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Trading: Definition, Pros and Cons, Strategies and Examples

Trading is the buying and selling of equities, such as stocks, options, currencies, etc. as opposed to investing, which suggests a buy-and-hold strategy. Trading success depends on a trader's ability to be profitable over time. Traders have a shorter term horizon compared to investing.

There are different type of trading styles depending on how long a security is held. The most common trading styles are day trading, scalping, swing trading, position trading and momentum trading:

  • Day traders hold positions for less than a day.
  • Scalpers open and close the same equity multiple times throughout the day.
  • Swing traders hold positions between two days and one month.
  • Position traders hold positions between one month and one year.
Momentum traders hold positions for as long as the momentum keeps on pressing.We'll look at each individual trading style later on in the article. Now, let's take a deeper look at both trading and investing, starting with the latter.

Key Insights

  1. Definition of Trading: Trading involves allocating capital with the expectation of profit within a short period, utilizing various financial instruments like stocks, options, futures, and commodities. Traders aim to capitalize on technical price movements, with strategies tailored to different timeframes.
  2. Understanding Trading: Traders share the goal of return on investment with investors but operate within shorter time horizons. Risk in trading is associated with the timeframe, with shorter timeframes offering less overnight exposure but limited recovery time for losses.
  3. Types of Trading: Trading encompasses a range of financial vehicles, including stocks, options, and futures. Each type of trading instrument offers unique profit opportunities and requires specific strategies aligned with the trader's timeframe and risk tolerance.
  4. Trading Styles: Common trading styles include day trading, swing trading, and position trading, each with varying holding periods and risk profiles. Traders adopt different styles based on their preferences, available time, and market conditions.
  5. Best Practices for Beginners: Starting a trading career involves identifying one's preferred trading style, managing emotions through a solid trading plan, finding a comfort zone in trading environments, and building discipline to adhere to trading strategies consistently. Continual learning and staying informed are crucial for success in the dynamic stock market landscape.


Index (Trading)

Definition of Trading

Trading refers to allocating capitals with the expectation of receiving a profit in return within a short period of time, depending on the style of trading utilized (day trading, swing trading, position trading...). The goal of the trader is to generate profits or gains from specific technical price breakouts. As price reaches targets near technical resistance levels traders take profit. In the eventuality that price moves against the trader's prediction, stop losses are places near recent support levels to limit risk and protect capitals. Trading can be done in various forms, such as, but not limited to, purchasing company shares, option contracts, future contracts, commodities, currencies and exchange-traded funds (ETFs).


Understanding Trading
Traders and investors share the same goal: return on investment. What differ is the timeframe (and techniques) utilized to achieve that. As we already know all trading and investing carries a certain level of risk. 

With regards to trading the risk is direct correlation with the time horizon of each strategy. Shorter time frames, for example day trading or scalping, do not have overnight risk exposure. The position is closed before the end of the trading session. 

However, the limited time horizon of these two strategies (just a few hours) does not avail extra time to recover loses in case traders are on the wrong side of the trade, increasing their risk. 

The longer the time frame available (example for swing traders and position traders), the greater is the chance to correct, recover and reverse any trades that moved against their predictions. 

At the same time, overnight exposure increases the risk of news releases, earning reports, or anything else that can cause large price fluctuations outside the regular trading hours and out of the traders' control. Those fluctuations, referred to as gaps, can occur both on the upside (positive) or downside (negative).


Types of Trading
Trading involves the use of pretty much the same form of investments utilized by investors, especially financial vehicles, such as (but not limited to) stocks, options, futures and commodities. What differ again is the time horizon and the strategies utilize as a result of different time frames.

Stocks
When purchasing stocks, traders buy (or sell, if they are short-sell traders) a certain number of shares at a specific price level, with the goal and intention to sell them (or buy-to-cover, if they are short-sell traders) when price reaches their desired targets. Stock traders profit from a trade when the price they paid for is lower than the price they sold the stock for.

Options
Options, as we learned before, are financial instruments that derive their value (that's why they are called derivatives) from their underlying securities, such as stocks and indices. When traders buy options, they pay a premium. The price of the premium varies depending on the price of the underlying asset and the amount of time left in the contract. Option traders make money when the value of the premium increases.

Futures
Futures are also derivative financial instruments, similar to options. However, future contracts obligate the buyer, or the seller (depending on the type of contract), to buy or sell an asset at a predetermined set price and future date, regardless of the current market price at the time of expiration date. Futures can be used to trade commodities and financial instruments, for speculative reasons as well as to hedge against unfavorable price changes in the underline asset.


Trading Styles
Day Trading
Day trading is a time-constrained strategy where the buying and selling of the same equity takes place within the same trading day. The position is not held overnight. The goal of a day trader is to reduce risk by reducing overnight exposure and increase profitability by using large size positions and/or leverage.

Swing Trading
Swing trading is also a time-constrained strategy, but it avails more wiggle room, with regards to time, when compared to day trading. Swing traders hold a position overnight (longer than one day) but for a maximum period of one month. They base their entry/exit strategies on technical patterns and charts analysis (technical traders) and/or on the studies of company fundamentals and quantitive reports (fundamental traders). 

While acknowledging both strategies, it's worth noting that here a at we focus on technical analysis and option vertical strategies. Holding positions overnight increases capital risks. Swing traders reduce their risks of capital exposure by using correct risk/reward ratios, proper position size, as well as stop losses placed below recent support areas. They profit by timing their entry strategy as price bounces off a support level or breaks out of a resistance area, and exit their position as price reaches upper resistance levels and/or key moving averages.

Position Trading
Position trading is sort of a compromise between swing trading and investing. While the strategies used by position traders are very similar to those used by swing traders, their approach to capital allocation is similar to investing. 

In comparison to swing traders, who hold a position from two days to a maximum of 30 days, position traders hold a trading position for not less than a month and for not longer than a year. This extra time gives a position trader more flexibility and wiggle room for error. They can plan their entry strategy with less precision, by gradually adding to an existing position overtime, and generally enjoying greater returns as their portfolio growth.

Scalping
Scalping is a style of day trading that focuses on taking advantage of small price changes, quickly reselling it and ideally, making a quick profit.

Momentum Trading
Momentum trading is a style of swing trading that takes advantage of a steep price move that accelerates by the day. Every pullback basically provides an entry opportunity that lasts a day or two before the previous resumes and accelerates once again. It's a like a fast moving train. If you don't just in quickly, it's gone.

We are going to focus on three main styles: day trading, swing trading and position trading. We will not discuss the last two trading styles (scalping and momentum trading) any further, as they are beyond the scope of this article and our educational programs.


How To Trade
Learn A-Z Trading Strategies
Build your trading foundation. Start learning technical analysis and/or fundamental analysis. Find a course, a teacher, a mentor. Find someone or something that will help guide you through the intricate jungle of trading, stir you in the right direction, correct your weaknesses and reinforce your strengths. With time you will learn to read charts correctly, take trades with confidence, have clarity of mind and develop a strong and discipline trading plan mind set.

Open a Trading Account
This is an obvious step, but also something that it needs to be said. First of all find an online broker and open the account. 

Do your own research:
  • Ask about commissions and fees, customizable platform with the features you need to make your trading and investing as smooth as possible. Look for commission free (or low commissions) brokerage. 
  • At the same time, make sure that in the search of cutting costs, you are not giving up features and platform functionality that could ultimately end up costing you more, in addition to making your trading more difficult. 
  • If you are a day trader, but also useful to the other styles of trading, ask for direct access (basically it's your direct line to the exchanges), and include Level 2 and, ideally, Level 3 data feed. It will cost you a bit more, but it's needed in order to succeed, especially in day trading. 
  • Using separate accounts based on the individual needs, can also be a good idea. For example have one account for investing and one for trading. 
  • Get familiar with your trading platform and take advantage of the free tools, resources and educational material/events that your broker offers. 
  • If your broker offers a trading simulator (also known as paper trading), that a major plus. If they don't, it's ok. 
There are several other platforms that offer free virtual trading and simulators.

Practice on a Simulator and Master your Skills to Perfection
Take advantage of trading simulators and practice as much as you can. Do not trade real money until you are profitable on a simulator. 

When you start making money paper trading (using a simulator), it means that you are ready to start trading with real money. If six months have passed, and you are still trading on a simulator, it's time to get your feet wet and take your first real trade. 

In both scenarios, make sure to take the necessary precautions to limit your risks. For example, use small positions, keep stop losses in place, and limit your trading activity (overtrading is a real and costly issue for most traders). 

Ideally you would want to practice on a simulator that uses the same platform of your real money trading platform. But again, if your broker doesn't offer simulators, other platforms do. And often time, it's free. Remember practice is what will make your trading great. Without it, expect low quality results.

Stay Informed and Continue Learning
Stay informed and keep on learnings. The stock market is an ever changing environment that is constantly evolving. It makes the job of the trader interesting, never boring and fresh . But you must stay informed keep on learning. Stay informed on the state of the market, read company news and economic events, join trading groups and trading communities, learn new skills. Practice as much as you can, be patient and continue to learn. It's a journey that keeps on giving.


Examples of Trading
Let's say that you are a swing traders (holding positions between 2 days and 30 days).
Your average position size is $5000 (max).
You decide to buy 100 shares of XYZ stock for the price of $20.


Scenario #1
A week later price runs to $25 per share.
First of all, congrats!

However, until you close your position(s), by sending the order to the broker and getting filled, any profit or loss is considered unrealized, meaning it hasn't been recorded on your account. The moment you close your position(s), fully or partially, that profit or loss that result from sending the order to broker and getting filled, becomes realized, meaning you have actually made a profit, or took a lost.

Now, back to our example.
Price is near a 13-week high, and approaching a major moving average, let's say the 50 SMA (Simple Moving-day Average).

This is a rather strong resistance. While the overall look of the chart remains bullish, price is starting to show a bit of weakness in the short-term, and the need to pull back.

You decided to exit your full position and take profit.
You have just earned $500 in 7 days (minus commissions and taxes; Uncle Sam is always watching). Congrats!

$25 - $20 = $5
$5 x 100 shares = $500


Scenario #2
A week later price drops to $18 per share.
What do you do? You have a few options

  1. Exit the full position
  2. Exit a partial position
  3. Wait and see (possibly placing a stop loss a few pennies below recent support levels)
  4. Add to your original position (averaging down)

You find yourself thinking about this trade day and night. It's affecting your sleep.
You decide to close the full position and take a loss.

You have just lost $200 in 7 days (plus commissions; no taxes on losses, unless you buy back the same equity within 30 days; remember Uncle Sam is always watching).

$18 - $20 = -$2
-$2 x 100 shares = -$200

Well, losses happen. It's part of the business of trading and investing, and it is something that all traders and investors have to prepare for, both mentally and physically. How?

  1. Before entering a trade, have a trading plan (exit, targets, stop losses).
  2. After entering a trade, use discipline, meaning stick to the plan.
It will save you a lot of grief and sleepless nights.


Scenario #3
You have a trading plan:

  1. Stop loss at $17.50
  2. Profit target at $25

A week later price is down to $18 and it's sitting above a key moving average, let's say the 8 EMA (Exponential Moving-day Average).

For the next five days, price continue to show a solid base above the $18 level and the 8 EMA, so you decide to add to your position by buying an additional 100 shares, for a total of 200 shares of XYZ stock.
Eventually price was able to move back above the $20 level and, ten days later, it reached your target at $25.

Since it was approaching the 50 SMA (again a major resistance in our example, just to stay consistent with Scenario #1), you decide to take a partial profit, by closing 100 shares at $25, and raising your stop loss to the $22 level for the remaining 100 share position (200 shares - 100 shares = 100 shares).

Despite a small pullback down to $23 (your stop didn't get triggered, so you still have 100 shares), price was able to stabilize and eventually move up.

A week later price broke above the $25 level and the 50 SMA and a month later it reached $30. At that point, you were happy with your trade and closed your position (100 shares).

You have just earned $1500 in two months days (minus commissions and taxes; Uncle Sam is always watching). Even though you are a swing trader, you decided to ride the bullish wave and stay a bit longer than what you had planned originally. 

Congrats!

First Profit Taking (100 shares at $25)
$25 - $20 = $5
$5 x 100 shares = $500

Second Profit Taking (100 shares at $30)
$30 - $20 = $10
$10 x 100 shares = $1500


Best Practices to Start your Trading and Investing Career
To conclude, let's look at some recommendations to put all this information into practice

Identify your Trading/Investing Style

  1. Are you comfortable holding positions overnight? If you are, day trading might not be for you. Instead, consider exploring swing trading, position trading and/or investing.
  2. Do you rather trade a few hours a day and then be done with it? If you are, day trading might be a more suitable style for you, compare to, let's say, swing trading, were monitoring daily activity is important.
  3. Do you have limited time and/or interest to monitor charts daily or even every other day? If so, investing might the appropriate style that better fits your needs and/or schedule.

Ask yourself those questions, and other similar ones. The answers will help guide you towards the trading style(s) that better suit your needs. Please keep in mind that there might be more than one style that we are attracted to or suitable for. For example, you might gravitate more towards swing trading, and also, occasionally enjoy day trading activities. Be flexible and keep checking with yourself.

Manage your Trading Emotions by Developing a Trading Plan (and Sticking to It)
Emotions can run while with trading and investing. When that happens, emotions can cloud our judgement that and decision-making process that negatively impact our trading experience, and potentially our lives as well. In order to control the emotions, we need to develop a trading plan that fits our needs.
Before entering any trade, precisely define the following parameters:

  1. Equity/Company to Trade and Invest (ex: Apple, AAPL)
  2. Strategy (ex: going long, buying)
  3. Style. How long are you going to hold this position (ex: swing trade, between 2 and 30 days)
  4. Position Size (ex: 100 shares of AAPL company)
  5. Entry (ex: ~$175)
  6. Use 1:3 risk/reward ratio, meaning risk $1 to make at least $3, to calculate targets and stops. The risk/reward ratio will help you decide whether or not, it's worth taking the risk to receive that potentially reward
  7. Targets. Have a least two targets based on upper resistance levels (R1: $200, R2: $220, R3: $240)
  8. Stop Losses. Use one or two stops losses based on lower support levels (S1: $170, S2: $165)
  9. Ask yourself the following questions, and use the answers to design your trading plan.

  • What are you going to do if/when price reaches the first target? the second target? the third target?
  • Exit partial position and raise the stops? Stay in the position? Exit the full position?
  • What are you going to do if price moves against your prediction? Exit the full position? Exit a partial position?
  • Wait for the stop loss to trigger? Add to the initial position?

After entering a trade, manage your position(s) and exit strategies accordingly, based on your trading plan. And most importantly stick to your plan!

Find your Comfort Zone
As you gain experience in trading and investing, work at finding your comfort zone. For example, use position sizes that don't keep you up at night; trade or invest in equities that give peace of mind; avoid trading or investing in equities that are too volatile or highly speculative. In other words, keep refining your styles and strategies to create the most comfortable trading environment that will help you thrive and succeed.

Build Trading Discipline
Create a safe trading environment. Learn the importance of discipline, what stocks are tradable and what stocks to avoid, when is the best time, and worst time, to trade and other valuable tips. To learn more, download your free guide below.


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