achieve and the procedures you will follow to get there, you will, over time, produce greater profits than losses.
Your plan should include things such as your goals and objectives, your trading system and procedures and how you will measure your performance. What will you do when you go on holidays? What accounting structure will you trade under? How will you handle a windfall profit? All of this needs to go in your trading plan. Once you have a plan, you then need to follow it. This is probably the most difficult part of the process and I’ll leave trading psychology to another time. Louise has a great trading plan template available through the Trading Game. If you haven’t already got a copy, make sure you register on this site and you’ll receive a free trading plan template.
6. An understanding of Charts and Indicators
As I mentioned, I use technical analysis to find my buying and selling opportunities. Technical analysis, you may recall, relies on looking at share price and volume information to determine the market psychology that is driving the trends in the markets and using that analysis to form a view on likely future stock behaviour. Once you have your charting software installed on your computer and you have a reliable source of data to feed into the program, it’s time to look at this information in the form of charts.
Charts display the underlying emotion of the market participants. If the people are predominantly feeling fear that they will lose capital or profits, the share price will decrease and if there is an underlying feeling of greed or hope the price will increase.
The most common form of charts used are bar charts and candlestick charts. Each single bar on a bar chart displays the opening price, the high and low for that period, and a closing price. The vertical line displays the high and low and the horizontal line at the left represents the opening price and the line at the right the closing price. On a daily chart the bar represents one day of trading. Of course you can use shorter and longer time periods for your charts – anything from 5-minute to monthly, or even yearly!Candlestick charts display the same information as bar charts but present a different graphical image. The period’s high and low price are still presented as a vertical line but the opening and closing price are drawn in as a ‘body’. When the closing price is higher than the opening price the body is shaded green (or white on a black and white chart) and when the closing price is lower than the opening price the body is shaded red (or black).
This single period of information looks like a candle with a wick – hence the name. Candlestick charts are quite clever as they give ‘weight’ to the more important information of the period’s opening and closing prices by portraying them as a shaded ‘body’. Also trends are observable not only by direction but by colour. For this reason I prefer to use candlestick charts in preference over bar charts. Now we can use the charts to compare different stocks in a technical process. We can overlay computed indicators on our charts such as trendlines, support and resistance lines, moving averages, momentum indicators and more.
Also we can look for patterns of candlesticks that tell us various things about the underlying psychology of the market and help us to determine the probable future price direction. The Trading Game shop has a huge variety of resources you can use to learn how to read charts and put together a trading system. Of course, attending the Trading Game Mentor Program will shortcut this process and help you build a personalised trading system under the expert direction of Chris Tate and Louise Bedford.
7. Stop losses
It has been said by many successful traders that the rules of trading are:
- Let you profits run
- Cut short your losses
- Keep your position sizes small
- Stick to your Trading Plan
The most ignored rule is cutting your losses short. Most people don’t set a stop loss, or if they do, they ignore it. “Oh, I’ll just give it one more day” they say and when the trade has turned into a nasty loss, instead of closing it like a mature adult, they throw it in the bottom drawer and rename it ‘a long-term investment’. Set a stop loss and stick to it. Your stop loss should be set before you even place you buy order. You can set a stop loss using a variety of methods such as percentage drawdown, pattern recognition or by using a volatility-based stop.
Many of Louise Bedford’s trading resources outline in detail how to choose the best stop loss method for you. Your stop loss acts to keep your loss small if a trade goes against you from the start. It also helps retain any profits you may have in an existing trade. As the share price rises, move your stop loss point up to position just under the latest share price action and when the trend reverses your stop will be hit and you can exit with the majority of your profits retained.
8. Capital Allocation
Most private share owners in Australia own shares in just one or two stocks. Putting all your eggs in one basket is never a good idea. You should diversify (to a point) and spread your capital across a range of stocks from different market sectors. But not so many that you begin to mirror the performance of the overall market. Spreading your money across too many stocks will also increase the level of brokerage fees you pay and be a nightmare to monitor. When deciding how to use your capital efficiently there are several models from which to choose.
The equal-portions model is where you simply divide your capital into even amounts. For example you might have $100,000 capital and decide to split it into 10 even parcels of $10,000 each.
This is a simplistic approach in that it assumes that all stocks are created equal. Trust me, buying $10,000 of NAB shares is very different to putting $10,000 into a speculative mining company that is still drilling for samples. The market capitalisation model compares the size of listed companies based on, you guessed it, their market capitalisation. Take a company’s number of shares that have been issued and multiply that by the share price to get the market capitalisation. The All Ordinaries Index, for example, is made up of stocks over a certain market capitalisation. Many fund managers and institutions also use this factor to determine whether to include stocks in their portfolios. You also could take this into account by allocating, say, 50% of your money to the top 100 stocks (top 100 by market capitalisation – these are generally slower-moving shares and therefore lower risk), 35% to the next 200 stocks and 15%of your capital to the rest of the market.
If you wanted to have 10 positions overall you could then buy, say, 3 positions of $16,666 in the top 100 portfolio, 3 of $11,666 in the next 200 portfolio and the last 15% with 3 stocks of $5,000 each.
9. Trading System
Your trading system outlines the detailed steps you will take to engage the market. It describes how you will enter a trade, how you will exit and how you will size your positions.
We have already looked at stop losses which is your exit methodology. There are other types of signals you could rely on to exit a trade, but the key is, they need to be rule-based.
Many traders spend most of their time looking for the ‘perfect’ share to buy. Often they commit too much effort to this task and neglect the importance of having an exit strategy and sizing their positions sensibly. Looking for an entry signal can be as simple as identifying a share whose price has crossed above a long-term EMA (exponential moving average), that has been laid over the weekly share price. Moving to a daily chart you could then look for a technical signal or pattern that indicates a higher probability of the share price moving higher. Now you’re ready to place a buy order.
Position sizing – How many should I buy?
Assuming you have already determined you will allocate your capital as described above, you would look up the market capitalisation of the company to find out which risk portfolio it belongs in (50%,35% or 15%), and buy the corresponding amount of shares. Another way to size your positions that is used by many very successful traders is “the 2% rule”.
This model aims to limit your loss for any one trade to no more than 2% of your total portfolio. For example, with trading capital of $100,000 you would only risk $2,000 on any one particular trade. To use this method you will also need to determine a stop loss point before placing the trade. Let’s say you want to buy a share with a price of $20.00. You might determine your initial stop loss point will be set at $17.70 – i.e. you are willing to risk $2.30 per share on this trade. If you want to cap the amount you are risking on this trade to $2,000 you can determine the number of shares to buy by dividing $2,000 by $2.30. The number of shares to buy is 869. So the total trade value is $17,380. Just do a quick check that your new position is not larger than 20% of your total capital and you’re good to go.
Some traders, especially ones with larger amounts of capital, use a 1% rule instead of 2%. Whichever you choose, write it down and use it consistently.
To get more ‘bang for your buck’ in the markets you can employ leverage. What this means is that for a set amount of money, you can take on more risk in exchange for the chance of greater gains. The simplest form of leverage is Margin Lending. Most people have heard of Margin Lending as it is (or used to be) aggressively promoted by most of the large broking firms.
The way it works is that a broking firm may have a selection of stocks over which they are comfortable to lend you money. You decide how much of one of these stocks you will buy and they will lend you typically 50% to 70% of the purchase price. The danger is, of course, leverage is a two-edged sword. Whilst your gains may be multiplied on the upside, you can also suffer magnified losses if the trade goes against you. Other forms of leverage can be used via CFDs, options and warrants. I encourage you to learn more about these through your own research. There are some great resources for this at the Trading Game online shop. To read more about other instruments that you can use to get more bang for your buck, read these links:
11. Other Strategies
There is some truth to the adage that the markets spend 70% of the time going sideways. If you only have a system that takes advantage of an uptrending market, what are you going to do when the market is going sideways or down? Fortunately there are some instruments (CFDs, options and warrants) and strategies you can use to make money during these times.
Short Selling When you buy shares (or other instruments) to make money from an uptrending market you are said to be going ‘long’. To ‘short’ the market and take advantage of a downtrend, you can use short selling. Short selling is similar to buying shares, only the buying/selling order is reversed. Instead of buying a stock and then selling it, you sell the stock first and then buy it back at a later time. Sounds weird, hey? What actually happens is you borrow shares that you don’t own (your broker will organise this for you), sell them with the expectation that the share price will drop, then buy them back at a later date. Your profit is the difference between the sell price and the buy price. If the shares drop in value during your trade, you’ll make a profit and if the price increases, you’ll incur a loss. A benefit of short selling is that unlike the options and warrants markets, there is no time decay (bought options and warrants decrease in value as they approach their expiration date).
12. CFDs, Options and Warrants
CFDs (contracts for difference), options and warrants can be employed via different strategies to make money from an up trending, down trending, or even sideways trending market. These tools are an important part of the sophisticated trader’s arsenal.
Any type of leverage is a dangerous thing in the hands of a novice. In nearly all of the collapses and failures littering the battleground of the GFC in recent years, a common feature is the misuse and lack of respect for the power of leverage. Do not use leverage until you have a track record of unleveraged, successful trading. It makes me cringe when I see brokers advertising for new clients with pitches that basically say “Ahh, welcome Mr. New Investor, would you like a margin loan with that?” Although I must admit, it is not as common today as it was a few years ago.
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Trading is not just about how much money you make – it’s about how much you keep. When you become a trader, your business is to buy, hold and sell stock. There are many different market instruments you can trade such as shares, options, CFDs, forex and commodities. You’ll need to find an accountant who understands the tax implications of the activities you are undertaking.
Trust me, there are plenty of accountants who don’t understand how a trading business works. For example, there are specific tax implications associated with whether you define your trading activities as coming under the banner of being an investor or being a trader. Your accountant also needs to have a positive attitude to trading. Having an accountant who is cynical about what you’re doing can damage your mindset. Do your research and find someone who can help.
As traders become more experienced they generally move their focus from the details of what and when to buy to the subject of psychology. Trading will often make you come face-to-face with your inadequacies. Your flaws will be highlighted and your strengths will be minimised. It’s at these times you need to have some background in trading psychology so you can work your way through the inevitable challenges. The aim is to trade in an unemotional manner. Letting your emotions control your trading decisions will have you ignoring your trading rules as set down in your trading plan. Some people justify this sloppy approach and claim to be trading by ‘gut-feel’. This doesn’t work. Admit when you are wrong about a trade. The market is much bigger than you. Learn from your past mistakes, adjust your plan and continue.
If you are still unsure about what is going on, consult a more experienced trader. There are plenty of books available on trading psychology. Consistency is the key to long-term success in the markets. Often people have a trading plan that is fundamentally sound but they second guess themselves and deviate away from their rules. Having a good grasp of your mindset can also help you establish a productive work/life balance, and let’s face it, isn’t that what we’re all trying to achieve?