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Basic Trading Concepts Tutorial

Developing a Trading Mentality

024.jpgMuch has been written about what type of personality it takes to be a successful trader. What makes this question particularly difficult is that there is no definitive answer about the characteristics a trader should have to be successful. If you assess your personal traits honestly and realistically, you can probably develop a trading program that fits your personality more easily than you can adapt your personality to a particular trading program.

But what provides a common thread among many successful traders is that they all have a trading mentality. That doesn’t mean just shifting from the traditional buy-and-hold mindset of the past to jumping into and out of positions readily, however. That is part of it, but a trading mentality includes several other factors related to attitude that may be somewhat different from what you have heard and believed in the past.

Speculation is okay.

You may have heard complaints about how speculators are to blame for all kinds of price distortions and how they manipulate prices, even when they are responding to perceptions of supply and demand. None of today’s economic developments or technological advances would have been possible without speculation. No one would have started a company without speculation. Speculation is simply a part of growth.

“Speculating” is not the same as “gambling.” Speculating can turn into a crapshoot, but successful speculating means two things: You always limit your risk, and you always try to have favorable probabilities.

Gambling creates risk. A bet in a casino or at a racetrack creates a risk to your money that did not exist before.

In trading (speculating), the risk already exists. Someone is carrying that risk, and a trader/speculator is willing to assume the risk that someone else wants to pass along because they do not want it. Trading is all about transferring risk from those who want to insulate themselves from adverse price moves to those who are willing to take on the risk in exchange for the possibility of profiting from a price move that would be favorable to them.

Speculators play a vital role in this process by always being available to take the other side of these trades and providing liquidity to the marketplace to make prices flow efficiently. Without speculators, prices for many stocks and products would be much more erratic and uncertain and potentially much more detrimental to the development of a sound economy. Trading allows both producers/consumers and speculators and to achieve their goals. As a trader, you are “speculating” on what will happen, not “gambling.”

025.jpgLosing is okay.

Nobody likes a “loser,” especially if it means money, but in trading you can be a winner by liking to take losses. You expect all of your trades to work or you wouldn’t have taken them. But because of the uncertainties of the marketplace, the reality is that many successful traders have built outstanding track records with only 40% or fewer winning trades.

One of the most important market adages is, “Cut your losses short.” When the market tells you that you are wrong, get out of your losing position quickly so the loss doesn’t grow and wipe out your trading stake, the key to staying in the trading game. If your analysis was wrong, the sooner you find out, the better off you usually are.

The market is not ‘against’ you.

You may not believe this when the market seems to be gunning for your stops or reaching a certain price level just to take your money. The market does try to confuse most participants most of the time, but don’t take it personally if you are the victim of an adverse price move. The market is not out to “get” you but is just flowing along, and your position just happens to be carried along with it.

It’s okay to sell what you don’t own.

Many newcomers to trading have a difficult time comprehending this fact. That’s understandable if your experience has been limited to buying stocks, but with trading instruments such as futures or options, it is as easy to sell as it is to buy. In fact, selling means no difference in the amount of money required or in the trading procedure other than saying “Sell” instead of “Buy.” So you can “Sell high, buy low,” even if you have never bought the instrument in the first place.

It’s okay to be a ‘bear.’

Generally, a market that is going up or is “bullish” is perceived as “good,” and a market that is going down or is “bearish” is called “bad.” But, as the previous item about going short suggests, being a bear and watching prices decline may be a good thing for your account. In reality, you should always have a two-sided view, neither bullish nor bearish but reacting to what you see the market doing. When you see an opportunity arise, being a bear or shorting the market works no differently than being long or bullish.

It’s okay to be emotional about trading.

Most advice about trading suggests taking the emotion out of trading, and it is true that you should not let emotions rule your trading decisions. But if you want to be a successful trader, you have to have a passion for trading – a passion that will push you to learn about the markets and trading, force you to study price action to become a well-versed expert in whatever method you choose and give you the desire to stick with trading when things may not be going so well. Passion drives people in many successful endeavors, and trading is no exception.

The Language of Trading: Lingo You May Hear

026.jpgAs with many other fields, traders have their own arcane terms and phrases to describe various conditions. Trading newcomers may be frustrated by a lingo they do not understand and which seems to make no sense at all.

A glossary of terms on this site provides the meaning of many words used by traders, but here are some of the more widely used trading terms and their explanations so you won’t be confused when you see or hear them used to describe some basic trading concepts.

“Dead-cat bounce.”Many times a market will experience a modest rally (a bounce) from depressed price levels. But most of this price rise is due to short-covering or weak long positions getting back into a market that very likely will exert little or no upside power.

“The trend is your friend.” This simple sentence is a very powerful one and is important for most traders. If you trade with the market’s trend, your odds for success are higher than if you trade against the trend. Most successful traders employ some type of trend-following trading strategy.

“Buy the rumor, sell the fact.”This is a frequently occurring phenomenon whereby a market makes a price move in anticipation of an expected result of a fundamental event. Then, when the event does actually occur and the result was as expected by traders, the market price will move in the opposite direction. For example, if grain traders expect a bullish report, the market will rally in the days before the report’s release but then actually sell off once the actual bullish figures are released.

“Bulls make money, bears make money, but pigs get slaughtered.”In other words, don’t be a greedy trader. Don’t try to take too much profit out of a market too fast. The two biggest and potentially most damaging human emotions in trading are “fear” and “greed.”

“Cut your losses short.”This trading maxim is even more important than “The trend is your friend.” Traders must limit their losses on their more numerous losing trades by using strict money management and by employing buy and sell stops.

“Markets ‘discount’ events.”This phrase is similar to the “buy the rumor, sell the fact” phrase. Markets many times “factor in” or discount events before they occur. For example, forecasters may predict a U.S. Corn Belt drought. Although the growing season for soybeans and corn does not end until early fall, corn and soybean futures prices may top out in June. Traders factor in the damage to crops well before most of the damage had actually occurred.

“Never meet a margin call.”In other words, traders should never let a trade become so much “under water” that a margin call from the broker is initiated. “Cut your losses short.”

“Short-covering.” This phenomenon occurs when traders who have established short positions decide to exit the market, either to take profits or because their trading positions have moved too far “under water.” Many times short-covering will occur after a market has been in a sustained downtrend without much upside movement recently.

“Long liquidation.”Traders decide to “ring the cash register” and take profits from long positions or weaker longs exit the market when it appears to be showing weakness. Long liquidation usually occurs when a market has been in a sustained uptrend and many bulls decide to bail out, knowing the market is vulnerable to a downside correction.

Consolidation, also known as“sideways trading.” Many times a market that has undergone a sustained trend will “pause” to catch its breath or move into a consolidation phase. This means price action on the charts turns more sideways and choppy.

A price “breakout.” This occurs when prices move solidly above or below a “congestion area” (or a sideways trading area) on a price chart. Many trend traders like to trade price breakouts.

“Basing” action.This is extended sideways trading at recent historic lower price levels. Prices are forming a “base” at lower levels, from which prices will eventually make an upside “breakout.” Keep in mind that markets can also see a downside price breakout at what was perceived to be a basing area at lower levels.

A market “correction.” When a market has made a sustained price trend, it will make a shorter counter move in the opposite direction. After this correction, odds favor the eventual resumption of the trending move.

“Locals.” These individuals trade in the futures trading pits in open-outcry markets at the exchanges. They trade for their own accounts and are a needed function of pit trading because they provide the important market liquidity for better trade execution (fills).

Basic Trading Concepts Tutorial

030.jpgIf you decide to become a trader, it’s difficult to just jump into a market and be one. Before you can even move into the nuts and bolts of trading, there are some basic concepts you need to understand – the idea of trading itself, your perception of trading, your resources, the use of money, the role you play in the trading process and a number of other items that deal mainly with the trader and not the trading.

The trading issues – trading instruments available, how markets work and other trading basics – are covered in the next tutorial. You may think you can just breeze through these first two tutorials, but they are the foundation of your trading education.

Knowing What You Don’t Know

031.jpgThat headline may sound like a strange way to start a tutorial, but when it comes to something as complex as trading, it is important to acknowledge the preconceived notions you may have about trading and to understand that you probably have much to learn about this complex subject, especially if you intend to master what could be the most difficult undertaking you will ever attempt.

First and foremost, despite what you may have heard or read about trading being an easy, get-rich-quick scheme, the truth is that there are no trading secrets and no easy paths to quick success in trading markets. Beware of anyone who tries to tell (or sell) you such. It’s no coincidence that trading markets is similar to most other human endeavors: Hard work and experience are required to achieve notable success. By the same token, understanding the process of trading can be achieved with perseverance and a willingness to continue to learn.

Ironically, a major advantage of being an experienced trader is knowing what you don’t know about markets and trading. There are certain elements of trading that you may never know nor understand, like knowing for sure what a market is going to do in the future. Market analysis and trading is not a business of bold predictions but one of exploring market probabilities based upon market knowledge, price history, human behavior and trading experience.

Knowing that you don’t know exactly what a market will do actually gives you a trading edge because it means you probably will exercise more caution and think about and plan for what could happen if a trade turns against you. Successful traders know that some trades will turn against them and that they need to take steps to preserve capital to trade another day.

Anyone who plans to trade for a while absolutely must respect the markets. Most people do not like to be “wrong,” but only the market is 100 percent right. Traders who think they “know” exactly what a market will do are not showing the markets respect.

Why do you want to trade?

032.jpgYou may be comfortable accepting the fact that you don’t know everything there is to know about trading yet, but you definitely should have a good idea about several things when you get into trading. The first is why you want to trade in the first place. People have a number of motives for trading, all of which have merit, but you should be clear what it is that is driving you into trading. Your reasons for trading may go a long way in determining your trading style.

Profits

Probably every trader’s goal is to make money. But if that is your main reason for trading, are you willing to do what it takes to achieve this goal? It will mean you have to provide the seed money and other resources you need to be successful, and it will involve a commitment to learning to gain trading experience.


If trading is going to be your business, you obviously have to put making money high on your list of goals. That requires consistent, strong discipline and the ability to control your emotions as none of the experience or success you have gained in other areas will guarantee that you will be a success in trading. Your trading approach may even be boring, but if your real goal is making money, you will have to have the discipline to stick with a trading plan.

Being ‘right’

Are you a person whose greatest satisfaction comes from being right about things? Traders generally love to compete and be better than everyone else in whatever they do. Just having the opportunity to crow a little about their prowess is their biggest reward.

However, trading may be one of the worst places to look to feed an ego. Whatever success you have had in other aspects of your life may not transfer very well to the trading arena, which has been known to humble even the strongest ego. Of course, traders have to have a strong sense of ego to have enough confidence to trade, but you’ll have to keep that ego in check whenever you enter a market position if you want to survive as a trader.

Excitement

Trading certainly can provide plenty of excitement, both highs and lows, and that may be reason enough for trading. But expect to pay an entertainment tax. Just being in a market position can be exhilarating and can inspire you to keep up with what’s happening in the market and in the world’s news events.

However, to be successful over a longer term – unless you have deep pockets – you usually will have to forego the excitement and emotion generated by trading, just as you have to keep a lid on your ego trip. You naturally will experience some excitement whenever you are trading, but it is a factor you must control. If excitement is an objective of trading for you, perhaps the solution is to have one account you trade conservatively and another account where you get a little wilder.

What Are Your Resources?

037.jpgIn addition to your goals for trading, you also should be well aware of the resources you bring to the trading table. They will play a big part in the markets you can trade and in the way you trade them. If you think you can be a big-time bond trader with a $5,000 account or a day-trader while working a full-time job, you’ll soon get a dose of reality when it comes to trading.

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Here are some resources you have to
consider as you ponder what and how to trade:

Money

There’s that word again, but the fact of the matter is that you can’t trade without sufficient capital – your trading stake that you need to guard carefully. You may be able to begin trading without having enough time or knowledge, but you won’t be able to begin trading without money. You have to have money to make money.

Your trading account will have to meet minimum requirements set forth by the trading industry. How much money you need depends on what you intend to trade. If you are buying stocks, you have to have at least half of the purchase amount in your account. If you are trading futures, you usually have to have a minimum of about 3 percent to 7 percent of the value of the contract in your account.

Those are the regulatory requirements, and there is no negotiating the amount. If you plan to trade the full-size S&P 500 Index futures contract, for example, you have to have about $20,000 in your account for each contract. If you are trading the e-mini version of the S&P 500, the requirement is about $4,000. The key point is that the amount of money required to trade limits what you can trade and the number of contracts you can hold.

In addition to the minimum regulatory requirements, you should also have a cushion above that to withstand the fluctuations of the marketplace. That suggests you should always have enough extra cash in your account to cover possible worst-case scenarios. At any one time, you may not want to have more than 50 percent of your account tied up in active positions.

If you are not adequately capitalized and the market makes even a slight adverse price move, you may either be forced to put up more money to hold your position or you may be forced out of the market. Having extra money in the account also relieves the pressure of having to be right about your position from the start, pressure that is not conducive to making wise trading decisions.

You also do not want to have the pressure of having the funds for trading come from money you need to pay the rent or buy groceries or from funding the account with your credit card. Your trading money should come from discretionary funds that you can afford to lose without affecting your lifestyle.

Time

Everyone has 60 minutes in an hour and 24 hours a day, but how much of your time can you devote to market analysis and trading? If you have a full-time job, it will be difficult to be a day-trader, no matter how well you think you might do with that style of trading.

The priority you place on the use of your time will play a big role in selecting the type of trading resources you need and the style of trading you can do. Time may be an important trading constraint for you.

038.jpgTrading Help

To perform the market analysis you need to make a trading decision, you will need information and educational resources. Typically, that includes expenditures for the following:

Electronic connection.Today’s active trader almost needs to have a connection to the internet, both to have access to information resources quickly and easily and to enter orders.

Data/price quotes.Today’s active traders also need real-time quotes as well as access to historical market data for their analysis. Brokers may provide sufficient data, but many traders want to subscribe to a source that will provide the most accurate, reliable data possible.

Analytical software. Another requirement for many active traders is software that can turn data into charts and technical indicators deemed necessary to analyze markets. All you need to do is specify the type of software you want, and some vendor is likely to have it.

Advisory services.In general, it’s probably advisable to do your own research, but your lack of time or knowledge may limit what you can do, causing you to turn to other more expert sources for information, analysis and perhaps trading recommendations.

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