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CFD Trading

CFD Trading Comprehensive Guide

 

TABLE OF CONTENTS

CFD TRADING

Introduction to CFD Trading

PART 01: So what the heck is a CFD, anyway?

PART 02: Understanding CFD Trading Costs

PART 03: Getting Started Investing In CFDs

PART 04: Where The Rubber Meets The Road – Your First CFD Trade

PART 05: Critical CFD Trading Skills

PART 06: Refining Your  CFD Trading Strategy

PART 07: Here There Be Dragons – Common Mistakes To Avoid

PART 08: Your Blueprint For Success

Glossary of Terms


 

INTRODUCTION



Hello and welcome! 

Before we get started, there are a couple things you should know.  First, this is going to be a very long, detailed post!  If you’re daunted by content-rich posts, then this one isn’t for you, but if you’re reading these words, then odds are you’ve at least heard of CFDs before, and want to know what all the fuss is about.

Even if you’re not quite sure what CFDs are, rest assured that you’ve come to the right place!

In the sections that follow, we’ll outline in detail not only what they are, but how you can use them to make a lot of money.  Depending on how good a trader you are, you can make a life-changing amount of money!

But that is getting way ahead of the game.  We’ll start simply, by explaining what a CFD is, why it matters, and outlining some of the terms you’ll need to get familiar with if you’re planning on buying and selling them, and you should.  They represent a fantastic investment opportunity for newbies and seasoned investors alike.

Ready?  Let’s get started!

 




PART 01:  SO WHAT THE HECK IS A CFD, ANYWAY?

 

Differences Between Buying CFDs and Various Underlying Assets
  Share CFDs
  Commodity CFDs
  Foreign Exchange CFDs
  Index CFDs
So Should I, Or Shouldn’t I Invest In CFDs?
Basics Of CFD Trading
Part 01 – Key Points To Remember

We’ll take it from the top, in case you’re new to the world of investing and aren’t sure what the acronym means.  CFD stands for Contract For Difference.

As the name implies, it’s a contract between you and a broker who sells CFDs, with your profit or loss being the difference in price between the time when a trade is entered into, and then time when you exit the trade.  You’re literally exchanging the difference between those two values with your broker.

There are all sorts of CFDs including:

  • Commodity CFDs (contracts that track specific commodities like soybeans, wheat, oil, etc.)
  • Foreign Exchange CFDs (contracts that track currency pairs)
  • Index CFDs (contracts that track a specific index, like the S&P500, the XJO, etc.)
  • And Share CFDs (contracts that track the stock of a specific company)

As a contract, this is not the same thing as simply buying a share of stock in a particular company, although the CFD’s price mirrors the actual stock price, moving in the same direction, because the CFD's value is based on the underlying asset.

The first question you might ask then, is why bother to buy a CFD if you can just buy the asset itself?

It’s an excellent question.  The main reason is that CFD margins are smaller, which means you have to spend less money to control the asset in question.

The best way to see this is to look at a conjectural example.

Let’s say you’re buying 100 shares of stock at $25. The total value of that investment is $2500.  A traditional broker usually uses a 50% margin, which means that you need 50% of the value of the asset to make the purchase, or $1250.

Now let’s look at the numbers if you buy a CFD, rather than the stock itself.  Most CFD brokers only use a 5% margin, which means that you could buy the same investment with an outlay of just $125.  Big difference, right?  Which means that you can buy a lot more investments with whatever amount of money you’ve got.

Let’s start the clock and move through time, beginning from the point when you finalize your purchase.

Your broker gets a commission called the spread. Let’s say the spread is 5 cents, so if the underlying stock appreciates by 5 cents after you enter into the contract, congratulations!  You just broke even.  If the underlying stock continues to appreciate, everything after that is pure profit when you close out the contract (sell).  So let’s say the stock appreciates to $26. You’d see a profit of $0.95 per share, 100 shares, or $95 ($1.00, minus the 5 cent spread).

What we’re really talking about here then is leverage.  That’s the biggest advantage that CFDs offer over more traditional investments.  The smaller the margin, the more leverage you’ve got, which allows you to control more assets with less money, and that’s huge.

Here are some of the other key advantages to CFD trading in general:

  • Global Reach – Most CFD brokers offer products from all over the world.  That means one-stop shopping for you.  You can take advantage of any opportunity from most of the world’s major markets, without ever leaving your broker’s platform.
  • Fewer Rules and Regulations – Sometimes, depending on what, exactly, you are buying, you’ll face a dizzying array of rules about what you can and can’t do.  Many instruments, for instance, prohibit short selling at certain times, or have different margin requirements. 
    While you’ll find a few rules in the world of CFDs, they are generally very few in number, and won’t cramp your style.  This is especially true when selling short, because since you don’t actually own the underlying asset, you can short CFDs at any time.
  • Full Service – Most CFD brokers offer the same types of trades as traditional brokers, including, but not limited to:  Stops, limits, and congruent orders, and possibly (but not always) guaranteed stops.
  • Extremely Low Fees – The fees charged by CFD brokers tend to be significantly lower than the fees charged by traditional brokers.  An important rule of business is “keep your fixed costs low,” and low fees = low overhead costs for you!
  •  No Day Trading Requirement – This is huge.  Some markets require a minimum amount of capital if you want to day trade, and the dollar value is usually pretty high, which shuts many novice investors out of the game entirely.
    That’s not the case with CFDs.  Accounts can be opened for as little as $1000 in some cases, although this will vary from one broker to the next, with some brokers requiring up to $5000 to set up an account.  Even so, this is a fairly modest sum by comparison.
  • Lots of Different Trading Options – See above, re: the different types of CFDs you can invest in.  You have a full menu of choices available, and aren’t restricted to just trading in stock CFDs (although stock CFDs are a great way to get your feet wet!)

It all sounds almost too good to be true, and it’s true that CFDs represent a tremendous investment opportunity, but…and you knew there’d be a “but,” didn’t you?  There are downsides, and before you jump into the world of CFD trading, you need to be aware of them.

The first downside is the spread.  Because you have to pay the spread, it means that CFDs aren’t very good if you’re after micro-profits…that is to say, tiny movements in price from one hour to the next.  The spread will invariably eat those kinds of profits up, and if you try to take advantage of small moves like that, you’ll consistently lose money.

The other big disadvantage is something we’ve talked about before:  Leverage.

Leverage is a two-edged sword.  When you trade at a profit, leverage will magnify the return on your investment, but don’t get cocky!  The same leverage that helps you when you’re winning can burn you badly on losing trades, where they magnify your losses, which means you’ve got to be very careful to manage your risk if you want to be successful.

Later on, we’ll talk at some length about things you can do and strategies you can employ to help minimize your risks.  For now, it’s enough to be aware that they exist.  When used correctly, leverage can be a powerful tool that will help you achieve your goals much more quickly than would otherwise be possible.

BACK TO PART 01 CONTENTS


Differences Between Buying CFDs And Various Underlying Assets

Earlier, we listed various types of CFDs you can purchase, and now that you’ve got a better understanding of what they are in general, we need to spend some time talking about how each of those types differ from simply buying the underlying asset.


Share CFDs

We’ll talk about share CFDs first, because they’re the easiest to understand and are where most people start out when beginning to invest in CFDs.

If you’ve purchased stocks, then you already know just about everything you need to know about buying share CFDs.  The process is functionally similar, but there are some important differences to be mindful of.  These include:

  • No ownership – when you buy a share of a company’s stock you physically own a tiny portion of the company in question.  That’s not the case when you buy a share CFD.  You simply own a contract that is in no way connected to the company’s stock (the underlying asset), even though the price of the CFD mirrors the company’s stock price.
  • Much lower commissions – Buying stock carries much higher commission rates than buying share CFDs.  Expect to pay about half commission rate.  That’s huge, because lower commissions equal higher potential profits for you.
  • Lower margins – We mentioned this above.  Many stock brokers require as much as a 50% margin.  CFD brokers require something closer to five (and sometimes less!).
  • Financing – A small fee your broker may charge you to hold a position overnight


Commodity CFDs

As we mentioned earlier, for any commodity you can buy outright on the market, you can buy a CFD.  We mentioned a few earlier, but here’s a more comprehensive list, in case you’ve never traded in commodities before:

Cattle  |  Cocoa | Coffee | Copper | Corn | Cotton | Gasoline | Gold | Hogs | Lumber | Oats | Oil | Palladium | Platinum | Pork Bellies | Silver | Soy Beans | Sugar | Wheat

And so on.  As you can see, there’s no shortage of options here, and this is only a partial list!

So the next logical question is, “What exactly is a commodity?”  You already know that Commodity CFDs are contacts that track the underlying asset, but if you’re considering trading in Commodity CFDs then you need to understand the underlying product as well!

To that end, here’s the shortest, simplest definition of a commodity.

It’s a hard asset.  A physical product people purchase on futures markets.  They’re bought, sold, and traded in large quantity with uniform quality.  What that means is that anything on this list can be made, grown, mined or generated anywhere in the world, but the uniform quality ensures that no matter where the good is produced, an apples-to-apples comparison can be made.

Here are the key differences to keep in mind when purchasing a Commodity CFD versus purchasing the underlying commodity itself:

  •  When you buy a commodity outright, it will come with an expiry date, something you don’t have to worry about when you buy a Commodity CFD
  • If you want to break into the commodities market directly, be prepared to spend a ton of money.  $20,000 is considered a pretty small contract, and they can run to about ten times that value.  For most investors who are just starting out, that’s a lot of money!  Again, Commodity CFDs can be purchased with a much smaller outlay
  •  Charting – If you don’t have a lot of exposure to commodities trading, then you’re probably going to want to read this twice.  Commodities are priced on the futures market, but all the contracts traded on the futures market have a different expiry date.  This can be seen on comprehensive pricing charts that track commodity prices.  The charts used for commodity pricing display two months’ worth of information, but Commodity CFD pricing is based only on the current month.  If you want to base your buying and selling decisions on more complete information, then in most cases, you’ll need to get that information from a source other than your CFD Broker.

Note:  Commodity CFDs are NOT recommended for people who are new to CFDs in general.  You need to have a deep understanding of the general commodities market and what you’re indirectly trading in before wading into these waters!


BACK TO PART 01 CONTENTS

Foreign Exchange CFDs

You’ve probably heard the term “Forex.”  That’s the shorthand used when referencing currency exchanges, and in particular, simultaneously buying one currency, then selling another currency to profit from the movement between a given currency pair.

In many ways, currency trading is a lot like a drug.  Its fast paced and always on.  Since currency trading isn’t done through a central exchange, you can do it 24/7.  There is no “closing bell” here, and fortunes can be made and lost in the blink of an eye.  It’s seldom that someone buys a currency position and holds it for more than a day.  Often, they’re closed back out within hours, minutes, or even seconds.

It’s explosively volatile, and is the single largest over the counter market on the planet.  To give you an idea of just how much money flows through the market on a daily basis, in 2010, the Bank for International Settlements reported that the average daily forex turnover was just shy of $4 Trillion dollars.  Yes, that’s “Trillion,” with a “T.”  That’s huge.  Nothing else even comes close.

The foundation of currency exchanges are currency pairs, and these come in two flavors:  Pairs and Crosses. 
Here are the major currency pairs:

  • EUR | USD
  • GPB | USD
  • USD | CHF
  • USD | JPY
  • USD | CAD
  • AUD | USD
  • NZD | USD

And here are the crosses. 
Crosses are different from major pairings in that the US Dollar is entirely absent from the pairing:

  • EUR | CHF
  • EUR | GBP
  • GBP | AUD
  • AUD | JPY

The position of the currency in each pairing matters.  The first currency listed in the pairing is called the Base Currency (also known as the Primary Currency), and the second is called the Quote Currency.  Currency pairs are quoted out to four decimal places, and each point of movement is referred to as a “Pip.”

Here’s how the terminology is used.  Let’s say that for the pairing AUD à USD, the price is .9400.  If the price moves to .9401, then it has moved one pip.  This lies at the bedrock of forex trading.

When trading currency, the prices you see listed on your broker’s information screen come from the biggest banks and corporations on the planet who are moving hundreds of millions, if not billions of dollars at a time.  This is literally the grease that keeps the wheels of international trade and investment turning, and either directly or indirectly, you can be a part of it, if you want to.

There are some seriously compelling reasons to want to, even though it is a highly speculative market. 
Its major advantages are:

  • It’s an “always on” market, with no closing bell
  • Has extremely low margins, paired with flexible position sizes
  • Is entirely commission free
  • And it’s the most liquid market on the planet

All of those are good things, and compelling reasons to consider jumping in, but of course there’s a downside.

All that volatility carries with it extraordinary risk.  It takes a steady hand and nerves of steel (and preferably a huge supply of Red Bull, strong coffee, or other highly caffeinated drink) if you want to do well here, and for these reasons, it’s not a good fit for the novice investor.

Our advice would be to get your feet wet via Share or Index CFDs, learn how to make money consistently there, then perhaps move into strategic Commodity CFD trading, and only once you’ve mastered that should you consider jumping into the wild and wooly world of Foreign Exchange CFDs.


BACK TO PART 01 CONTENTS

Index CFDs

Index CFDs are functionally quite similar to Share CFDs, but where the latter track against shares of a particular company, the former track against an index, so what is an index, exactly?

Simply put, it’s a group of shares in companies that have a common element.  That commonality could be that they’re all tech companies, or all pharmaceutical companies, or something else.

The Dow Jones Index is comprised of the 30 biggest companies in America, and the price of the index is weighted according to the size of each of the companies that make up the index.  Put another way, if the majority of the shares in the companies that make up the index rise, then the value of the index will rise in tandem.  If a majority of those shares fall, then the value of the index will fall by a corresponding amount.

If you’ve had at least some exposure to the world of investing, then you’ve probably heard of Index Funds.  These are funds that buy stocks in the companies of a particular index, and see their performance mirror the performance of the index as a whole.

They’re great investment opportunities, because by buying into an index fund, you automatically gain a certain amount of diversity in your portfolio that you simply don’t get if you buy stocks in one specific company.

Index CFDs offer the same basic advantages, which makes them a compelling choice to consider, and not markedly different from Share CFDs, which means that they’re newbie friendly.  Another huge plus.

Here are some of the bigger indexes from around the world that you may have heard of:

  • Australia’s XJO
  • China’s Shanghai Composite
  • France’s CAC 40
  • Germany’s DAX
  • Hong Kong’s Hang Seng
  • Japan’s Nikkei Index
  • Singapore’s Straits Times
  • The UK’s FTSE
  • The US’ NASDAQ
  • The US’ Russell 2000
  • The US’ S&P 500

Not only are Index CFDs a great way to help diversify your investment portfolio, they’re also ideal if you think that the economy of a given country is going to generally do well, but you’re short on company-specific research.  This way, you don’t need it and can still reap the benefits.

BACK TO PART 01 CONTENTS



So, should I or shouldn't I invest in CFDs?

Now that you know what CFDs are and what basic flavors they come in, the next question is about you.  You may or may not be well suited to investing in CFDs, and it’s important to be honest with and about yourself when making the decision.

Personally, we love CFDs, so please don’t think we’re trying to dissuade you from taking the plunge, but as much as we love them, we also want to make sure they’re a good fit for you, so as to maximize your chances of making consistent profits.

With that in mind, here are some reasons you SHOULDN’T invest in CFDs:

  • If you don’t understand basic market mechanics, hold off on adding CFDs to your portfolio.  It doesn’t require a ton of experience to invest in them successfully, but you absolutely need a firm grasp of the basics of buying and selling on the market.  If you don’t have that, get your feet wet with stock purchases and master that before moving on to CFDs.
  • Ignorance of the hidden dangers of leverage.  One of the most common mistakes that novice investors make is underestimating their exposure.  This happens because they fail to take into account how leveraged their positions are.  As we said earlier, if you make a profitable trade, leverage will magnify your gains, but if you come out on the losing end, it will also magnify your losses.  More novice investors than we can count have seen the value of their accounts wiped out because they didn’t properly account for the impact of leverage on their positions and failed to manage their risk accordingly.  Until you’re sure you’ve got a firm handle on that, it’s best to steer clear of CFDs
  • If you’re driven by your emotions.  This is where so many investors, novices and veterans alike can sometimes go astray.  If you don’t take anything else from this guide, then take this lesson to heart:  Emotions have no place in investing.
    If you’re not investing dispassionately, then CFDs are not for you.  You need to create a cogent, comprehensive strategy and have the discipline to stick with it, regardless of what you’re feeling emotionally.  You need to be able to say goodbye to an investment that’s losing money, rather than try to ride it out because you have some kind of emotional attachment to the investment, or the company the investment relates to.
    Sometimes, companies we love and care about make bad calls.  When that happens, the market punishes them for it.  If you’re too close to the issue, emotionally, then you’ll take a drubbing, right along with the company in question. 
    Don’t allow that to happen to you.  Build your strategy around your risk-tolerance, then stick with it, no matter what.  Until and unless you can do that, then sadly, you’re not ready to invest in CFDs, and if you do, you’ll likely lose more money than you make.

For the purposes of the rest of this guide, we’re going to make the assumption that you’ve done some soul searching and self-analysis, and have reached the conclusion that CFDs are a good fit for you.

If that’s the case, congratulations, and we hope you’ll find what comes next to be of value.


BACK TO PART 01 CONTENTS

Basics of CFD Trading

There are two ways you can trade CFDs, and you need to be fluent in both.  They are trading long and trading short.

The difference is as follows:

A long trade is just like when you buy a share of stock.  The key idea behind it is to buy low and sell high.  That is to say, you buy when your data tells you that the value of the CFD in question is set to rise.

A short trade is the flip side of that equation.  In that case, you’re selling high, then buying low.  Essentially, you’re selling something you don’t own with the expectation that the price will drop, then buy it back at the lower price and pocketing the difference.

Obviously, there’s a lot more to successful trading than just this (and we’ll be going into a lot more depth in later sections), but this is the foundation of your entire investing enterprise. 

These two things allow you to make profits, no matter which way the market is moving.  If you only focus on one, then you’re limiting yourself to only being able to generate consistent profits when the market is moving in a single direction, and that’s not good because it will limit your success.

You don’t want your success to be limited by anything, so take the time to master both types of buying and selling, and while we’re on the subject of your success, here’s something else to keep in mind, especially if you’re a novice investor:

Don’t get into the game thinking that you’re going to make money on every single trade.

You won’t.

No one does.

The reality is that even the best, most successful investors in the world only succeed in turning a profit on about sixty percent of their trades.

Think about that for a second, then phrase it another way:  The best guys in the world fail four times out of ten.

That’s true not just in the world of investing, but in just about everything.

Take baseball, for example. The best guys in the league bat around .300.  That means that they successfully hit the ball about three times in ten, or put another way, they fail about 70% of the time.  Keep in mind that these are the best players in the world, and on top of the game.

The point of all this is simply to outline that failure happens, even to the best of the best, and honestly, it happens a lot.

The difference between a successful investor and a failed investor isn’t that one is flawless and the other isn’t, it’s that the successful investor takes steps to minimize his exposure to loss and keeps playing, while the failed investor lets his emotions take over until he loses everything, and then, simply can’t afford to play anymore.

The biggest secret to your early success is simply this:
Keep your positions small until you really get a feel for the market.

The second biggest secret is that from day one, you should be
treating your investment portfolio like a business.

All businesses exist in order to make a profit.  If they don’t do that, then they soon cease to exist, just as you will cease to be an investor unless you consistently make a profit.

By viewing your portfolio as a business, you’ll go a long way toward putting yourself in a constructive frame of mind.  One that will help install the discipline you’ll need to find long term success.

We’ll be building on both of these ideas in later sections, as we walk you through developing your own trading strategy, but to give you a sneak peek, and using the first “secret” we mentioned, if you’re not sure or not as confident about a given position, go small.  If you’re very sure, then go bigger (but still not too big).

By varying the sizes of your positions based on your confidence level, you can help minimize your risk, and when you do suffer losses, they’ll be both minimal and manageable. 

In the sections that follow, we’re going to outline the ins and outs of investing in CFDs, but then, we’re going to move beyond just that and show you how to build the investment strategy we referenced just above.

Once you’re armed with that information, you’ll be primed for success, and should consistently make profits with your CFD positions.

Before we do that though, let’s summarize.

BACK TO PART 01 CONTENTS



Part 01: Key Points to Remember

  1. CFDs are a type of derivative, because their value is determined by something else (in this case, the underlying asset, whose price movement it mirrors)
  2. The basics of CFD trading involve long trades (buy low, sell high) and short trading (sell high, buy low)
  3. If you opt to trade in CFDs, then you’ll face fewer rules, regulations and restrictions than with most other types of investments
  4. CFD Brokers also charge smaller fees, and allow you to use more leverage
  5. Leverage is a two-edged sword, and one you should be extremely careful of.  When you’re successful, leverage will make you even more so.  When you fail, it will also magnify your losses.
  6. When first starting out, it’s best to keep your positions small, until you have a good feel for the market.  In fact, varying the sizes of your positions based on your confidence level is a key component to a successful investment strategy, but we’ll cover the particulars of that in a later section
  7. From the very beginning, you should view your investment portfolio as a business.  This will help train your brain to approach investing with discipline, and it will plant the seeds for your long-term success.
  8. CFDs aren’t for everyone.  You should have some basic familiarity with the way markets, buying and selling work before jumping in.  You should also fully understand the implications of leverage and be disciplined enough to stick to your investment strategy and not allow your emotions to rule your decision making.

BACK TO PART 01 CONTENTS


 


PART 02: UNDERSTANDING CFD TRADING COSTS

 

Brokerage Fees
   On-Line Trading
   Over The Phone Trading
   Full Service Firms

Beware Of Promises About Commission Free Trading!
Paying The Spread
CFD Financing
Foreign Currency Exposure
How Corporate Actions Affect You
  What About Dividends?
  What About Stock Splits?
  What If A Company Goes Bankrupt?
The Tax Implications of CFDs
Part 02 – Key Points To Remember 


Having covered the basics, now it’s time to start digging a bit deeper, and in this section, we’re going to be taking a closer look at one very important aspect of CFDs that doesn’t get a lot of press.  It’s not sexy or glamorous, and it’s not terribly exciting to think about, but it really matters in terms of your overall level of success.

We're talking about costs.

Remember in the last section where we talked about the importance of treating your investment portfolio like a business?  Well, this is the first of many times we’ll be going back to this.

No business can find long term success unless it keeps a watchful eye on its overhead costs.  In terms of your investment portfolio, keeping your costs low is every bit as important as formulating a winning strategy, and can sometimes mean the difference between making money on a given trade, and losing money.

Therefore, it’s extremely important to thoroughly understand what your costs are, and what kinds of things are driving them.  That’s what this section is all about!


Brokerage Fees

We mentioned in the last section that the fees CFD brokers charge tend to be about half what a traditional stock broker charges, but there’s some variance here, depending on exactly how you trade.

There are three basic ways you can do that:  Online, over the phone, or with a full-service brokerage firm that includes professional advice and assistance.  We’ll look at each of those three just below. 

For the moment, the most important points to remember is that brokerage fees are the most visible costs you’ll  have to bear as an investor, but they’re not the only ones, and that they tend to be significantly less when using a CFD Broker.


BACK TO PART 02 CONTENTS



On-Line-Trading

This is far and away the simplest and easiest way to trade.  It’s super convenient, and there are some really great online brokerage services that offer an amazingly robust set of features.

You can expect to pay between $7 to $12.50 per side, or 0.1%, whichever is greater, and you should be aware that most online brokers offer volume discounts.  That’s probably not going to matter to you right away, but once your turnover hits a million bucks a month, you’ll see your fees reduced further still.

If a million dollars a month sounds like a lot of money to you, consider this:  If you make 10 trades (both sides) at $50,000 each, you’re done, which means you can hit that volume a lot quicker than you might think!



Over the Phone Trading

The internet has existed longer than CFDs have, so this is kind of a holdover, imported by CFD brokers because it was the way stocks were traded before there was an internet.  It’s a little old school, but it’s the method some people simply prefer to do business.

Your fees will be a bit higher if you choose to trade in this manner, ranging from $12.50 to $35 per side, or 0.125% to 0.35%, depending on how complex your order is. 

Note that you can find some brokers who will accept phone orders at no extra charge, but this is becoming increasingly rare.  Most brokers encourage their clients to place orders online, and the extra fees are an important part of that.



Full Service Firms 

Full-Service brokerage firms have been around almost as long as the stock market itself.  They are high-end service offerings that involve lots of hand holding and professional advice, but of course, they’re also the most expensive way you can trade, charging as much as 1% per side.

Think about that for a second.  If you use the least expensive, online trading option, then compared to that, the full-service broker is ten times more expensive.  Unless the professional advice you’re getting provides returns ten times better than you can get on your own, you’re not getting a great deal.

In practice, this would be quite rare, and because of that, you’re almost always better off to do your own research and reap bigger profits as a result.


Beware Of Promises About Commission Free Trading!

There are a number of brokers who promise commission free trading, and with good reason.  It is an irresistible lure.  Unfortunately, if something sounds too good to be true, then it almost always is.

Mostly, this is used as a marketing gimmick.  The reality is that commission free brokers simply raise their costs in other areas in order to make up the difference.  In this case, the most common approach is to increase the spread you have to pay.  So for instance, if a broker normally charges a 5 cent spread, then a commission free broker might use an 8 to 10 cent spread.

Don’t take these numbers as gospel.  We’re only using them as examples.  You’ll need to research specific brokers to get a feel for their cost structures.


BACK TO PART 02 CONTENTS

Paying the Spread

While we’re on the topic of the spread, this is a good time to acknowledge it as a very real cost you’re going to have to pay.

A bit earlier, we made mention of the fact that CFDs were ill-suited investments to make if you want to capture micro-profits, holding positions for a very short timeframe (measured in minutes or hours).  The reason for this is the fact that you have to pay the spread.

Here's an example of how that works:

Let’s say you’re buying a Share CFD for a company, priced at $50.  The price you pay might be $51.  The difference is the spread.

Let’s say you bought 50 shares.  If you turned around and sold them as soon as you completed your purchase, you’d lose fifty bucks, because you’d be selling at $50, but you bought at $51.  In other words, the stock price needs to rise by at least a dollar in order for you to break even. 

Anything after that, less the selling commission, is money in your pocket, but as you can see, the spread can really impact your bottom line and is something you should always be mindful of when conducting trades.


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CFD Financing

Most investors use CFDs for day trading, but you can hold your positions as long as you like.  If you hold them past 5pm New York time (7am Australian Eastern Time), then you’ll most often be charged a small financing charge for maintaining your position overnight.

Having the option to do this gives you more investment opportunities, but again, this is not something you should do lightly.  So how much are we talking about here?

The exact rates vary from one broker to the next, and you’ll want to carefully read your broker’s PDS (Product Disclosure Statement) to understand the full cost, but in general, brokers charge 2-3 percent above the cash rate.

So for instance, if you’re trading in Australia, and have taken a $5000 position, and the Reserve Bank of Australia’s rate is 3%, and your broker charges 2% above that, then you’re looking at a charge of:

·       Position size ($5000) * (RBA Rate (0.03) + broker’s fee (0.02) = $250

·       Divide this number by 365 to get the one day rate = $0.69

As you can see, this is a very modest fee, and it’s not something that should dissuade you from holding a position for longer than one business day.

Having said that, you should only do so if you are extremely confident that the price will continue to rise the following day (long position).

Again, this fee is small enough that it should not often dissuade you, but you do need to be mindful of the fee, because it’s part of the cost of doing business, and will have some impact on your final Return on Investment.

Here’s something interesting:  It works in reverse if you’re holding a short position!  In other words, instead of being charged a small fee, you get a small credit if you’re holding a short position.  The same math applies.

Note:  Markets aren’t open on the weekend, so if you hold your position over the weekend, then you’ll be charged (or credited) for Saturday and Sunday as well.


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Foreign Currency Exposure

A lot of people get addicted to the fast pace and extreme volatility of the currency (forex) markets, but there is a small wrinkle you should be aware of that a lot of people overlook.

Most brokers hold your profits in US Dollars.  That’s true regardless of what currency pair you’re trading (even if you’re trading Crosses, which don’t involve US Dollars on either side). 

What that means from a practical standpoint is that your country’s exchange rate as compared to the US Dollar matters a great deal, and can impact your total Return on Investment.


How Corporate Actions Affect You

Corporations are always in motion.  Always busy, and their actions can impact your trading positions in a variety of ways.

We’ll go over some of the basic things you can expect to see happening as you begin investing.  Some of these will serve to enhance your positions and their profitability, while others will have to be counted as expenses against you.


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What about Dividends?

At first glance, you might not think that dividends will play any role in your CFD trades.  After all, you’re trading a derivative, not the actual shares of stock.  The reality though, is that they can, and do have an impact on your CFD positions.

A dividend is essentially a reward paid to investors for the profits that the company has paid.  They are paid twice a year, with the first annual payment being referred to as the “interim dividend,” and the second being called the “final dividend.”

From the perspective of a CFD investor, the most important date to remember is the “ex-dividend” date, often called the Ex-Div date for short.  If you buy before this date, and are still holding it when the dividend date rolls around, you’re entitled to a dividend if one is paid.  If you buy after the Ex-Div date, you’re not.  It’s as simple as that.

When the dividend is paid varies from one broker to the next, but in general, the payment will be made either the day before the ex-div date, or the day of.

Important Note!  If you’re holding a short position, then you don’t get a dividend.  Instead, your account will be debited by the dividend amount. 

For instance, if you hold a short position of 1000 share CFDs on a given company, and that company pays a ten-cent dividend, then you’re going to see a hundred bucks debited from your account on the day the dividend is paid.  This is the kind of thing that can (and should) influence your buying and selling, short/long position strategy!

It’s also important to mention that in the overwhelming majority of cases, a company’s share price will fall by an amount equal to the dividend payment when it occurs.  In rare cases, this doesn’t happen, but it happens often enough that you can rely on it.

Yet another point is the fact that actual shareholders receive Franking credits, which are tax credits for the taxes the company has paid on its profits before the dividend is paid.  CFD investors do NOT get these credits, which does have some tax implications at the end of the year, but certainly shouldn’t often dissuade you from holding a given position.

What About Index CFDs and Dividends?

This is yet another dividend-related wrinkle.

If you’re holding an Index CFD position, and one or more of the companies that make up the index pay a dividend, then your account will be credited or debited, based on the company’s position contributes to the index in question.

This seldom makes a huge difference, but can either be a nasty surprise or an unexpected boon, depending on the shape of your position (short or long). 

Say, for instance, you’re holding a short Index CFD position and are anticipating a nice profit, but you failed to take the dividend payments into account.  This can easily wipe out any profits you were expecting!

The reason for all of this is simply that because CFDs are priced according to the underlying asset, anything the corporation does has to be reflected in the CFD market, or the pricing picture would become skewed over time and not track perfectly, like it’s supposed to.


What about Stock Splits

Once in a while, a company will implement a stock split.  If you’re holding 10,000 shares of that company’s stock at a $100 share price, then after the split, you’ll be holding 20,000 shares at $50.

When this happens, it will be reflected in the CFD market as well.  Again, any action the corporation takes is reflected in the CFD market.  If that weren’t so, then the pricing would not, and could not be accurately reflected.


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What if a Company Goes Bankrupt

It’s a sad fact, but corporations often do go bankrupt.  Here’s the thing though; that never happens overnight.  There are signs and forewarnings, and if you’re paying attention, you can see it coming well in advance.

If you’re holding a long position in such a company, then as the stock price continues to deteriorate, it will inevitably trigger your exit strategy and you’ll mitigate your losses before they become catastrophic, but there’s another way of looking at it.

A company that’s swirling the drain represents a profit opportunity in the form of taking short positions – provided that you exit the position before the bankruptcy is finalized.

Note that everyone else (your broker included) is going to see the bankruptcy coming, and when a company is in distress, the rules for investing begin to change.  You may be required to put up up to a 100% margin on your position, and close the position out at the last available trade price as determined by your broker.

This is a key point.  In certain exceptional cases like these, your broker can and will change the normal rules of trading as they deem appropriate.  This isn’t done as a means of punishing you, but to keep the market functioning smoothly.  Sometimes it works in your favor, and sometimes it doesn’t, so don’t take it personally.


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The Tax Implications of CFDs

There are a couple of important points here.

For the purposes of this section, we’re going to assume you’re living in Australia.  If you live in some other country, you’ll want to study that nation’s tax code carefully, and it might be best to get the help of a professional tax preparer for at least your first year, so you can get an in-depth look at how your investing profits and losses impact your tax situation.

The first point worth mentioning is this:  Profits and losses are treated differently if you’re running your investment portfolio as a business, versus if you’re making trades as a form of gambling.

This goes back to something we talked about earlier, and our recommendation is that from day one, you treat your investment enterprise as a business, because of the discipline it helps instill in you.

From a tax perspective, the difference is this:  If you’re treating your enterprise as a business, then your losses will count as an allowable deduction.  If you’re not, they won’t.


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Part 02: Key Points To Remember

  1. Your investment costs really matter.  Keeping them low will help improve your ROI (Return on Investment).  Also, having a firm understanding of your costs is key to your long-term success because it keeps you from paying for crap you don’t need, or paying too much for services in general
  2. Corporate actions can and will have an impact on your CFD positions.  It pays to be aware of them.  This comes down to doing your due diligence, and understanding the companies or products you’re investing in
  3. If you’re investing in CFDs, then the major costs you should be aware of are:
    + Brokerage fees
    + Paying the spread
    + Paying Dividends(or having them credited to your account, depending on what kind of position you’re holding)
    + CFD Finance (if you’re holding a position overnight)
  4. It pays to consult a tax professional for at least your first year of investing so you can learn how to properly handle your profits and losses from a tax perspective
  5. We recommend running your investment portfolio like a business from day one.  Not only can you count any losses you incur as an allowable deduction, but it also helps to foster greater investing discipline.

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PART 03: GETTING STARTED INVESTING IN CFDS

 

Direct Market Access CFDs
   Advantages of DMA CFDs
   Disadvantages of DMA CFDs
 Market-Maker CFDs
   Advantages of Market Maker CFDs.
   Disadvantages of Market Maker CFDs
DMA Vs. Market Maker – Which One Is Right For You?
Finding The Right Broker
Questions t o Ask Of A Potential Broker
Opening An Account
Types Of Accounts
   Individual Account
   Joint Account
   Company Account
   Trust Account or SMSF
   Limited Risk Account
Funding Your Account
Self-Assessment – Which CFD Market Is The Best Fit For You?
Before You Make Your First Trade
Defining A Basic Investment Strategy
   Market Entry Criterion
   Your Money Management Plan
   Understanding The Risk vs. Reward Tradeoff
   Your Exit Criterion – Know When To Hold ‘em, Know When To Fold ‘em
Fine Tuning Your Strategy
   Controlling Leverage
  Tools Of The Trade
Part 03 – Key Points To Remember

 

Everything to this point has been background information so you’ve got a clear picture of what you’re getting into, should you decide to invest in CFDs.  In this chapter, we’ll be talking about getting your account set up and preparing you to make your first trade.

If, after having read everything to this point, you’re on board with the idea and have decided that CFDs are for you, then this section will tell you everything you need to know to get started.  Ready?  Let’s do this!

 

 

Direct Market Access CFDs

This is the first of two basic kinds of market access you can get, depending on the broker you choose to work with.  DMA CFDs offer a number of compelling advantages that you might find too strong to ignore.  Having said that, there are some shortcomings too, but don’t worry, we’ll go over the pros and cons, just below.

Advantages of DMA CFDs

  • Complete Transparency -  This is the biggest single advantage of DMA CFDs.  The reason you get such good transparency is the fact that your orders are placed directly into the underlying market.  In other words, you’re cutting out the middle man, and plugging your orders directly into the ASX (the Australian stock market), or the market of whatever country you’re trading in, if you’re not in Australia.  Your orders are replicated exactly as you place them by your broker.
    When you place orders, you can view your trades in the market depth, so you know exactly where your orders sit at literally any point in time, and that’s a huge advantage.
  • No Requotes – The best way to describe this is to tell you what it doesn’t mean.  Sometimes, you place an order to buy a share CFD at, say, $30, but when you put the order in, your broker comes back and tell you that no shares are available at that price, and quote you another rate, say, $50.25.  That sucks, and it can hurt your profits and limit your opportunities.
    Fortunately, that never happens in the DMA CFD world, because of the aforementioned transparency.
  • Pre-Market Auction – Since your orders are going straight into the underlying market, the DMA CFD model also gives you the opportunity to participate in the pre-market auction, which opens up opportunities you normally wouldn’t have access to.
    Note that the Australian market staggers its starting time alphabetically, according to the following schedule:

Shares Beginning With

Opening Bell

A-B

10:00:00

C-F

10:02:15

G-M

10:04:30

N-R

10:06:45

S-Z

10:09:00

**Note:  All start times are +/- fifteen seconds

  • It should also be noted that the Australian market temporarily halts trading around 4pm and allows all participants one final opportunity to buy or sell in a closing auction.
  • Increased efficiency – one of the side effects of your orders being placed directly into the underlying market is speed.  There’s no middle man, so there’s no time lost.  While it’s true that CFDs are not great investments for capturing micro-profits and holding positions for mere minutes, it’s also true that speedy execution of trades can be a compelling advantage that can often increase your profits. 
  • Ability To “Improve The Quote” – This is (or can be) another compelling advantage.  You can improve the current bid or offer by placing limit orders within the current spread.  So for instance, if the current bid/offer is $50.00/$50.18, then you can place your orders within that range and gain a tactical advantage by essentially moving you to the head of the line.

Disadvantages of DMS CFDs

Clearly then, DMA CFDs offer some pretty compelling advantages, but it’s not pure upside.  There are some disadvantages too, and you should be aware of them.  They include:

  • A Somewhat Limited Range Of Opportunities – Data feeds that link brokers to international markets are expensive.  Because of that, DMA CFD brokers don’t typically offer as much in the way of exposure to global markets, which can limit your opportunities
  • Higher Platform Charges and Expenses – Because DMA CFD brokers use prices that come direct from the underlying exchange, you get better visibility and more complete, real-time data…at a cost.  The added cost can be worth it, provided you’ve got the skills to make good use of it
  • Higher Trading Costs – Because DMA CFD brokers are hedging your orders directly into the underlying market, they incur market-based fees, which are reflected in higher brokerage costs.


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Market-Maker CFDs

A CFD market maker “makes the market” on a whole range of products on several markets, worldwide.  They have the ability to set their own price, but not with perfect freedom.  The price still reflects (somewhat imperfectly) the price of the underlying asset.

Here are the major advantages of using this type of broker:

Advantages of Market Maker CFDs

  • A global range of options – You get broad, truly global market access when you use this type of broker, which gives you trading options you’d otherwise be shut out of entirely.  Consider this to be one-stop shopping.  From a single control panel, you have access to a world of opportunity!
  • Super Easy To Use – Simplicity is one of the hallmarks of Market Maker CFD brokerage systems.  You get an intuitive interface, making it easy to buy, sell, and track your trades.
  • Extras! – The two biggest extras you get here are free charting, allowing you to get (and keep) a bird’s eye view on all your positions, and access to software to help you do research and enhance your trading strategy.  Note that some brokers charge a nominal fee for accessing local charts and data.  These charges are most often reimbursed after a certain monthly trading quota is met, but this varies from one broker to the next, so you’ll want to read the terms and conditions closely so you’ve got a good understanding of the fee structure.
  • Low margins – this is huge, but as we’ve mentioned before, it can be a bit of a two-edged sword.  Leverage can help dramatically improve your ROI, but it can also come back to bite you if you don’t use it well and correctly.

Disadvantages of Market Maker CFDs

There’s really only one disadvantage to talk about here, and it can be a pretty important one.  Trades are executed more slowly because you’re essentially dealing with a middle man, and you don’t have as much transparency or depth of information because the pricing isn’t perfectly reflective of the underlying market.

DMA Vs. Market Maker – Which One Is Right For You?

Ultimately, working out which of these is right for you comes down to what you’re looking for in a broker.  To answer that question, you’re going to need to ask yourself some hard questions, and get honest answers back.

If you value convenience, ease of use, and global reach, then a Market Maker CFD broker is going to be a natural fit for you.  This is also true if your interests run to international Index CFDs commodities and forex.

On the other hand, if you’re only trading in your local market, then you have to really ask yourself if the added advantages offered by a Market Maker broker are going to be things you’ll make regular use of.  If not, then you have your answer!

Note:  If you’re wondering what the prevailing trends are, according to a recent Investment Trends survey, 47% of respondents indicated that they preferred the DMA model, while 14% said they preferred the Market Maker model.  Which one will you prefer?  Only time will tell!

Then again, there’s a third option.  Why not have your cake and eat it too?  After all, most CFD brokers, regardless of type, only ask for a starting balance of $1000 or so, which means that it should pose no special challenge to open both types of accounts and try them out to see which one you like better. 

It won’t take many trades on each system to get a good feel for where your preferences lie.


 

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Finding the Right Broker

This is both more complicated, and much simpler than it first seems.  The simple truth is that there are a lot of brokers to choose from.  It’s a pretty crowded market place, and because of that, a lot of brokers use freebies and giveaways to lure you into choosing them. 

This helps you in two ways:  First, you’ll get lots of great extras and incentives, which is always nice, but there’s a much more straightforward benefit.  More competition means lower rates as brokers cut their prices (and profits) to the bone to stay competitive, and that helps your bottom line.

One thing you should be aware of is that while your choice of broker is important and definitely matters, it’s not something that will make or break your trading career.  If you find that your first pick isn’t everything you had hoped it would be, it’s a fairly simple matter to move on to some other broker that meshes better with your needs and trading style.

Another point here is that over time, your needs are going to evolve and change, so the first broker you select may not be the one you stay with in the long run, and that’s okay.  When you’re first starting out, you don’t really have the tools and experience you need to pick the “perfect” broker for you, so your primary goal should be to find one with low commissions and a simple interface that makes it easy for you to get started.

As you gain more experience, you’ll start to get a better feel for what you need, and can begin comparing other brokers with the one you started out with to see if there might be a better fit somewhere out there.


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Questions To Ask Of A Potential Broker

Once you’ve gained some trading experience, you’ll have a much better sense of what you’re looking for in your “perfect broker.”  Once you have that experience under your belt, the following pointed questions will help you narrow the field and ultimately make a good decision on that front.  Bear in mind that you may find that the broker you initially decided to go with is the one you decide to stay with.  It happens, but if it doesn’t don’t be alarmed by that either.

One final thing to consider is your chosen broker’s position on hedging trades.

DMA CFD brokers automatically hedge every trade, which means that they adopt the opposite position in the market, but Market Maker brokers manage their own hedging strategy, based on their knowledge of their clients’ experience.

  • What are your fees, commissions and trading costs?
  • Is mobile trading allowed?
  • Do they provide DMA or Market Maker CFDs?
  • How many markets can be accessed from the platform?
  • What’s the range of their products and markets?
  • What kind of software do they offer?
  • Do they have demo accounts available?
  • And most importantly – what kind of research tools are available?

This last one is probably the single most important question you can ask.  The ability to get eyes on detailed, timely research is huge, and can dramatically improve your ability to make winning trades, and thus, enhance your ROI.

While you’re on the topic of quality data to guide your decision-making process, it’s also worth asking about educational materials.

The quality of your chosen broker’s customer service and support is also critical, but that’s not something you can really ask your broker, because of course, according to just about everyone, their customer service is world-class.

No, to find that out, you’re going to either have to call in and see for yourself, or do some research and see what other people are saying about it.  If you do ask about it, the one thing you definitely want to hear is that 24-hour support is offered, either six or seven days a week.

Finally, and this isn’t a question really, but it’s something you’re going to want to do for every broker on your semi-finalist list:  You’re going to want to carefully read two documents:

  • The FSG (Financial Services Guide)
  • And the PDS (Product Disclosure Statement)

All brokers will have both of these documents, and make them readily available.  The first document describes the range of services offered by the broker in question, and gives you full details on how the company operates, including how they get paid and how they handle customer complaints.

The second document outlines what products they offer and any additional charges and fees that trading in those products may introduce to the equation.  You’ll also get full details on the risks and advantages of investing in specific products, and all the information you’ll need to determine whether or not a given investment opportunity is a good fit for you.


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Opening An Account

Opening an account is almost always a simple, straightforward process that will only take a few minutes of your time.  It’s simply a matter of creating a login, selecting the type of account you want to open, and verifying your identity.

Identity verification is usually as simple as providing a copy of a picture id like your driver’s license, though the exact requirements will vary slightly from one broker to the next.  Just follow their simple, step-by-step instructions and you’ll be done in no time!


Types Of Accounts

One of the first, important questions you’ll need to answer though, revolves around the type of account you want to open.  We’ll describe each of these in turn, just below.


Individual Account

These are the most common types of accounts, and are the easiest to open.  You’ll just need to read and agree to the terms spelled out in the FSG and PDS, and provide your identity verification (photo id – driver’s license, passport, etc.) and fund your account, which we’ll go into later.

Note that some brokers might require a certified copy of an original document for identification purposes, but this isn’t always the case.


Joint Account

Joint accounts are great if your goal is to open an account with a business partner.  In this case, both parties can execute trades and both can add or withdraw funds from the account.  In this case, the ID verification requirements apply to both users.


Company Account

Company accounts are a bit more complex to set up, and there are a few more hoops to jump through.

These accounts do share some traits with joint accounts, in the sense that all Directors much fill out the forms and prove their identity.  In addition to that though, you must prove the formal existence of the company itself, and name the parties who will be authorized to make trades and changes to the account, and to make a declaration of liability in the event that something goes wrong.


Trust Account or SMSF

Trust accounts are functionally similar to company accounts in that all trustees (if there are several) must fill out the forms and provide identification, with one trustee being named as the manager of the account, with that person being in full control over any and all decisions about what trades are made, and having the ability to add or withdraw funds.

As with the company account, the Trust itself must be proved to exist and be authentic.


Limited Risk Account

Not all brokers offer these, but a few still do.  These types of accounts offer some protection in the event of a worst-case scenario, and guarantee that you can’t lose more than your starting balance. 

This added security comes with certain restrictions and limitations though, and you won’t have access to the full range of CFDs the broker offers.


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Funding Your Account

Once you’ve created your account, selected the type that works best for you, and verified your identity, the next step is funding.

As with the account creation process, this is pretty simple and straightforward.  Most brokers give you three options here.  You can either fund via direct deposit, which involves linking an established bank account to your trading account, via credit card, or by way of BPAY. 

Depending on the broker you’ve selected, some fees may apply.  One of the more common promotions offered is that the broker will absorb those fees, even if they’re normally charged, so that’s something to keep an eye out for.

One question that often comes up, especially with new traders who are just starting out is “how safe is my money.”

We’ve mentioned that Australia has some pretty stringent rules on that front, so if you’re trading here, then you can do so with a high confidence level that your money is quite safe.

This is because most brokers keep the funds of their investors in Trust Account that’s separate from the rest of the broker’s business accounts.  That firewall keeps the money safe, even in the event that the broker’s firm goes bankrupt.


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Self-Assessment – Which CFD Market Is The Best Fit For You?

This is a totally separate question from the DMA vs. Market Maker question, and has more to do with the types of opportunities you’ll be most interested in trading in, once your account is up and running, and there’s a lot more to this than first meets the eye.

One of the key things that will guide your thinking here are the markets and types of investments you already have experience in dealing with.

This is simply a case of using what you know.  If you’ve got a good background in tech companies, for instance, and you have a firm understanding of one in particular, then use that.  You’ll save time and be able to start making trades that much more quickly, without having to do a ton of research.

Another important consideration is what your personal trading window is.  If you have an office job, working 9-5, and you live in Australia, then it’s going to be hard for you to make trades during the day on the AUX, so international markets will have more appeal, because you can conduct trades when you get home in the evenings.

Yet another important consideration is your tolerance for risk.  If you are fairly risk averse, then you’ll want to trade in low-volatility markets, but of course, that comes with certain tradeoffs too, not the least of which is the fact that your potential for profits will be somewhat lower.

The simplest way to get a handle on market volatility is to look at the ATR, which stands for “Average True Range.”  This is a simple indicator that gives you a good top-level view of how volatile any given market is over time. 

Reaching a good understanding of your risk-tolerance is an essential component to successful investing, and will go a long way toward helping you achieve long term success.  It will also allow you to make a fairly realistic prediction about what kind of return you can expect, although we’ll have more to say on that topic in a later section.


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Before You Make Your First Trade

We’re still not done yet, and you’re still not quite ready to jump in and start trading.  We’ve gotten a lot of the groundwork covered, but the last thing you want to do is go off half-cocked, and that’s what this next section seeks to prevent.

We’ve mentioned a couple of times that our recommendation is that from day one, you should treat your investment portfolio like a business, and we’ve outlined the main reasons that’s so important.  Now, we’re going to tell you how to go about doing that.

The very first thing you’ll want to do is to write up a formal business plan.  This will help you answer some key questions like why are you investing in the first place?

To make a profit, sure, but beyond that, what’s the point?  What goal are you trying to achieve?  Are you building a retirement nest egg?  Putting together money for your dream house?  What?

Ultimately, this comes down to being a variant of the “what do you want to be or do when you grow up?” type question.  It’s important, because understanding what your aims and goals are is an essential component to defining your overall investment strategy, and speaking of that, that’s where our guide is headed next!


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Defining a Basic Investment Strategy

Your investment strategy has several moving parts, but the “Big Three” are:

  • Your Goals
  • Your Expectations (ROI)
  • And Your Tolerance for Risk

Only by having a thorough understanding of these three components can you begin to devise a workable investment strategy for yourself.  That matters because investing without a plan is a recipe for disaster.

If you go in without a plan, then you’ll be inclined to shoot from the hip, make decisions sans research, and allow your emotions to take over.  That never ends well, and given that, the next question then, becomes “how, precisely, do you construct a viable strategy?”  To do that, you need to work out some trading particulars, which include:

 

Market Entry Criterion

Whole books can and have been written about timing your entry into any given market.  You’ll find lots of different opinions on the subject, and lots of different strategies to inform you of when it’s the “right” time to enter into a position.

At the end of the day though, all those strategies have one thing in common.  They all rely on one or more measures to inform the decision, which takes emotion and guesswork out of the equation.

The purpose of all this focus on finding the proper time to enter the market is to build expectancy into your system.  That’s something we’ll explain in more detail later. 

For now, the important thing to understand is that while perfecting your market entry strategies are important, don’t sweat it if you don’t do it perfectly.  It’s not going to kill you, but refining your technique is something that will help ensure profitability as you gain more experience.

Ultimately, your goal should be to develop a viable market entry strategy for the following three market types:

  •  Range Bound
  • Trending
  • And Volatile Breakouts

These three cover all possible trading conditions.

You’re bound to get lots of advice on the subject of entering each of these types of markets, but for now, let’s just keep it simple.  Use the following indicators to build your strategy around:

  • For Trending Markets, use moving average indicators to inform your decision
  • For Range-Bound Markets, use oscillators like Bollinger Bands, RSI, or Stochastics to inform your decision
  • For Volatile Breakout Markets, use chart pattern analysis

 

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Your Money Management Plan

If you want to achieve any level of success in the market, then you’re going to need to learn to manage your risk.  That means managing your money and making sure that you’re not putting all of your investment eggs into one basket so as to prevent a catastrophic loss.

The question is, how?  How precisely do you do that?

Fortunately, there’s a really simple answer.  It’s called “Fixed Percentage Risk Per Trade.”

This is a formulaic approach that tells you how large any given position should be (how many CFDs you should buy).  In order to make the calculation, there are a few basic pieces of information you need.  These are:

  • Your entry price
  • Your initial stop-loss
  •  How much capital you’ve got in your account
  • The percentage of capital you opt to risk on any position (let’s just arbitrarily say you settle on 2%) – a good rule of thumb is to never risk more than 1-2% of your capital, so use whichever makes the most sense to you

Here’s how you use the formula:

Let’s say you’ve got $25,000 in your account.  You’ve entered a position at $20.00, and your initial stop loss is $19.50 (fifty-cents away).

  • 2% of your capital is $500 ($25,000 * 0.02)
  • $500/ $0.50 = 1000 share CFDs

That’s useful as far as it goes, but this formula will also tell you when (or if) you should increase your position size, or reduce it.

 

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Understanding The Risk vs. Reward Tradeoff

The higher the risk, the greater the (potential) rewards.  That’s it in a nutshell, and it’s a concept that most people understand intuitively.

It really matters in terms of devising a successful trading strategy though, and the first thing you need to do is to have an honest conversation with yourself about how much risk you can tolerate.

If your risk threshold is low, then you’ll take a pass on high risk opportunities that could have big payoffs, or could lead to catastrophic losses.

On the other hand, if you have a relatively high tolerance for risk, you’ll be much more inclined to take those trades, which will open the door to more trading opportunities, but require much better risk management skills to be successful.

Each person’s tolerance for risk is different, which is why it’s so crucial to understand where the line is for you.

Looking at the risk-reward ratio in conjunction with your winning trades percentage gives you a valuable measure that enables you to accurately assess your trading performance.

Your risk-reward ratio is calculated as follows:

(Average Win Amount/Average Loss Amount)

This gives you a snapshot of how much money you make when you exit a trade profitably, versus how much you lose when you misstep.

Obviously, the higher the risk-reward ratio, the better your profits, but that’s only true if your win percentage is high enough to make it pay off.  If you’re mostly conducting losing trades, then the system can still lose money.

The best way to think about this is to consider the lottery.

If a ticket costs you $1, and you stand to win $10 million, then you’ve got a HUGE risk-reward ratio.  On the flip side though, the win percentage in such a scenario is incredibly low, which explains why almost nobody makes money playing the lotto!


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Your Exit Criterion
– Know When To Hold ‘em, Know When To Fold ‘em

While the absence of a clearly defined entry strategy won’t necessarily make or break your portfolio, the absence of a clearly defined exit strategy will kill you faster than anything.  Worse, defining a cogent exit strategy is one of the hardest elements of successful trading to master.

Think about it.  You’ve entered a position and have seen it increase in value.  When, exactly do you sell?  If you sell too soon, sure, you’ll lock in profits, but if the value of the position keeps rising, you’ll essentially leave money on the table.

Or think about the flip side:  You enter a position and it starts to lose money.  How big a loss are you willing to withstand before you bow out?

Being able to answer those questions definitively is crucial to your long-term success, because if you fail to properly define your exit and start losing money, you’ll damage your confidence, which will hurt your chances of success in all future trades.

This then, describes the two parts you’ll need in order to properly define your exit strategy:

  • How and when to exit when taking profits
  • And how to exit at a loss

Without both of those things, you can’t expect success in the long run.

The key here is the concept of expectancy.  Expectancy comes in two flavors:  Positive and negative.  This simply describes setting the conditions of all your trades so that the odds are ever in your favor. 

Note that this isn’t the same thing as trying to devise a system that increases your percentage of profitable trades.  Its main purpose is to ensure that you win consistently by ensuring that your successful trades are vastly more profitable than your losing trades lose.

Here’s how you calculate expectancy:

(Percentage of Winning Trades * Average Win Amount) – (Percentage of Losing Trades * Average Loss Amount)

This will tell you whether your trading strategy is a positive expectancy system, or a negative expectancy system.  Obviously, if you’re trading in a negative expectancy system, then you need to change that immediately, or you’re doomed.

Don’t let this discourage you though!  Knowing is half the battle, and once you know, you can start taking steps to get your trades back on track.


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Fine Tuning Your Strategy

Obviously, you’ll be in a better position to fine-tune your strategy after making your first few trades, so we’ll have much more to say about this in later sections, but there are some additional things you can feather into your thinking before you start that will serve to modify your basic strategy.


Controlling Leverage

Historically, the stock market earns investors an annual return of about 11%, totally unleveraged.  If you’re trading CFDs at 2x leverage, and meeting the industry average, then you can realistically expect to earn about a 22% return.  If you’re trading at 3x leverage, then on average, you can expect a 33% return.

Having said that, we’ve talked before about the potential dangers of leverage.  If you’re not careful, and you find yourself on a losing streak, then your losses will be proportionally magnified based on the amount of leverage you’re using.  This is why we recommend starting slow and cautiously.

From Day One, you’ve got to have a firm understanding of exactly how leveraged your positions are, so you can better control your risk.  This is not something anyone is going to tell you, or do for you.  Just because you can trade with only a 5% margin doesn’t mean that you should!

Ultimately, the decision about how much leverage you use is on you.  Use it with care and caution.

So how do you know exactly how much leverage you’re using?

It’s easier than you might think.  Here’s the formula:

(Total Exposure/The Size Of Your Account)

To put some real numbers to this, if you’ve got $5k in your account, and you’re controlling $20k worth of CFDs, then your leverage is (20,000/5000) = 4x.

The next logical question then, is that good?  Is that bad?  How do you know?

While the answer differs for everyone, here are some basic rules of thumb:

  • New traders who are first starting out should aim to keep their leverage at or near 1.0
  • After 3-4 months of trading, and once you’ve gained some familiarity with using stop losses, aim to keep your leverage between 2.0 and 3.0
  • Once you’ve got some experience under your belt, and have been trading for about a year, are familiar with stop loss strategies, risk management techniques and understand your strengths and weaknesses as a trader, aim to keep your leverage around 5.0
  • If you consider yourself to be a professional trader, aim to keep your leverage between 7.0 and 10.0

Any more than that, and you’re flirting with disaster.

Now, having said all that, what are your investment goals?  Are you aiming to make a 20% annual return on your investment?

If so, and given that the stock market offers an annual rate of return of about 11% unleveraged, then you can meet your investment goals with just 2x leverage.

That’s the kind of thinking you need to be engaged in.  Only by having a clear understanding of your aims and goals can you properly control leverage and use it for maximum benefit without getting carried away.

If you don’t take anything else away from this section, remember this:  Regardless of what your investing aims and goals are, your first, overriding priority is to stay in the game.  After all, you can’t achieve your goals if you’re not even playing, and if you don’t keep a good handle on your leverage, you can easily wipe out the entire value of the account.

To make sure that doesn’t happen, you’ve got to stay in the game, and that means being very careful with leverage, over and above anything else!


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Tools Of The Trade

In order to make successful investment decisions, you need two things:  Software and data.  The problem is that raw data in isolation isn’t very useful.  There’s so much of it that it can be hard to pull anything meaningful out of it.

Software helps turn raw data into actionable investment intelligence.

Fortunately, most brokers do an excellent job at providing free charting software that can turn those oceans of raw data into intelligence you can use. 

Most of the free charting software offered by brokers is quite good, and is more than enough to get you started.  Sooner or later though, you’re going to want more than the simple charting software can provide, and when that day comes, here are some other programs to consider:

  • AmiBroker – An excellent versatile tool that gives you the ability to build your own indicators using a simplified coding language, and provides full-featured back-testing capabilities as well as excellent EOD (End of Day) data.
  • Incredible Charts – a low-cost options that has lots of great charting features and data services.  If you’re just starting out and looking for something a bit more robust than what your broker is providing, this one’s a great option
  • MetaStock – With more than a decade of experience and hundreds of thousands of users, this is one of the most popular trading platforms available.  Owned by the Reuters Corporation, it’s simply amazing, and you’ll be dazzled by its broad range of features
  • Ninja Trader – One of the best options out there, once you’ve gained some experience at trading.  One of the coolest aspects of it is that it gives you the ability to “replay” your trades and consider alternatives to the actions you took.  This helps improve your skills in a big hurry, and as such, is an invaluable addition to the program.
  • TradeStation – one of the oldest software packages out there, and often cited by professionals.  It gives you the ability to create your own indicators and build out your trading strategy online.  Great stuff!
  • Wealth Lab Pro – This platform was acquired by Fidelity Investments, which is a powerhouse in the world of investing, and as such, the platform is highly regarded and well-trusted.  A little more expensive, but well worth considering!


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THE IMPORTANCE OF DATA    Data drives every aspect of your investing decisions.  If it’s not, it should be.  The last thing you want to do is to make decisions based on gut feelings or emotion.  Keeping everything data driven is the best way to avoid letting your emotions cloud your thinking.

 

Where data is concerned, you’ve basically got three flavors to choose from, and we’ll describe each in brief, just below:

  • End of Day (EOD) data – This is simply data downloaded at the end of each trading day that reports the open, high, low, close, and trading volume of all charts.
  • Real-Time Data – This is hands-down the most expensive data you can incorporate into your (paid) trading platforms, but there’s a wrinkle.  Your broker will almost always provide live-streaming data on commodity, index, and forex markets, but the drawback is that you can’t export that to any third-party software you might be using.  To get it there, you’ll need to pay for a data subscription
  • Snapshot Data – This is simply data you can download at various times during the trading day.  For instance, you can set up your system to download data on an hourly basis, so you can scan it and identify additional trading opportunities

In terms of where to get your data, there are a number of brokers available, and they wouldn’t still be in business if they didn’t offer a quality product.  To keep things simple, our recommendation is justdata  Simple, accurate, and reliable.  What could be better?


EVALUATING SOFTWARE    Whatever software you work with, here are some key ingredients a good program will have.  Note, don’t be alarmed if the software you’re using doesn’t offer all of these, but as you gain more experience trading, keep this list handy, because it may guide you to a program that meets your needs better.  Here’s the list:

  • Accurate and complete, fully adjusted market data
  • Some kind of ability to scan for specific criteria.  For instance, an ability to show any shares making a new 20-day or 30-day high
  • An ability to build your own indicators, which allows you to really customize your strategy
  • Some back-testing ability that allows you to fault-test your trading strategy

And now you’re ready to trade, which brings this section to a close.  We’ll pick things up in the next section with making your first trade and beginning to put your strategy into action!


YOUR INTERNET CONNECTION    For some people, especially day traders who only hold their positions for a matter of minutes (or sometimes, even less), the faster your internet connection, the better, because the added speed allows you to execute trades more quickly and efficiently, and maximizes the number of opportunities you can take advantage of.

CFDs aren’t really designed to be used for that kind of trading (because you have to pay the spread, which negates small-move profits in almost all cases), and for that reason, while a fast internet connection matters, what matters more is simple reliability.

All that to say that when you’re designing your trading system and setting up your computer, you should probably opt for an internet provider that offers rock-solid reliability and is very responsive should your connection fail for some reason.  Of course, get the fastest connection you can afford, but focus on the reliability.  The first time something goes wrong, you’ll be very glad you did!


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Part 03 - Key Points to Remember

  1. Direct Market Access (DMA) CFDs are great because of their transparency.  Your orders are directed straight into the underlying market
  2. Market Maker CFDs are great because of their convenience.  Its one-stop shopping in several markets all over the world.  Pricing largely replicates the pricing of the underlying assets
  3. Asking the “right” questions can cut to the chase and help you zero in on the right broker for you
  4. Opening and funding your account is pretty simple, although there is some paperwork involved, and you’ll need to comply with some basic background checks and identity verification.  Funding can be handled via direct transfer, credit card, or BPay
  5. Australia has stringent requirements of brokers where funds held on deposit are concerned, so your funds will be quite safe.  If you’re trading in some other country, you’ll want to do your due diligence so you know your risks and potential exposure.
  6. Having both a business plan and a well-thought out trading plan is essential to your long-term success
  7. Only trade positive expectancy trading systems
  8. Know yourself.  Know what your investing goals are, as these will help you develop, then refine your system
  9. Controlling leverage is an essential component of managing your risk – remember:  Above all else, your goal is to stay in the game.  That means keeping a tight rein on leverage and knowing  how much you’re using at any point in time
  10. Work smarter, not harder.  Use tools and technology to help you refine your strategy

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PART 04: WHERE THE RUBBER MEETS THE ROAD – YOUR FIRST TRADE

 

The Value Of A Demo Account
Differences To Be Aware Of – Live Demo vs. Actual Trading
What Kinds Of Orders Can You Place?
  Market Orders
  Limit Orders
  Stop Orders
  OCO Orders
 If Done Orders
What The Heck Is a Requote, Anyway?
Part 04 – Key Points To Remember 

 

At long last, you’re ready to start trading! You’ve got a basic system in place, and all the prep work has been done. You’ve found a broker you feel is a good fit, your account is funded, and you’re ready to begin. Now what?

 

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The Value Of A Demo Account

Almost all brokers these days offer a free demo account, and you owe it to yourself to spend some time playing with it to master the basic operation of the platform. There are no hard and fast rules here, but our advice would be to simply keep using it until you’re comfortable navigating through the system and can quickly and easily find every piece of information you need in order to conduct trades.
Your chief goal is to master the following basic operations:

  • View a Chart
  • Place a Market Order
  • Place a Stop Order
  • Locate Your Trading Instruments
  • View The Market Depth
  • Save Your Layout

Once you’ve done that, you’ve pretty well reached the outer limits of what the demo can teach you, and you’re ready to make an actual trade.


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Differences To Be Aware Of – Live Demo vs. Actual Trading

While many, if not most demo accounts offer the ability to make “fake” trades to get a feel for it, these are of limited value. It’s just not the same. Until and unless you’ve got actual money on the line, you’re not going to get the kind of experience you need to be successful.

Our recommendation then is that after you’ve mastered the platform’s basic operation, it’s time to just jump in. Of course, do so with care, and make sure your initial trades are small, so that you’re only risking a tiny fraction of your account’s value, but the simple truth is that there’s just no substitute for real world experience, and there’s only one way you can get that. 

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What Kinds Of Orders Can You Place?

While the particulars of each broker’s system will vary, one of the first things you’ll see is a place where you can execute different kinds of buy/sell orders. Broadly speaking, the kinds of orders you’ll be able to place are as follows:

  • Market Orders
  • Limit Orders
  • Stop Orders
  • OCO Orders
  • If Done Orders
  • Guaranteed Stop Loss Orders

We’ll take a closer look at each of those, right now.


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Market Orders

This is the most basic type of order you can execute. They give you the ability to buy or sell at the current market price, whatever it happens to be.
If you place a “buy” market order, then your broker will execute the trade from the first available seller at the lowest price possible, provided that the volume you’re buying is available. The inverse is also true. If you issue a sell order, then your broker will execute it, selling your CFDs to the first available buyer at the highest possible price, provided that the correct volume of CFDs is being requested by some other buyer.


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Limit Orders

This type of order allows you to buy at a lower level, or sell at a higher level than the current price. So for instance, if the current price of a CFD you’re interested in is $10, you could set an automatic buy order at some price lower than this (set by you), or, if you are currently interested in selling your CFDs and closing out your position, you can set a price that you would sell at that’s at some value higher than the current price (again, set by you).
When that price is met, the order will be executed automatically. This is excellent, but it brings to light a philosophic difference in trading, and a debate that has been raging for as long as markets have existed.
On the one hand, there’s a school of investment thought that says you should buy when the price is low and falling, on the thinking that you’ll get in at a good price, and stand to make money when it rises again.
The other, competing school of thought is that you want to enter the market just when the share price begins to rise, and ride the wave up, selling just as it crests to lock in your profits.
There are no “right” answers here, and both strategies can be used to make you money. Ultimately, it comes down to which school of thought is a better fit for your personal trading style.


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Stop Orders

Broadly speaking, there are two “types” of stop orders.
The first type is a stop to close out a long or short position, and this is probably the most important type of order you have at your disposal, because it’s the mechanism by which you mitigate losses.
Before you ever enter into any position, you should have a clear understanding about when you want to exit a trade if something goes sideways and you start losing money. That’s the price you use to define your stop order, and it will limit the amount of money you lose.
The second is a stop designed to open a new long or short position. This sub-type of the stop order is perfect for breakout traders who want to buy above the current price or sell short below the current price.
Breakout traders focus primarily on resistance. That is to say, if you’ve been studying a stock’s price for a while, and you notice that it often flirts with a given high, but never quite manages to hit it, it can be said that the stock encounters resistance at that price.
If something changes and it suddenly breaks out of that price boundary, then it’s a clear sign that the company has done something radical and different that has shifted the paradigm, which means opportunity for you.
That’s when you’d want to use a stop order to open a position. To take advantage of a company that has suddenly broken through a price barrier it has struggled to achieve, because it almost always means that big things are afoot for the company in question.

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OCO Orders

OCO, or “One Cancels The Other” orders are a great tool designed for people who can’t sit in front of their computers and watch the ebbs and flows of market activity all day long.
Here’s how you would use it:
Let’s say you’re currently holding a position of 5,000 CFD shares in a given company. You purchased them at $50. You know you’re not going to be in front of your computer, but you want to either lock in profits or mitigate losses, depending on how the market moves, so you issue an OCO, which says (for example):
I want to sell if the price hits $60, OR, if the price falls to $46. That way, whatever happens, if the price hits either of your target, that “side” of the order is executed, and the other “side” of the order is canceled out.

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If Done Orders

These are flexible orders that combine entry point and stop loss. So for instance, you establish a price you want to buy in at. Your order will only be executed IF the price hits your desired level, and if that does happen, then the stop order will automatically be executed, in the event that the stock price falls, thus limiting your losses.

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What The Heck Is a Requote, Anyway?

Trading is a very precise activity, and the numbers really matter. To give you a simple example, if you’re anxious to buy 5,000 shares of a given CFD at a set price, and that number of shares isn’t available, then you simply cannot conduct your trade at that price.
If you want the shares, you’re going to have to be willing to purchase at some higher price, which is a requote. This is something that happens every single day on the market. As the demand for a given company’s stock rises, so too does the price.
NOTE If you’re using a DMA (Direct Market Access) broker, then requotes aren’t available. You only find them in Market Maker systems. If you’re using a DMA CFD broker, then what you’ll find in their stead is a Volume Weighted Average Price (VWAP)

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Part 04 – Key Points To Remember

  • Most brokers offer live demo accounts, and these are useful in terms of mastering the basic function and navigation of the system. Having said that, nothing is better than live trading in terms of experience. Even if you keep your initial trades tiny, so you’re only risking a fraction of your account balance, that’s still hands-down the best way to get real world experience you just can’t get any other way
  • When trading CFDs, you’ve got a wide range of options and order types. It pays you to practice with the demo account before you actually make your first trade so you’ve got a clear understanding of how (and when) to make use of each of the order types
  • Stop Orders are your best friend, and absolutely essential in terms of managing your risk and mitigating losses. They ensure that when a trade goes south, you only lose a small amount of your account value, enabling you to stay in the game and recover
  • OCO (One Cancels the Other) and “If Done” orders are ideal for people who don’t have a lot of time to devote to trading and can’t watch the market like a hawk all day long.
  • GSL Orders (Guaranteed Stop Loss)

 

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PART 05: CRITICAL TRADING SKILLS

 

Analysis
Economic Analysis
Technical Analysis
Fundamental Analysis
Quantitative Analysis
Proper Position Sizing
Market Movement
Managing and Mitigating Losses
Scaling
Profit Taking
Re-Entry
Part 05 – Key Points To Remember

Making your first trade is a thrilling experience, but it also opens your eyes to all the things you don’t know. Regardless of how much prep work you’ve done, the fact remains that when you’re first starting out, you simply don’t have the skills you need to be successful in the long term.

There’s no way to get that, except time and experience.
Go out and make those trades, and as you do, here are the things you should be focused on to make you a better trader.

 

Analysis

If you’re not making trades on the basis of a solid foundation of analysis, then you’re almost certainly making them on the basis of instinct. Your gut reaction. Emotion.
That might work here and there, but it’s certainly not a good approach if you want to see long term success. Analysis is (or should be) the foundation of everything you do, and every decision you make. Good analysis is what gives you a trading edge. It’s the thing that makes it possible for you to consistently win in the market.
It should also be noted that analysis can take a number of forms, and that you don’t necessarily have to do all your own work. In fact, when you’re just starting out, it can be instructive to rely on the well-considered analysis of other traders you trust and respect, and who are pursuing trading strategies similar to the one you’re devising for yourself.
We’ll cover the major types of analysis you’ll be undertaking in the sections below to give you a feel for it.

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Economic Analysis

Traders using economic analysis to inform their trading decisions tend to focus on news releases that report on the economic performance of the company you’re looking to invest in. Much of this analysis focuses on the movement of interest rates, and for a good reason.
In general, when interest rates fall, it speeds up economic activity. When interest rates rise, it tends to curtail economic activity. Low interest rates help to increase corporate profits, while higher interest rates put a damper on them. That’s why they’re such a critical part of this type of analysis.
Having said that, there are several other economic indicators you should be paying attention to, including reports that track the rate of inflation, retail spending, housing starts, and total employment. All of these help paint a picture of how the economy is doing and what direction it’s headed in.
In the United States, interest rates are set by the Federal Reserve, and in Australia, they’re set by the Reserve Bank of Australia. These entities control the broad shape and direction of the game. They set the basic parameters the trading takes place under.
If you’re interested in Forex trading, this type of analysis is particularly important because currency valuations are highly sensitive to changes in interest rates. It’s useful (but somewhat less so) when trading share CFDs because interest rates are only one variable among many, and it requires some experience in order to properly interpret the signals you’re seeing, and how they’ll play out with regards to the company, index, or commodity you’re considering investing in.

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Technical Analysis

This type analysis focuses on price, and the ways that price moves and changes over time. Stock market prices are most often displayed as charts (lines, bars, or candlesticks). Price can then be used as a means to produce a number of indicators, which appear as lines on the chart.
With some experience at interpretation, these indicators can tell you whether or not the market is trending a certain direction, and when a turning point is likely to occur. It can also tell you if the market is in consolidation (moving sideways), with a series of up and down movements, but no clear move in either direction.
There are two great things about this type of analysis. First, the data is easy to access, so anybody with a computer can get their hands on it. Second, markets are price driven, so your analysis can be applied to any market, anywhere in the world, and as a fun side note, price movements are fractal, which means that the same trend you spot on a daily chart can also be seen on an hourly chart, or a chart that looks at a five-minute window. Pretty cool.

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Fundamental Analysis

This type of analysis focuses on the underlying performance of the company you’re researching, and makes the assumption that share price will track with company performance. In other words, if you find a company that’s going like gangbusters, it’s not really a stretch to assume that its stock price will be rising, reflecting its stellar performance.
To get a handle on how a given company is doing, your first stop will almost always be the company’s annual report and any other periodic reports they might issue. The data these reports contain can be used to create ratios that will allow you to compare different companies across different industries.
News releases are also studied closely, as companies almost always announce big expansion plans well in advance of their happening.
As you might expect, fundamental analysis is most useful when trading share CFDs, but can also provide valuable insights in the commodity market.

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Quantitative Analysis

This is often referred to as “data mining” and isn’t for the faint of heart! It will see you diving deep into historical data to find relationships that are of statistical significance. Increasing computer power is opening doors here, and making quantitative analysis more accessible to more people, but it takes patience and skill to do well.

You won’t find many charts here. Instead, you’ll be pouring through databases and creating pivot tables and decision cubes which can help you make sense of the vast quantities of data you’ll be sifting through. Using these tools, you can spot seasonal patterns, which can open your eyes to trading opportunities you wouldn’t have even known existed otherwise.

Quantitative analysis can be applied to any market, so with practice and the right tools, you can use it to analyze companies, whole industries, commodities, indices, or currencies to find trends and relationships in the data.

So which type of analysis is right for you? Ultimately, that’s going to come down to how you want to trade and what you want to trade in, because certain types of analysis are better suited to certain markets.

Having said that, there are no “right” answers here. Don’t feel “locked in” to one particular type of analysis. Be flexible. Be willing to change and try something else if you aren’t getting the results you’re looking for.

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Proper Position Sizing

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Market Movement

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Managing and Mitigating Losses

  • Percentage Stops
  • Volatility Stops
  • Time-based Stops
  • Technically-based Stops

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Scaling

  • In
  • Hold
  • Out

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Profit Taking

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Re-Entry

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Part 05 – Key Points To Remember

  • You can’t expect to find long term success without mastering the core skills of the trade. Until you feel as though you’ve gained mastery (and prove it by consistently earning profits over say, a year or more), you should trade very conservatively to help ensure you stay in the game.
  • Good analytic skills are crucial to your long-term success in the market. Note that you don’t necessarily have to do your own analysis, and in fact, when you’re first starting out, it can pay big dividends to learn by following the analysis of a more experienced trader. You do, however, need to at least be able to understand what you’re looking at.
  • No matter what type of analysis you use or perform yourself, the overriding goal is to find an edge you can use when making trades. Proper analysis is what separates failed traders from successful ones. If you don’t perform analysis, then you’re relying on gut instinct, which is essentially a roll of the dice, and that’s no way to trade.
  • Few things are more important than properly controlling your position size. This is the primary means by which you manage your risk, and is the reason that new traders are advised to keep all of their position sizes small.
  • Always adopt low-risk entry techniques and only act when all your indicators say that the market is ready to move. It’s a perfectly valid choice to do nothing…you don’t have to act on every signal you see.
  • Get into the habit of placing a stop loss order every time you enter a trade. This, combined with proper sizing will allow you to control your risk to a great degree. It obviously won’t eliminate all risk, but it will certainly make your trades safer.
  • Scaling in is another tool you can use to manage risk, allowing you to test the waters by starting with a modest position, adding to it as the market moves in the position you expected it to.
  • Holding a position is challenging and takes nerves of steel. The most important thing to remember is that trading isn’t a game of “set and forget.” You’ve got to watch the market constantly, keeping an eye out for evidence (which comes to you by way of your ongoing analysis) that conditions in the market may be about to change, which is your signal to take profits.
  • In a similar vein, scaling out is also an important tactic, as it helps ensure you lock in profits, in the event that the market unexpectedly turns against you.
  • You can use as many exit signals as you’re comfortable with to help inform you when to take profits. The most important thing is to have clear, well-defined rules and stick with them so that your emotions don’t take over and wreck your position.
  • Don’t forget that after you’ve exited a trade to take profits (or to mitigate a loss) it’s perfectly acceptable to re-enter the trade, provided that your entry criteria are still valid.



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    PART 06: REFINING YOUR TRADING STRATEGY


    Calculating Risk
    Pivot Tables
    Equity Curves
    Managing Drawdown
    Keeping Accurate Records!
    Part 06 – Key Points To Remember

    This part can’t happen until you’ve got some live trades under your belt, and you’ve had a chance to field-test your trading strategy. Once that happens, you’ll undoubtedly see areas where you could improve. At that point, it’s time to take your trading to the next level, and the ideas presented in this section will help you do just that!

    There’s one aspect of this that stands heads and shoulders above everything else though, and that is your trading diary. If you take your time and build it right, starting from the first trade you make, you’ll find that it’s the most indispensable tool you’ve got at your disposal. A well-constructed trading diary will not only show you the things you’re getting right, but will also clearly illustrate where things are going wrong for you.

    This includes not just weak points in your strategy from a technical standpoint, but also those times when you let your emotions cloud your judgement (because you should include emotional observations in your diary as well as the technical aspects of your decision-making process).

    We’ll have more to say about all that later. For now, it’s important that we plant the seed in your mind that your trading diary is vitally important. Before we circle back to it though, let’s talk about some other ways you can improve your trading game, and that starts with understanding one simple truth:
    Nobody is born with a deep understanding of successful trading. Like anything else, it’s a learned skill, and as the saying goes, “if you swing a hammer enough times, you’re bound to get better at it.”

    That’s certainly true, but you don’t have to just randomly swing that hammer and hope for the best. You can study the strategies and observations of investors with a proven track record and learn from them. In fact, that’s been done before and proved to be wildly successful.
    William Eckhardt and Richard Dennis took a group of completely untrained people (“The Turtles”), taught them a trading strategy, then gave them accounts to put the strategy they’d just learned to the test. The Turtles went on to make millions of dollars doing nothing more than faithfully executing the strategy they’d been taught, and remember, none of these people knew the first thing about investing when they started out!
    Bear that in mind as you study the moves of successful traders. Learn from them, then apply the things you learn faithfully. Let their thinking guide yours, then, once you’re trading successfully by copying the moves of others, begin to experiment with your own personalized twists and tweaks to your increasingly robust system.
    Having said that, let’s take a look at a few things that the pros use, do, and understand that you may not (yet):

    BACK TO PART 06 CONTENTS

    Calculating Risk

    This is hardly the first time we’ve talked about risk. That’s because it’s vitally important that you understand it, not just conceptually, but as a tangible element that should bound and drive your thinking.
    Among the most important aspects of risk is calculating your risk-reward and win percentages. Knowing these two numbers gives you powerful insights into how effective your trading strategy is, and can highlight areas where improvements need to be made.
    The key here is in keeping detailed records, all of which should go into your trading diary.
    The simplest way to keep track of your trades is probably in spreadsheet form, and if that’s what you’re doing, then be sure to include a column that shows your profits and losses on a trade-by-trade basis.
    Details matter here! It’s very easy, especially if you’re making short trades, to accidentally record a profit as a loss, so be careful when entering your values!
    It will probably also be instructive to have a column that lists the types of trades (Share CFD, Commodity, Index, etc.) and whether the position was short or long, so you can quickly and easily spot trends. For instance, if you observe that most of your short trades end badly, that’s important to know, and something you can work specifically to correct.
    Here are some formulas you can copy directly into Excel, when putting your spreadsheet together. All you’ll have to do is change the cell id’s, and you’re all set (this assumes that you’re putting your data in column “C” on the spreadsheet. Obviously, if you’re putting it somewhere else, then you’ll want to adjust accordingly. Note that if you’ve made more than 30 trades, then you’ll also need to expand the boundary of the formula).

    To calculate your win percentage:
    =countif(C1:C30,”>0”)/count(C1:C30)
    Be sure to format this data as a percentage, with no decimal places

    To calculate your Risk-Reward:
    =-averageif(C1:C30,”>0”)/averageif(C1:C30,”>0”)
    Be sure to forma this data as a number, out to two decimal places

    NOTE: if you’re using an older version of Excel, then the “averageif” function may not be available. If that’s the case, then use the following instead:
    =-(sumif(C1:C30,”>0”)/countif(C1:C30,”>0”))/(sumif(C1:C30,”<0”)/countif(C1:C30,”<0”))


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    Pivot Tables

    You’ll find the Pivot Table Tool in Microsoft Excel, and the more trades you make/the more raw data you find yourself working with, you’ll find it increasingly useful. Pivot Tables allow you to view your trades in different ways (through different “lenses” so to speak) to help you spot trends and identify things that do and don’t work.
    When applied to raw datasets, it allows you to conduct research on any type of market (forex, commodity, share, etc.) and identify potentially profitable trading opportunities. That’s a great thing, because these days, there are oceans of data available, but sifting through it takes time and work. Pivot tables help cut through the clutter, making the process of finding gems hiding in the data a much easier prospect.


    Your Equity Curve

    In an ideal world, your equity curve should smoothly and steadily rise over time. That means you’re consistently adding profits! Of course, we don’t live in a perfect world, and especially in the beginning, yours might not be so smooth.
    If you’re not sure what an equity curve is simply a plot of your trading account balance, over time, tracked on a daily basis.
    The technical term for account losses is “drawdown,” and drawdowns are measured as a percentage, so for instance, if your account balance gets to $5000, then drops to $4000, you’ve experienced a 20% drawdown.
    This curve really matters, and not just because it is reflective of your overall profitability. It can also tell you a lot about how effective your trading strategy is, because you can match losses with specific trading days, use that to identify specific trades, and learn how and why those trades went wrong, then make corrections from there.


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    Managing Drawdown

    Managing drawdown is just another way of saying managing your losses, and that’s a lot harder than you might think, especially if you’re a new trader, because a few bad trades can completely wreck your confidence.
    Here’s the thing though: If you manage your risk well, you won’t put your account in jeopardy, even when you lose money on trades. That all goes back to only risking a small percentage of your total account balance on each position, having firm limits and a good understanding of the amount of loss you’re willing to endure before exiting, and sticking with your strategy, even when your emotions are going haywire.
    Bear in mind that some trading strategies have more drawdown than others. If you tend to hold positions over a fairly long term, you can experience significant drawdowns. On the other hand, traders that tend to adopt positions held for shorter periods of time don’t see as much of a drawdown, but their strategies tend to be more difficult to execute well and consistently.


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    Keeping Accurate Records!

    All of this brings us back to good record keeping, and the importance of your trading journal. It is critical that you record as much information as you can in your trading journal, and the best way to capture as many of the details as possible is to record log entries as you enter and exit positions, or at the very least, at the end of each trading day.

    Simply recording your account balances from one day to the next isn’t good record keeping, because that doesn’t capture any significant detail, and those details matter if you want to work out what you’re doing right and wrong, so you can make improvements.

    Depending on how frequently you trade, keeping an accurate accounting of not just the numbers, but the analysis that guided your thinking, and what you were feeling, both when you made the trade and when you exited.

    Fortunately, the software offered by all Brokers tracks all your trades, although the data may not be in an especially useable or accessible format, which means that you’ll want to grab what details you can from your Broker, and input them in your own spreadsheet, so you can capture whatever level of detail makes the most sense for you.

    When putting your trading journal together, structure is important, so spend some time thinking about it. Remember, you’ll be wanting to capture more than just buy and sell values, but also the type of analysis you used, how it shaped your thinking, and your emotional state during the life of the position.

    That’s a lot of different types of information, and how it’s presented is important in terms of making it accessible and digestible so you can make sense of it later on. After all, the whole point of the exercise is to help you improve your trading strategy. If you can’t make heads or tails of your own journal, it’s not going to help you much!

    One way to get into the habit of making journal entries is to start your journal before you make your first trade. Granted, you won’t have any specifics to include, since you’re not actually trading, but you can still include your observations and analysis, recording the direction you think the market will move, and comparing with how it actually moves.

    As to the actual format, here’s a good general guideline to get you started. Break your journal into the following functional areas:

    • Daily Prep Work
      What are today’s trading goals? This doesn’t have to be about making X amount of money – it could be just about making some incremental improvement to your strategy
      Today’s opportunities (opportunities you have identified based on market conditions and your analysis – the more detail here, the better!)
    • Daily Activity
      - Market Situation
      - Your thoughts, feelings and actions related to the situation
      - Consequences or outcomes (what happened as a result of your actions)
    • Daily Review
      - Did you achieve your goal? How and why?
      - On a scale of 1-10, how would you rate your trading performance today?
    • Losing Trades
      - Description of company, and position
      - What went wrong?
      - What can you learn from the mistake?
      - What will you do differently tomorrow?

      This is the kind of detail you’re looking for where your journal is concerned. This is task and action oriented, and will allow you to make consistent, incremental improvements. Try it for a week and see for yourself! You’ll be hooked, and your journal will quickly become an invaluable tool.

    BACK TO PART 06 CONTENTS

     

    Part 06 – Key Points To Remember

    • Learn to know and love your equity curve. Your goal, and a clear picture that you’re on the road to success is a smoothly rising equity curve.
    • Linear thinking will get you killed in the market. Markets do not move in a linear fashion, they move in cycles. The more quickly you embrace this truth, the better you’ll do.
    • Don’t get cocky. If you find early success in trading, don’t assume that’s the way it’s always going to be. You should be continuously monitoring the performance of your portfolio because that’s the surest indicator of how effective your trading strategy is. Be prepared to make rapid, decisive changes if things suddenly go south.
    • The only way your trading system improves is if you build a feedback process into it, and the most critical pieces of that are the records you keep and your trading diary. Don’t neglect these things, or you’ll seriously limit your own success!
    • In addition to recording your trades, be sure to not your objectives, results and emotions in your trading diary. This is something you should be adding to and reviewing on a near-constant basis.
    • Set process-oriented trading goals that you can control. As a trader, you never want to be in the position of trying to dictate to the market, because simply put…you can’t.
    • You should always know the statistics for your own trades (wins versus losses) without even looking it up. It should be at the very forefront of your mind, always, as this is how you identify where your system needs improvement.
    • New traders should focus primarily on two things: analysis and minimizing losses. Intermediate traders should add developing strategies for profit taking and making adjustments to position size (scaling in and out of positions), while advanced traders should be constantly tweaking and refining all aspects of their strategy.

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    PART 07: HERE THERE BE DRAGONS – COMMON MISTAKES TO AVOID

    Uncontrolled Losses
    Too Much, Too Soon
    Being Driven By Fear Or Greed
    Forgetting To Lock In Profits
    No Reentry
    Putting Stock In Untested Ideas
    Chasing Entries
    Overtrading
    Eliminating Mistakes
    Part 07 – Key Points To Remember

    We’ve mentioned this before, but it’s something that bears repeating. You’re going to screw up. Not every trade is going to be a winner. In fact, even the best traders in the world only make a profit on a minority of their positions. The difference is that they know how to control the risk, setting up the conditions where their losing trades don’t lose much, and their winning trades pull in big profits.

    That’s what you should be aspiring to, and one of the keys to becoming a successful trader is to understand and avoid the most common pitfalls that befall traders of all levels of experience (though obviously, this is skewed heavily toward beginning traders, who tend to make more mistakes!)
    We’ve gathered all of the biggest, most common mistakes that traders make, and put them all in one place so that you’re not only aware of what they are, but also know exactly how to avoid making them in the first place. If that sounds good to you, then read on!

     BACK TO PART 07 CONTENTS

    Uncontrolled Losses

    This is one of the first lessons that beginning traders need to learn, because nothing will end your trading career faster than uncontrolled losses. The faster you get a firm handle on controlling your risk, the better off you’ll be.
    The problem, in practice, is this: A new trader enters a position and he (or she) misread the tea leaves. The market promptly moves the other way. The fledgling trader, convinced that his analysis was correct, stubbornly clings to the idea that he was right, and maintains the position as losses continue to mount, counting on a turnaround at some point to save the day.
    Then, the money runs out, and that’s game, set and match.
    This is why proper position sizing is so important, but that’s only one part of the equation. The other part is making firm, well-defined rules about when to exit a trade, and standing by those rules, no matter what. That is, after all, why you made them! To protect yourself from exactly the kind of nightmare scenario described above. Of all the mistakes on the list, this one is probably the most tragic, because it can so easily be avoided. Never forget that.

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    Too Much, Too Soon

    We mentioned proper position sizing in the section above, but it deserves its own section, because it is its own type of mistake.
    Too many traders don’t have a firm understanding of how important proper position sizing really is, but as we said, it’s one of the twin keys that help you control risk.
    It should be noted though, that the “too much, too soon” mistake isn’t just about taking care not to risk too much of your trading capital on any given position, it’s also about properly controlling your leverage. You should know exactly how much leverage you’re using, without even looking it up. If you don’t, you’re flirting with disaster.
    This can be avoided simply by being mindful, and using a simple, rules-based system to help you define the “right” position size for you, bearing proper leverage use in mind.
    When you’re first starting out, your trades should be positively tiny, even when you’re convinced that you’re going to make money, because honestly, you just don’t have the tools or the experience to make that call with any kind of certainty.
    Even when you have some experience under your belt, you’d be ill-advised to allow any position to occupy more than about 2% of your total trading capital, no matter how convinced you are that it will work out in your favor.
    It only takes a few wrong guesses to wipe your account out completely unless you abide by strict rules where position sizing is concerned. Go slow and take your time. Nobody ever went broke by investing too little, too quickly, but plenty of investors have seen their accounts wiped out by investing too much, too fast.

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    Being Driven By Fear Or Greed

    This is a tough one, because of course, everyone wants to make money. It’s important to understand though that successful investing is a skill. A process. Making money is a happy consequence of mastering the process, but if you’re focused exclusively on dollar signs, then you’re missing the point.
    Greed can manifest itself in a number of different ways, but here are the primary scenarios where you’ll see it take hold:
    • You see some early success in trading and get cocky, which causes you to forego due diligence and research. Shortcutting the process might work in the short run, but in the longer term, it will kill you. New traders are especially susceptible to this, but traders at any kill level can fall victim to it.
    • You enter a trading position, and get caught up in the excitement when the market moves strongly in your favor. The excitement of big gains growing even bigger blinds you to reason, making you forget to take profits, or to keep delaying until it’s too late, and the market starts to reverse course. This variant is seldom fatal, but it will consistently reduce your profits, making you a less effective trader than you could be.
    • You get overly focused on the dollar signs, which prompts you to seek out high risk trades, in search of high profits. In your impatience, you forego your risk-mitigation strategies, and before you know it, your account is wiped out. This one can happen to traders at any level, although again, newbies are the most susceptible to its lure. This is essentially a “get rich quick” mindset, and if you have it, you need to beat it out of your system by any means necessary. Again, if you’re focused on dollar signs, then you’re not focused on process, and that will kill you as quick as anything, and quicker than most things.
    Letting your emotions run amok is another highly dangerous mistake in the same general category. The clearest sign that you’re falling victim to it is when you start making decisions based on gut feelings. Here’s a hard truth you need to come to grips with sooner, rather than later: No amount of instinct can take the place of hard data and good analysis.
    There are two basic ways that getting emotional will manifest: First, if you have a personal connection with a given position. For example, let’s say that you’re an Apple fanatic, and because you are, you buy share CFDs that track Apple stock.
    Your emotional connection to the company could easily cause you to ignore your process and buy or hold when you should sell, causing you to lose money needlessly.
    The second basic manifestation comes when you suffer a losing trade, and novice traders are especially prone to this. The losses freak you out, making you lose what little investing confidence you had. That, in turn, causes you to freeze when you should act, or to act in panic when you should research or bide your time. Both can be deadly, and see your investment account balance zeroed out in a big hurry.
    Both of these things come down to a general lack of investing discipline, and in both cases (greed or fear-based problems), the solution is the same.
    Dedication to the process.
    That’s the only way you can loosen the grip that your emotions have on you. When you catch yourself getting cocky, or acting out of fear, just…take a deep breath. Remember the process and start marching to the beat of its drum. Do that, and you’ll find that problems like these vanish in short order.
    NOTE, however, that vigilance is called for, because fear and greed may be beaten back for a while, but they’re always lurking on the periphery. Always ready to descend on you and control your thinking, unless you’re guarding against them.

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    Forgetting To Lock In Profits

    We’ve mentioned this before, and it deserves special attention here because this is something that many investors from beginners to intermediate, struggle mightily with. There are a couple of reasons why.
    First, when most people think about exit strategy, they tend to think in terms of mitigating losses, but if you never lock in your profits, you’ll never make any money in trading, no matter how good you get at controlling losses, so it matters too.
    As you’ve read in previous sections, there are several different approaches you can take to help determine when it’s the “right” time to take profits, and there’s no “one size fits all” answer here. What matters is the fact that just as you define clear and precise rules about how much of a loss you’re willing to take on a position before bailing, you also need to get into the habit of defining clear and precise rules about where and when you’ll lock in profits.
    A lot of people are under the mistaken assumption that profit taking somehow runs counter to the mantra of “let your profits run.” The reality is that they’re not mutually exclusive because nothing says that once you exit a trade to lock those profits in, you can’t re-enter and continue to ride the wave if it makes sense to do so, which is our next topic under consideration!

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    No Reentry

    It bears mentioning again that although many people claim that learning when to re-enter a position is one of the hardest trading skills to master, we disagree.
    Just treat it as a discrete event. Close your position when it makes sense to do so, but then, re-evaluate the market landscape to see if it makes sense to re-enter, just as you did when initially evaluating the merits of the position. It’s the exact same steps, performed again on the same target, and as such, is no easier or harder than evaluating any other position you’re considering adopting.

    Also note that re-entry doesn’t necessarily mean re-entering the position in exactly the same way. For instance, let’s say you initially bought low, adopting a long position on a particular asset. The market moves in your favor, and when your analysis tells you the time is right and your profit conditions have been met, you sell and lock your profits in.

    On further analysis, you reach the conclusion that the price is about to start trending down. That would be a perfect time to re-enter, but via a short position, in anticipation of the price falling.

    The key advantage to re-entry is that you’ve already done a lot of the groundwork and due diligence. You already know the particulars of the asset in question, so all that remains is to study the current pricing trends to see what makes the most sense.
    In other words, re-entry cuts down on the amount of research you have to do, since you’re already intimately familiar with the asset in question. That makes you a more efficient trader, and very likely, a more effective one too, and that’s a big win.

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    Putting Stock In Untested Ideas

    Anyone can fall victim to this. You come up with what you think is a brilliant plan, or you adopt a strategy you’ve read about that has worked for someone else and…you do it without testing it first.
    That’s not just bad, it’s dangerous. Can you imagine buying a car, if you knew that nobody had bothered to check the components to be sure they wouldn’t explode the moment you put the key in the ignition and turned it?
    Testing is crucial! If you aren’t testing your ideas before you implement, then you’re essentially flying blind, and that is a recipe for disaster. Many Brokers offer software that allows for at least some level of back testing your ideas. If your broker doesn’t offer anything like that, then it’s well worth the money to invest in third party software that gives you the ability to do so.
    Simply put, proper testing not only allows you to test new ideas, but also to continuously refine existing ones.

    Chasing Entries

    This is a mistake that almost every novice trader makes at least a few times, early on.
    The most common manifestation looks like this: You see a report about a business doing some great, new amazing thing on the evening news. On the basis of the report, you go all in, expecting to make a huge profit.
    The problem though, is that by the time the report made the evening news, the information about the company’s plans has been in circulation for quite some time, in the form of various disclosures and reports issued by the company.
    In other words, by the time you stake out your position, you’re already late to the party. Many novice traders regard the above as “doing research.” It isn’t.
    While it’s true that you might make money on the position, it’s also true that if you’d done some actual research, you would have identified the opportunity much earlier, so not only will your profits be reduced, but your risk will be increased. That’s never a good combination.

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    Overtrading

    This is a pretty straightforward one. Lots of beginning traders (and more intermediate traders than we’d care to admit) get the idea stuck in their heads that trading is a volume business. It isn’t. You can make a nice, solid income with relatively few trades.
    On the other hand, if your investment strategy is sound, then the more opportunities you have to execute it, the better. Just bear in mind that more trading doesn’t necessarily equal better trading. Think quality over quantity.
    By all means, go for quantity if your strategy is going like gangbusters, but don’t make trades just for the sake of trading. There are costs involved in every trade you make (brokerage fees, possible financing charges, and the like), and if you start ignoring that fact, you’ll drag down your profits.
    This kind of mistake is seldom fatal, but it certainly can be.

    Eliminating Mistakes

    When it comes to eliminating mistakes, at least half the battle is simply being mindful of them. After all, you can’t chart a course around something unless you know it exists in the first place, right? So step one in mistake avoidance is to be aware that it exists in the first place.
    Also note that most of the mistakes here have process-driven solutions. In other words, there are a series of logical, ordered steps you can take that, when performed diligently, will help you avoid trouble. That gives you a powerful one-two punch: Mindfulness and process.
    Stick to the process and be situationally aware, and you’ll go a long way toward eliminating the worst of the mistakes, which in turn, will go a long way toward making you a highly successful trader!

     BACK TO PART 07 CONTENTS

    Part 07 – Key Points To Remember

    • If you want to maximize your chances for success, then before you make your first trade, you should test the trading system you’ve devised both backward and forward (literally!). Something that hasn’t been profitable in the past is not likely to be profitable in the future. Use that knowledge to your advantage!
    • While overtrading is great for your broker, it’s not so great for you! If your risk-reward isn’t great, it’s probably because you’re chasing too many marginal opportunities. Learn from that and be more selective.
    • Never chase an opportunity. If you know where and how to look, you’ll find plenty of opportunities, and you’ll only increase your risk and decrease your potential for profits by showing up late to the party.
    • If there’s one thing that new traders really struggle with, it’s knowing when to cut your losses and get out of a position. This is why it’s so important to get into the habit of placing a stop order every time you enter a position, no exceptions!
    • Simple mistakes like transposing numbers, adding a zero or hitting the wrong button can be easily eliminated. This is just a matter of being more mindful and triple checking everything before you place a trade. And don’t forget to review your trades after the fact too! There’s no such thing as being too careful!
    • If the market just handed you your butt, it can be hard to get back on the horse and make that next trade. That’s okay, and understandable. Just scale back your position sizes to take some of the sting out and try again!
    • Winning trades can be every bit as bad as losing them, especially for beginning traders. Overconfidence leads to cockiness, and that can allow greed to take over. Don’t allow a winning streak to cause you to deviate from the trading plan you have mapped out. If you do, you’ll find yourself taking stupid risks and overleveraging, which can END your trading career.
    • If you’re keeping a trading diary (and you really should be!), then use it! That’s what you’re going through the trouble of keeping it for. It can help you spot mistakes or weak spots in your trading strategy.

     

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    PART 08: YOUR BLUEPRINT FOR SUCCESS

     

    Know Thyself
    Nix The “Get Rich Quick” Mindset
    Find Your Niche
    The Power Of Detachment
    Understanding The Nature Of Trading
    Develop A Routine
    Guard Against Stress
    Never Stop Learning
    Never Stop Testing
    Consider A Trading Coach
    Follow In The Footsteps Of Successful Traders
    Play The Odds
    Independent Variables
    Countertrend Trading
    The Donchian Channel – Tracking Extremes
    Turtle Power!
    Trading On Trends
    MACD & Moving Averages
    Seasonal Trends
    Trend Trading
    Current Price?
    How Liquid Is It?
    ROE
    How Much Debt?
    Entry & Exit Points
    Breakout Trading
    Size Matters
    Some Patterns Are Better Than Others
    Pairs/Forex Trading
    Dividend Trading
    Part Eight – Key Points To Remember

    While mastering the basic skills required to trade, and eliminating common mistakes are both important, and will certainly make you a good trader, those two things by themselves won’t be enough to make you a truly great one. If becoming a great trader is your goal (and it should be!), then you’ll need to do even more. You’ll need to step up your game, and take things to the next level.
    That’s what this next section is all about. Upping the ante. We’ll show you the way!

     

    The Power Of Positive Thinking

    You know what happens if you don’t believe you can succeed?
    Nothing.
    Seriously, if you’re plagued with self-doubt and pessimism, you’re never going to get anywhere. The first step on your journey toward becoming a great trader is to step away from negative thinking. Just leave it behind.
    That’s a lot easier said than done, especially when you’re first starting out, because there will no doubt be people around you who look at what you’re doing with a skeptical eye. They’ll tell you there’s just no way to beat the market. They’ll tell you you’re doomed to fail, and if you let them, those thoughts will stick in your mind like a splinter and infect the whole of your thinking.
    If that happens, it’s going to wreck your confidence and a cloud of negativity is going to influence your thinking, which is going to hurt both your effectiveness and your efficiency.
    On the flip side, believing that you CAN do something goes a long way toward making that true. If you think you can, you’re going to be more apt to look for opportunities to prove yourself correct. You’re going to be willing to take a few well-considered chances and constantly stretch yourself to learn more and master the skills you need to succeed.
    Not that you can’t learn the basics in the absence of positive thinking, but having a positive outlook certainly makes the process easier and more fun! All that to say, it matters. It matters a lot. Believe in yourself and your own success. Believe in abundance, and you’ll go far.

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    Know Thyself

    This is another key piece that too many traders overlook. You’ll never be as successful as you could be if you don’t really know yourself, which includes knowing what you’re trading for.
    Way back at the beginning of this piece, we talked about the importance of understanding what you’re trading for. What goals you’re hoping to achieve. It’s not really possible to answer those questions until and unless you know yourself.
    Knowing yourself is important to other aspects of your trading game too though. For instance, having a firm understanding of how risk-tolerant you are is key to helping you set stop orders to exit trades in such a way that you don’t go into full-blown panic mode when a trade goes south. Sure, you can get to that point by trial and error, but wouldn’t it be so much easier to just know yourself well enough right from the start that you don’t have to guess? Of course it would!
    The same thing goes when you’re defining rules for yourself regarding taking profits. If you know yourself, and you have a clear understanding of your trading goals and objectives are, that understanding will help illuminate the precise points at which it makes sense for you to lock in profits. Without that understanding, it’s something you’re going to struggle with.

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    Nix The “Get Rich Quick” Mindset

    A lot of traders enter the game with the mindset that if they find the “right” opportunity, they’ll be able to turn it into a fountain of riches that has virtually no end. That overnight, or in a week (maybe a month), they’ll go from rags to riches and never have to worry about money again.
    It would be completely awesome if that were the case, but honestly, if that’s’ how it worked, don’t you think that everybody would be trading?
    The simple truth is that like any skill, trading takes time to master. It’s not something you’re going to start doing on Monday, and by the end of your first week, be in a position to retire. Not even the best traders in the world are that good.
    There’s no quick path to riches here, and anyone who tells you otherwise is no doubt trying to sell you something. Don’t believe it.
    Becoming a successful trader takes three things:
    • Patience
    • Persistence
    • And Determination
    You’ve got to have the patience not only to give yourself the time to master the basics, but also to spot those winning opportunities that will start making money for you, the persistence to stick with it and keep refining your strategy, and the determination to keep dusting yourself off and getting back on the horse, even when you face a losing streak.
    “Get Rich Quick” thinking has no place in any successful trading operation.

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    Find Your Niche

    The market is a vast, ever-changing place. In fact, it’s so vast that it can cause some traders to be afflicted with “analysis paralysis.” There are just too many choices. Given the amount of research you need to do in order to spot great opportunities and turn them into profits for you, it’s impractical to regard the entire width and breadth of the market as your playground.
    Instead (and this goes back to the whole notion of knowing yourself), let your personal interests guide you. If you have no particular interest in commodities, even if you found some great opportunities there, it’s just not something you’re going to be especially thrilled about researching…so don’t.
    The market is a really big place, and there are opportunities that cater to every interest, taste and preference. Plus, if you stick with what you know, your due diligence and research will tend to go faster, and that’s important at the margins.

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    The Power Of Detachment

    This is something we’ve talked about before, and the fact that it keeps coming up and we keep stressing it should give you an idea just how important it is.
    If you get lucky acting on instinct, you might make a few successful trades and make a little money. If you get very lucky, you’ll be able to avoid catastrophic losses, at least for a little while. In the long run though, trading on the basis of gut instinct and emotion will get you killed.
    Emotion is not a substitute for analysis and critical thinking. When trades go your way, keep your emotions in check. Don’t get greedy and don’t get cocky.
    Likewise, when trades turn against you don’t panic and make decisions out of fear. Never forget that there’s a reason you took the time to craft detailed exit strategies. Just keep your cool, stick to your plan, and try again when you identify the next trading opportunity, learning from the mistake you made. That’s how you win.

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    Understanding The Nature Of Trading

    While it’s true that emotion has no place in trading, it’s not all number crunching and analysis, either. Granted, those things are vital to your success, but the simple truth is that trading is one part art, and one part science.
    Most of this book has been about acclimating you to the science part. The data. The numbers. Helpful formulas. Different types of analysis, and tools you can use to help you in that process.
    Here though, we have to give a nod to the role that artistry plays. It’s not art in the same way that painting or sculpting is, sure. No question about that, but developing and refining your trading strategy, then testing it, both in software and in the real world has a certain artistic quality in the same way that composing a piece of music or writing does.
    It’s a fairly technical form of art, but make no mistake, if you overlook this aspect, then you’ll never be as effective as you could be.
    If you’re wondering what the artistic portion of the equation looks and feels like, look no further than the balance between your winning trades and your losing ones. It manifests itself in the way you limit your losses and let your profits run.
    It’s important to note too, that this doesn’t mean you’re relying on intuition or emotion, but rather, drawing on your growing body of experience, and feathering that into your thinking, along with the more technical aspects of trading. Do that, and you’ll take your game to the next level!

     

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    Develop A Routine

    Muscle memory. It’s a term that body builders and martial artists know well, and it applies to trading as well, albeit in a slightly different form.
    Routine matters though, because when you establish a routine and stick with it, it helps you focus your energies on the things that matter most, until they’re second nature to you.
    Your trading journal will help you greatly in terms of establishing your routine, and at the end of the day, it comes down to three functional areas:
    • Preparation
    • Research
    • And Review
    There’s nothing magic here. All three of these are self-explanatory, but they’re all essential to your long-term success.
    If there’s one thing that most new traders tend to gloss over, or overlook entirely, it’s the review time, and that’s something you should be doing at the end of every trading day. The reason? Review is your opportunity to learn. To assess what went right, but more importantly, to assess what went wrong, and in doing so, identify specific things you can do to help ensure the mistakes you made don’t come back to bite you in the future. That’s how you grow as a trader.

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    Guard Against Stress

    We’ve talked about stress before, but it bears mentioning again here, because it feeds into some other things that are critical to your success as you continue on your journey toward becoming an excellent trader.
    When you let stress get the better of you, it clouds both your thinking and your judgment. It makes it more likely that you’ll make rash, snap decisions based on instinct, fear, or emotion, rather than rationality.
    Not to mention the fact that it makes you a nightmare to be around as a person, and let’s face it, no matter how much you love trading, and no matter how much time you spend doing it, you have a life outside of it, and a variety of personal connections to maintain. Nobody likes being around a grouch, which is why managing your stress is so important.
    Besides, what is the point of becoming a successful trader if you’re miserable all the time? You should be doing the things that make you happy, and trading can help you with that. The profits you make from trading can, long term, help you realize those dreams you’ve had to defer for most of your life.
    Again though, that doesn’t do you any good if you’re too stressed out to enjoy them, or if stress puts you in an early grave, so managing stress is a lot more important than most people realize.
    Fortunately, there are some really easy ways to reduce and control your stress, and while that isn’t the overriding goal of this work, it’s an important enough topic that it’s worth spending some time outlining them, at least in brief.

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    Visualization

    When you start feeling your stress levels rise, close your eyes and visualize your life and how it will be, once all your trading goals are realized. What will your life look like?
    Can you see your dream house? Is it on the beach, or in the mountains? What does it look like? What do your furnishings and other creature comforts look like?
    Picture your life, and see yourself in it.
    Alternatively, picture yourself in a hammock, staring lazily up at the clouds, or put any other image in your mind that you find soothing and relaxing. Don’t just think about it – see it. In vivid color and detail. Enjoy your little virtual reality mini vacation in your own mind until you feel your stress levels receding. You’ll be amazed at how quickly that happens!

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    Meditation

    You don’t have to get all new agey for this to work, so you don’t have to sit cross-legged on the floor and chant mantras, although if that’s your thing, by all means do it! You can keep things much simpler though, if you want to.
    Just close your eyes, clear your mind, and relax. Some people find it hard to do that. There’s just too much clutter and too much noise for them to shut things out. If that’s the case for you, then you might find it helpful to listen to some soothing, relaxing music, or even a “nature sounds” soundtrack (waves crashing on the shore, tropical rain forest, thunderstorm, etc.).
    For other people, what works is a desktop Zen rock garden or similar. There are no “right” answers here. The important thing is to find something that works for you, and devote at least a little time every day to taking your mind off trading and the worries of the day and just relax. Try our Trading Mindfulness commentaries HERE.

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    Unplug!

    This one is both really easy, and incredibly hard. Step away from your computer. Go outside. Get some fresh air.
    We saved this one for last, but the reality is that it’s one of the most powerful relaxation techniques you can engage in. Believe it or not, there’s quite a lot of research that’s been done on stress, and scientists know a great deal about what causes it.
    Stress is caused by the release of the hormone cortisol. This is the “fight or flight” hormone, and the more stressed out you are, the more of it floods into your system. It’s not healthy, and long term, can lead to a raft of medical issues, some of them potentially fatal.
    The good news though, is the fact that it’s easy to reduce cortisol levels. The other two stress reduction strategies are effective, but neither are quite as effective as simply getting outside for a while. Studies have shown that a fifteen-minute walk can reduce your cortisol levels by as much as 25%. Even better, walking in the woods has nearly twice the impact on your cortisol levels as walking in an urban area.
    Take advantage of that fact if you’ve got some woods near your house, and go enjoy them!
    There’s a lot more that could be said on this subject, obviously. In fact, whole books can (and have!) been written on stress and how to deal with it, but even if all you do is take a little time out of your day and make use of one of these three strategies, mixing and matching as you see fit, then you’ll find that your stress levels fall dramatically. Fifteen minutes a day is all it takes, though by all means, if you need more time, take it! It’s your life. Be happy in it.

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    Never Stop Learning

    Your trading strategy isn’t a “one and done” kind of thing. It’s not something you create, and then use as-is forever, or at least, it shouldn’t be.
    It should be in a constant state of flux as you seek, on a daily basis, to refine your processes and improve your analytic skills. In order to do that though, you’ve got to commit yourself to a cycle of continuous learning and improvement.
    That means, among other things, reading books on the subject, watching instructional videos, and most importantly, maintaining, studying and learning from your trading journal so you can identify the mistakes you’re making and develop an action plan to keep you from making them in the future.

    Never Stop Testing

    This is something we’ve mentioned before, but it bears repeating here, because simply reading about all things trading-related isn’t enough. Before you implement any changes to your trading strategy or try out a new idea, you should thoroughly test it so that you’re satisfied that once you begin using it live, it will help, and not hurt your overall strategy.

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    Consider A Trading Coach

    Different people learn in different ways. What works for you may not be an effective learning paradigm for someone else, and some people really struggle with spotting their own mistakes and missteps. If that describes you, then you may find tremendous value in hiring a trading coach.
    His job isn’t to make your trades for you, but to help you in all phases of your trading operation. To be available to offer advice, and words of wisdom and encouragement to be sure that you stay on track and on top of things. To point out mistakes when you make them (and you will – that’s a natural part of the learning process).
    Of course, hiring a person to coach you has a significant downside: It’s expensive, and if your budget simply won’t support that, then there are two other options available, but there’s a catch: You’ve got to be self-motivated. If you aren’t, then these aren’t going to work for you.
    The first option is to use your trading journal and “coach yourself.” The big drawback here (besides requiring you to be self-motivated) is the fact that if you’re not so good at spotting your own mistakes, then this is going to be difficult for you to use well without training.
    The second is a bit more promising though. There are self-directed coaching guides you can buy, and these are highly recommended for those who need a bit of a helping hand, but who lack the funds to hire a person to guide them.
    They’re somewhat limited, in the fact that, as books, you may develop a specific question or situation that just isn’t covered in the materials, but on balance, these kinds of guides make a great resource, and will serve you well.

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    Follow In The Footsteps Of Successful Traders

    Too often, beginning traders get lost in the weeds, trying to develop their own strategies for trading. Here’s the thing though: You don’t have to reinvent the wheel. The market has been around for a very long time, and legions of traders have already worked out a wide range of winning, reliable strategies.
    The best way to find rapid success is to find a trader who operates in a similar fashion to the way you want to, and copy his (or her!) moves. If it’s working for them, it can work for you, and once you get some hands-on experience with it, you can start making tweaks and changes to the overall strategy to truly make it your own.

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    Play The Odds

    One of the most important things to remember about trading is that there are no guarantees. There’s no such thing as a “sure thing” in this game. Even if a strategy has had something close to a 100% success rate in the past, that doesn’t mean it’s going to work in the future. There are simply too many variables, and too many things outside of your control to guarantee that.
    At the end of the day, trading is a numbers game. You’ve got to play the odds. If your analysis tells you that a given trade has a (roughly) 65% chance of succeeding, that’s your edge. Make that trade. Sure, it might not work out, but if you keep making trades at those odds, over the long term, you are going to succeed and make money.
    A lot of the time though, it’s going to feel like you’re not making much progress. The important thing is to remember that when things start going south, you get out of the failing trades quickly, and let the profitable trades run. Do that consistently, and you’ll find that your account balance grows steadily over time.
    Play the odds, and do everything you can to stack them in your favor. That’s the heart and soul of it. By sticking with low-risk strategies and cutting your losses early, you set the conditions for steady, sustainable growth, and that’s ultimately what wins the day.

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    Independent Variables

    Independent variables, when used well and properly, can help to improve your probability of success, which means that they can help you make more money in the long run. There are more than 180 indicators that traders use to evaluate potential opportunities, but did you know that the vast majority of them (over 98%!), are derived from just four pieces of information? It’s true! Most of the indicators you’ll be looking at are based on the following:
    • The opening price
    • The high price
    • The low price
    • And the closing price
    That’s it. Those are the most fundamental pieces of information in terms of evaluating a position you’re considering entering into, but they don’t capture everything.
    So why is it that some indicators are “better” than others if they’re all derived from the same basic information?
    That’s where independent variables enter the equation!
    The standout indicators incorporate things like volume. See, while price matters, adding volume data to your analysis can change the picture, allowing you to see the opportunity in a new light and bring it into sharper focus.
    Volume, of course, isn’t the only independent variable you can use. There are others, including:
    • The movement of other markets (currency, commodity, other stock markets besides the one you’re trading in, etc.)
    • The market environment as a whole
    • The sector environment (how price is moving for all companies in a given sector)
    • And seasonal patterns, which includes historical trends and tendencies
    The point here is that you can get better results simply by looking at the same information in a variety of different ways. New information added to the equation changes the picture, sometimes dramatically, and that can help improve your chances of success!

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    Countertrend Trading

    The essence of countertrend trading is entering into a position in anticipation of a reversal, which is a strategy that works best when applied to large cap stocks, commodities, and indices. It’s not recommended for traders dealing with smaller companies, because in general, when a small company’s stock enters a trend, they can last for an extended period of time.
    Big companies don’t offer as many surprises or sudden reversals of fortune like smaller companies do, and because of that, when a large company’s stock price begins trending one way, and approaches resistance or support levels, you know that there’s a very high probability that things will reverse course (unless you have other information that supports the possibility of a breakout).

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    The Donchian Channel – Tracking Extremes

    Markets are chaotic systems. That’s why even the world’s best traders don’t profit from the majority of their trades.
    Even chaotic systems though, obey certain rules most of the time. Markets can’t exist at extremes, so for instance, if a market suffers a significant drop, then odds are excellent that it will reverse course in relatively short order as traders begin taking advantage of the suddenly more attractive prices on offer.
    A Donchian channel is used to determine the overall volatility of any given market. All you need to calculate it are the highest and lowest points in the data for the last “X” number of days. The channel is bound at the top by the highest points, and at the bottom by the lowest.
    If the current price breaks out of the top, that’s a good long position entry. If the price breaks out on the downside of the channel, that’s a good short position entry point.
    So how good and useful is this? Well, earlier, we mentioned a group called “The Turtles.” This was the exact indicator they used to trade commodities and make millions, in the 1980’s. In particular, they looked alternately at a 55-day or a 22-day Donchian channel breakout to identify opportunities.

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    Turtle Power!

    Here’s an interesting variant on the Turtles’ idea, but this time, applied to large cap stocks, rather than commodities. Basically, we’re going to flip the script, and do exactly the opposite of what that group did. In other words, trade countertrend.
    This variant is devastatingly effective, as you can verify for yourself, via Backtesting. Here’s how:
    Look up the top 20 companies on the AUX. Get the relevant data and create a 15-day channel, with a plan to enter a long trade when the share hits a 15-day low. As for exit strategy, use a 4% trailing stop.
    The results you will get from this strategy are nothing short of amazing!
    Note that there’s more than one way to skin this particular cat, too. You can get similar results if you enter countertrend when you see the market move 3-4x ATR over 10 candles, or when it breaks below the lower Bollinger band, two standard deviations from the average, so again, don’t feel as though you’re locked into just one type of analysis here.

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    Trading On Trends

    As you have seen, countertrading can make you a lot of money with relatively little risk, but trend trading can be just as, if not even more profitable. Think about it: The longer a trend continues, the more money you stand to make!
    Of course, as we’ve mentioned, prices never move in a straight line, but in a jagged, saw-toothed pattern, which means that any successful trend-based strategy must take a couple of things into account.
    First, it must allow you to correctly identify when the trend begins. Second, it must allow you to hold the line when small reverses occur so you can let your profits run, but exit clean when there’s a significant reversal. That’s the trick.
    This strategy can be employed with mid-cap companies, indices, commodities, and currency markets (forex).

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    MACD & Moving Averages

    Moving Averages are perhaps the simplest way to track a trend. This is simply an average of the price over time (X number of days). Any time the price is above the moving average, it’s rising. Any time the price is below the moving average, it’s falling. Simple.
    A variation on this basic theme is to use two moving averages, one short term, and one longer term. The same basic thinking still applies though. If the short-term trend is higher than the long term one, the price is rising. When the short-term trend is lower, the price is falling. When the two lines cross, that’s your entry or exit signal.
    The one time that moving averages can get you into trouble is when the market is moving sideways. If you see that behavior, then it’s probably the wrong time to deploy this particular strategy. If you try to enter the market when it’s moving sideways, you’ll invariably see a string of losing trades. Not a happy situation!
    If you haven’t heard of the MACD, you’re not alone. Outside of investment circles, the term is practically unknown.
    What it is, is the distance between the averages. As with the moving average itself, it can cross the trendlines, with the difference being that it provides its signals slightly earlier than just using the moving average itself, and that’s’ what gives you the edge. Your “buy” signal occurs when the MACD crosses above the signal line. Your “sell” signal occurs when it crosses below.

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    Seasonal Trends

    Trading signals is all well and good, but especially where commodities are concerned, there are historical trends that can guide you and help you become more profitable. Simply put, there are certain times of the year when trends are much more likely to occur, so rather than simply trading signals all year long and hoping for the best, why not limit your trades to those periods of time when you know that trends are more likely to occur?
    Note that you certainly can make money trading on the signals throughout the course of the calendar year, but if you opt for that approach, you’ll make far more losing trades than winning ones. It’s just that your winners will be significant with proper planning, which will make you net profitable.
    You can up your game though, trading when you know trends are most likely to occur, have a higher percentage of winning trades and make a lot more money.
    In simplest terms, it works like this: crop-based commodities (soy beans, wheat, etc.) tend to see their prices drop just after harvest. The reason? The harvest itself. Once those crops start coming in, the supply of that commodity increases dramatically, causing the price to drop. The further you get from harvest, the more the price tends to rise over time.
    Commodities aren’t the only markets that see seasonal trends. In fact, all markets tend to, to one degree or another. A historical analysis of the AUX revealed that the market typically sees strong bullish periods in April, July, and December, and strong bearish patterns in June, September, and October.
    The rest of the months, the market basically goes nowhere (moving sideways).
    Of course, there are always years where this does not occur, but these are exceptions. The rule of thumb described above holds true far more often than not.
    Put this knowledge together with the MACD, and the basic idea is to take an entry when the MACD crosses its signal line, but ONLY IF the historic seasonal patterns suggest that the market is in a period where trend formation is likely, so you would trade long when the MACD crosses above the line in March or April, trade short if the condition is met in May or June, then long again in July and August, and short again in September or October, and long again in December.
    As we said earlier though, you may not see an appropriate signal at all, in any given month, and if you don’t, it’s fine – it just means that there’s no viable opportunity present. Just keep a watchful eye out for when you do!
    Regarding exits when pursuing this strategy, when the MACD crosses back the other way. Your stop is placed slightly above (or below, as appropriate) such that you’ll exit the trade before the market moves strongly against you.

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    Trend Trading

    Mid-cap companies are those that have firmly established themselves in the market, but are not industry leaders. Prospects for growth in such companies tends to be quite strong as these companies aren’t juggernauts which find growth difficult but have extreme longevity and durability.
    Based on these traits, mid-cap companies are ideal candidates for trend-based trading, and you can identify viable candidates by studying fundamental data.

    Current Price?

    The first thing to look at is the company’s stock price, and the first question you should ask yourself is: Is the company under or overvalued at its current price?
    The fastest way to find your answer is to look at the price to earnings ratio (PE for short). To get this value, simply divide the current price by the profits the company is generated. That gives you Earnings Per Share (EPS). A ratio of 6-7 is cheap. A ratio of 20+ is expensive. Good trading opportunities can be found in companies with a PE ratio of 12 or less.
    We’ll have more to say about equity (and specifically a company’s return on equity) in just a bit, and it’s another important data point to consider before pulling the trigger on a trade.

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    How Liquid Is It?

    Some mid-cap companies just don’t get a lot of play. They just don’t have much in the way of trading volume. That means that if you enter a position, you may find yourself with a shortage of buyers when it comes time to sell, and that matters because when your signals tell you it’s time to exit a trade, you need to know that you can do that.
    A good rule of thumb here is to look for companies that have an average daily trading volume of at least $2 million. At that level, unless you’re holding extremely large positions, you should have no difficulty exiting a trade.

    ROE

    Return on Equity is essentially a measure of how efficiently and effectively a company uses the resources it has. Over the long term, a company’s share price tends to rise at something close to the same rate as the ROE. In terms of identifying investment opportunities, look for companies with at least a 15% ROE.

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    How Much Debt?

    This is a critical bit of information you can glean from a company’s annual statements. There’s no magic number here, but you should understand that the more debt a company holds, regardless of its ROE, the greater the potential risk to you, as an investor.
    Your ideal target company will have an ROE of at least 15% and relatively little outstanding debt. A company’s debt to equity ratio is the measure you want to look at here, and a good rule of thumb is a ratio of 70% or less.

    Entry & Exit Points

    So, let’s sum up. If you find a mid-cap company that:
    • Sees at least $2million a day in average trading volume
    • Has at least a 15% ROE
    • A debt to equity ratio of 70% or less (the lower the better!)
    • And a price to earnings ratio of 12 or less (the lower the better!)
    Then you have found a viable trading opportunity! To determine your entry and exit points, use your trend analysis and the MACD, exactly as described above, only applied to the share price of the company you’re interested in. That’s it. That’s all there is to it!

    Breakout Trading

    Breakout trading is best conducted with small cap companies. As the name implies, these companies tend to be quite small, not well established in their respective industries, and prone to sudden, rapid changes of fortune.
    A small company might develop the next big whiz-bang distraction and suddenly become worth a billion dollars overnight. Or, it might run out of money before it accomplishes anything of note, and simply disappear beneath the waves.
    When a small company breaks out, you’ll see that reflected in its stock price, IF you know what you’re looking for. The secret to that is in studying chart data. It should be noted, however, that chart patterns are highly subjective, although the ability to chart patterns with a computer has removed much of this subjectivity in recent years. Even so, it’s something to bear in mind.

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    Size Matters

    We’ve talked about average daily trading volume before, and when we mentioned it earlier, we mentioned it in the context of ensuring liquidity. That is to say, ensuring that the company in question had enough trading volume that you’d have no difficulty finding buyers or sellers when it was time to exit your position.
    That still matters here, but the reality is that small cap companies with high daily trading volumes tend to perform poorly, and most will wind up losing you money. You want a company that doesn’t have a tremendous amount of daily trading activity, but not so little that you’ll have trouble exiting the position. Here, a good target is $1 million a day or more.
    In terms of stock price, using historic data as a guide, the sweet spot seems to be shares that trade at or below $6 a share. Breakouts are not only more likely to occur here, but are also much easier to spot. While you’ll occasionally spot opportunities priced higher than this, they tend to have a much lower win percentage and won’t make you as much money.
    Having said that, the lower the share price is, the harder it is (in general) to find buyers and sellers when you’re ready to exit your position, so it’s a bit of a balancing act.

    Some Patterns Are Better Than Others


    Broadly speaking, chart patterns can be divided into three categories:
    • Triangles
    • Parallel
    • And Broadening
    There are some other patterns that don’t fall neatly into these categories, but these are the basics, so that’s what we’ll focus on here.

    Triangle patterns consist of the classic patterns known as:
    • Ascending (a flat top line, and an upward sloping lower line)
    • Descending (a downward sloping top line and a flat lower line)
    • Symmetrical (an upper line that slopes downward and a lower line that slopes upward)
    • Ascending Wedges (both lines slope upward and converge)
    • And Descending Wedges (both lines slope downward and converge)
    All of these patterns are created by a period of consolidation which is characterized by decreasing volatility. The amount of fluctuation decreases as the pattern approaches the tip of the triangle.

    Parallel patterns are a small family where the lines containing the price action are virtually parallel, which makes them markedly different from triangle or broadening formations because the two boundary lines don’t converge to a point at the start or the end of the pattern.
    There are three patterns that can be classified as parallel:
    • A rectangle (horizontal pattern)
    • A channel up (rising pattern)
    • And a channel down (falling pattern)

    While the share price may be moving sideways, rising or falling, the range of fluctuation remains fairly consistent.

    Broadening patterns occur because of increasing volatility in the underlying share, and a breakout of these patterns can indicate a strong move in the share price.
    The set of broadening formations is the equivalent of triangles, consisting of:
    • Broadening ascending (a top line that slopes upward, with a lower line that is flat)
    • Broadening descending (a top line that is flat, and a lower line that slopes downward)
    • Broadening formation
    • Broadening wedge up
    • And Broadening wedge down

    As to which types of chart patterns have historically been the most profitable, they are as follows:
    • Ascending Triangles, Symmetrical Triangles, and Rectangles can all be traded profitably when the breakout occurs on the upside.
    • Broadening Descending and Broadening Ascending patterns can also be profitable when trading long, using a 3% stop loss.

    Where short trading is concerned, you’ll find your most profitable chart patterns to be the descending triangle and broadening ascending patterns.

    If both the market and sector are falling, then the symmetrical tringle, ascending triangle and rectangle can also be traded short with success, and descending triangles and broadening ascending patterns are even better in falling markets.

    We’ve talked about how important independent variables are in previous sections, and this is a quick summation of the other variables you can factor into your analysis to help improve your odds. For long trades, look for the following opportunities and market conditions:
    • Sector in an uptrend
    • Market in an uptrend
    • Share price between $0.20 and $6.00
    • Average daily trading volume between $1 million and $10 million
    • Volume in the up legs is higher than volume in the down legs of the pattern
    • Look for the following chart patterns: Ascending Triangle, Symmetrical Triangle, or Rectangle

    Find an opportunity like that and you stand an excellent chance of success, because lots of outside variables are trending the same way you’re predicting the price to move.

    For short trades, the following is your recipe for success:
    • Sector in a downtrend
    • Market in a downtrend
    • Share price between $0.20 and $6.00
    • Average daily trading volume between $1 million and $10 million
    • Volume in the down legs is higher than volume in the up legs
    • Look for the following chart patterns: Descending Triangle or a Broadening Ascending pattern
    In either case (short or long) use a stop loss of 3% to exit.

    BACK TO PART 08 CONTENTS

    Pairs Trading

    This is not just an interesting concept, but it’s “market neutral,” meaning that it is immaterial whether the market is currently rising or falling. It’s a nice, low-risk strategy that sees you trading two highly similar CFDs that tend to move in a similar fashion, such as share CFDs of two companies in the same sector, or highly similar commodities such as gold and silver.
    If the price of one goes up, then it’s highly likely that the price of the other will too. If the price of one goes down, again, it’s extremely likely that the price of the other will drop as well. Sometimes though, the stocks move away from their normal behavior, and that’s what creates the trading opportunity.
    To enter into a pairs trade, create two equally sized positions, one for each asset in the pair (company, commodity, or whathaveyou). You’ll be buying shares in the company you believe to be undervalued, and selling the position you believe to be overvalued.
    How well this works for you depends on your analysis and how well the companies perform relative to each other.
    Again, this works whether the market is rising or falling. The single most important point to consider is that the two assets tend to move the say way over time.
    Some charting software will plot pairs for you, which is quite handy, but you can create it yourself simply by dividing one company’s share price by the other. The exact value of the ratio doesn’t really matter. What you’re more interested in is the change to this ratio over time, particularly when prices reach an extreme, based on historical data.
    Figuring out where to place stop orders can be tricky with this strategy, because you can make money if both assets move higher or lower, which means that a stop could hit while you’re making money.
    In order to manage your risk, simply monitor the change in profit or loss on the position and exit when the loss hits your max risk level. Because you’ve got a trade on both the long and short sides, these trades don’t tend to fluctuate much on a day to day basis, which simplifies things from a management perspective.

    BACK TO PART 08 CONTENTS

    Dividend Trading

    This is an interesting trading approach. It’s a rare trader who buys CFDs specifically to capture dividends, but you can certainly do it, and it’s a viable strategy when well-executed. After all, if you buy a CFD on a share that pays a dividend, you already know the company in question is profitable.
    One of the first questions you’ll want to ask if you’re looking at a company that pays a dividend is “what’s the yield?”
    To arrive at the answer, you simply take the share price, divided by the dividend paid, which is typically quoted as some number of cents per share. So for example, if a company pays a fifty cent dividend and is trading at $10 a share, then the dividend yield is 20%. That’s exceptionally high, but you get the idea.
    On the Australian market, you’ll find that dividends tend to range from 0-10%, with the average being around 3.5%. Also note that companies that pay dividends on the Australian market pay then twice a year, with the first payment being called the interim dividend, and the final one, which follows the company’s annual report, being referred to as the final dividend.
    Note that companies are certainly not required to pay a dividend, even if they turn a profit. The board of directors may decide that they need to retain those profits in order to facilitate further growth, so it’s not a sure thing, by any means.
    When trading dividends, the most important date you need to know and remember is the ex-dividend date, which is the date that you normally receive a dividend payment.
    So what happens to a company’s share price on or around the ex-dividend date? If you look at the historic data, you’ll find that the share price tends to climb in the days immediately preceding the dividend announcement, then drops by the amount of the dividend on the ex-dividend date.
    A novice trader might think that there’s an opportunity to sell short in the days just before the dividend is announced, then reap a nice profit on the other side, but it’s not that easy. Remember, if you’re holding a short position when the dividend is announced, then the dividend amount will be debited from your account, which will wipe out any potential profits you may have realized.
    Having said that, there is an opportunity here, provided that the broader market is not falling.
    To take advantage of the opportunity, you’ll want to find a company paying at least a 3% dividend yield and an average daily trading volume of at least $10 million.
    The idea is that you’ll enter your position when the share price drops any time during the two weeks leading up to the ex-dividend date. You’ll want to place a stop at the most recent low on the position, then hold it until it either hits a stop loss, or exit the position one day before the ex-dividend date.
    Because you’ve bought on a down day, and you know that historically, the price rises leading up to the announcement of the dividend, you create an opportunity to profit.

    BACK TO PART 08 CONTENTS

    Part Eight – Key Points To Remember

    • Never underestimate the power of positive thinking. If you believe you’ll succeed, that puts you in the right mindset to actually succeed.
    • Having said that, belief isn’t enough. At the end of the day, trading really isn’t about the money, it’s about approaching the market in an organized, systematic way. About doing the things that all successful traders do. Making the right moves.
    • At the end of the day, it’s not really about the money, it’s about the game. Money is just the byproduct of implementing a successful strategy.
    • Your trading routine should include pre-market preparation, research, market review time, and of course, the time spent actually trading.
    • Trading is stressful! Know that and accept it. It’s not something you can change, but you can manage it via good preparation, and a willingness to step away from the computer, take breaks, and by spending time with your friends and family. Also, when you’re first starting out, use low-risk strategies to help reduce stress further.
    • Read everything! If you’re not learning, you’re not growing. That’s just as true for trading as it is for anything else. You should constantly be studying the moves of successful traders and keeping in contact with other traders you know to compare notes and share ideas.
    • As a rule of thumb, if you’re looking at a large cap company, the optimal approach is to trade them countertrend. For mid-cap companies, look for trends, and seek out breakouts in small cap shares.
    • Another rule of thumb: Trade the top 20 shares by entering long positions when the shares reach a 15-day low. Use a 4% trailing stop to exit.
    • Pay attention to seasonal patterns when trading indices, currencies and commodities. By studying seasonal patterns, you’ll gain familiarity for when trends are likely to form, and can be on the lookout for them.
    • Use analysis of fundamentals to find mid-cap shares to trade.
    • The best long trade chart patterns are ascending triangles, descending triangles and rectangles. The best short trade chart patterns are descending triangles and broadening ascending patterns.
    • If you are a breakout trader, be sure that the market, sector, and volume indicators all support the breakout before entering into a trade.
    • Pairs trading is a low-risk, market neutral way to trade CFDs. By entering one position long and the same size position short in a correlated share, you can profit from the difference in movement between the two shares.

    BACK TO PART 08 CONTENTS



     

    Glossary of Terms

     

    Over the course of this piece, we’ve talked about a wide range of subjects, many of which may be new to you. Although not every term listed here was specifically mentioned in what you just read, these represent the core language of the professional trader, and are all terms you need to be familiar with. Use this as a handy reference.


    Average True Range (ATR)

    This is a measure of market volatility over a specified period of time. To calculate, you simply take the average of the difference over a select number of days between the highest price and the lowest price, including any gap.

    Back Testing
    Testing, using historical data to see if your chosen strategy is effective and profitable. Used to validate whatever system you’ve devised for yourself.

    Base Currency
    The first currency listed in a currency pair

    Bear Market
    A market that’s going up.

    Bull Market
    A market that’s going down.

    Commodity CFD
    A type of CFD that derives its price from the underlying commodity it’s meant to track, such as soybeans, wheat, oil, or gold.

    Consolidation Market
    A market that’s neither clearly moving up or down.

    Contracts For Difference (CFDs)
    A formal agreement between two parties to pay the difference in price from when the contract was opened until the contract is closed. CFDs can be traded over share, index, commodity, or forex markets.

    Countertrend Trading
    Entering a trade when planning/expecting the price to reverse direction.

    Currency Crosses
    Any currency pair that doesn’t have the US Dollar on either side of the equation.

    Currency Pair
    The means by which forex trading happens. The price is quoted in terms of the relative values of one currency against another.

    Debt-To-Equity Ratio
    The ratio of the total debt of a company to the amount of capital that shareholders have invested in the company.

    Derivatives
    Any financial instrument that derives its price from the underlying security, index, currency pair, or commodity it tracks.

    Donchian Channel
    An indicator that has two boundary lines determined by the highest and lowest point in the last “X” number of days. It’s a useful method for differentiating a breakout from a consolidation.

    Down Trend
    Any series of lower highs and lower lows in the market price of any asset, over time.

    Earnings Per Share (EPS)
    The profit a company makes, divided by the number of outstanding shares the company has. This is each share’s slice of the profits.

    Ex-Dividend Date
    The first day in which the buyer of a share is no longer entitled to a payment of the dividend the stock (or CFD) offers.

    Exposure
    The sum total value of all your positions in the market at any particular time. The greater your total exposure, the greater the chance of a big win or loss.

    Finance Charge
    The cost to hold a given position from one trading day to the next. This charge is generally calculated, based on the country’s cash rate plus a small interest charge, added by your broker.

    Fixed-Dollar Model
    This is a risk management model, where you allocate a fixed amount of money to risk on any given trade.

    Fixed Percent Risk Per Trade
    This is a risk management model where you allocate a fixed percentage of your overall trading capital to risk on any given trade (generally, traders following this model keep their risk on any one position limited to 1-2%).

    Forward Testing
    The inverse of back testing. This is you testing your strategy in real time, as movements in price unfold. Forward testing is more reliable than back testing, though much slower to complete.

    Fundamental Analysis
    A method of evaluating the value of a company that relies on fundamentals like their financial statements, PE ratios, future growth projections and company financial statements.

    Guaranteed Stop Loss Order (GSL)
    A type of stop order that guarantees a set price for which you can close your trade, regardless of whether the market traded at that value.

    Hedging
    A risk management technique designed to either reduce, or completely eliminate your financial risk.

    Index CFD
    A CFD that derives its price from the underlying index it’s tracking, like FTSE, Nikkei, The Aussie 200, Dow Jones, NASDAQ, etc.

    Initial Margin
    The minimum amount of investment capital required as collateral to establish a CFD position. Many CFD brokers, for example, only require a 5% margin.

    Leverage
    The ability to invest with other people’s money as a means of amplifying your profits. WARNING: Using leverage is a two-edged sword, and will also magnify any losses you experience!

    Leveraged Trading
    Controlling an asset even though you only put up a small amount of your own money.

    Liquidity
    How actively a contract or market is traded, and the ability to get in and out of any given trade easily. If a market is highly liquid, there are almost no barriers to entry or exit. By contrast, a market with low liquidity is slower and more difficult to enter and exit. Example: Forex trading is highly liquid. Investing in real estate is relatively illiquid.

    Long Trade
    The act of buying a contract first and selling second. This is the traditional “buy low, sell high” approach to trading.

    Margin Call
    The amount you will be required to pay y our broker to bring your account up to the appropriate initial margins to cover your current trades.

    Marked to Market
    The process by which margins are updated in real time, or at the end of each trading day, and the resulting cash payments credited or debited to your account.

    Market Capitalization
    The total value of a given company, calculated by multiplying its current share price by the total number of shares issued.

    Market Makers
    A company whose goal is to provide buying and selling prices over various financial instruments in the market.

    Martingale Strategy
    An investment strategy that recommends increasing your position size when a loss occurs, on the thinking that you’ll turn a profit when the price turns around.

    Opening Gap
    The difference between the closing price and the subsequent opening price of any given asset.

    Options
    A derivative that gives you the right to buy or sell a set number of shares on or before a specified date. Options work like insurance, where you pay a small premium and may benefit from a large payout if you’re correct.

    Oscillators
    An indicator useful in technical analysis that ranges between two set levels to show whether a security or contract is overbought or oversold.

    Percentage Stop
    A type of stop-loss order that is placed a set percentage below the current share price, designed to close out a losing position before your losses become unmanageable.

    Position Sizing
    This is a risk-management technique that tells you how many shares of a certain position to invest in, and the amount of risk you’ll be allocating to that particular trade.

    Post-market Auction
    The last available trading opportunity of the day, just before the market closes. The ASX (Australian Stock Market) has a volume weighted average calculation that determines the actual closing price, depending on the number of buyers and sellers at the close.

    Pre-Market Auction
    The identical matching out of prices, as described in the definition of the post-market auction, where sellers are able to bid for a contract and the ASX determines the opening price as a result of that calculation.

    Price-to-Earnings Ratio (PE)
    A means of valuation calculated by dividing the current market price by the earnings per share.

    Product Disclosure Statement (PDS)
    A document that every financial services company is required to provide when offering or recommending a financial produced that is licensed under the Australian Financial Services Reform Act. This document will outline how the product in question worked, its potential benefits, and associated risks.

    Pyramiding
    A position-sizing rule where traders add to their existing position(s) in an attempt to maximize the potential profits on winning trades.

    Quote Currency
    The second currency listed in a currency pair.

    Range-Bound Trading
    Trading in a range, where prices fluctuate between two set points, over and over again. The two points are typically referred to as “Support” and “Resistance.” Oscillators are the most appropriate technical indicators in range-bound trading systems.

    Requote
    When you attempt to buy a certain number of CFD shares at a certain price, and your broker does not have that quantity available. Your broker may requote you a higher price, giving you the opportunity to accept or reject the offer.

    Resistance
    A price that a given asset struggles to break through at various times. The more times the market flirts with this price without breaking through it, the stronger the resistance is said to be.

    Return On Equity (ROE)
    The return a company generates based on the net assets they hold. It provides a good snapshot of how efficient the company is. To calculate, divide profit by net assets.

    Return On Investment (ROI)

    The amount of return you’ve realized on your invested capital. Calculated by dividing your return by your initial capital outlay.

    Scaling In
    The act of initiating a trade by opening a small position in order to determine whether you should add to it to bring it up to your normal position size. For instance, if you’re using a fixed percent risk per trade risk management strategy that specifies buying 1000 shares in a given position, you may test the waters by only buying 500, with a plan to add the remaining 500 shares later, if the position develops in your favor.

    Scaling Out
    The act of gradually closing your trade as it moves in your favor or reaches some specified profit objective. It’s the opposite of scaling in, and is especially useful as trades approach resistance levels.

    Sector CFD
    A CFD that derives its price from the underlying sector it’s tracking, such as the tech or health sector.

    Share CFD
    A CFD that derives its price from the underlying company’s stock it’s tracking.

    Short Trade
    Selling high and buying back low. This is the opposite of a long trade. You open by selling on the expectation that the price will soon drop, so you can buy back at a profit.

    Slippage
    The difference between where you want to get in and where you actually get in for any given position you take.

    Spot Price
    The price that is quoted for immediate settlement. The spot price is often called the market price at a particular point of time.

    Stop-Loss Order
    A conditional order type you place with your broker to close your position if the price of your asset drops to a predetermined level (set by you).

    Support
    The opposite of a resistance price. A price that the asset is unable to fall below for a certain amount of time. The more often the price hits a support level, the more significance traders place on it.

    Technical Analysis
    Any application of mathematical formulas applied over the price and/or volume history of the market in an effort to determine the probable next move of any particular asset.

    Technically-Based Stop
    A type of stop order where the placement is determined by information gleaned from a chart. Such a stop could be placed when an asset moves beyond support or resistance, veers away from a trend line, or other such conditions.

    Tick
    The smallest unit of measure by which the market price of any asset moves.

    Time-Based Stop
    A type of stop order (used to exit from a trade), based on a specified amount of time. Very rarely used, but can be valuable in certain situations.

    Time Decay
    The drop in value of a derivative as time passes. Time decay is especially relevant in terms of trading options.

    Trading Plan
    Your overall trading strategy that defines your entry, exit, and risk-management parameters. Your trading plan should be back-tested before you ever enter the market.

    Trend-Following Trading
    A trading strategy that attempts to profit from markets that tend to move either up or down for extended periods of time. As a (very general) rule of thumb, trend-following strategies allow you to make the most money with the least amount of effort.

    Trend Line
    A line drawn across a chart to line up successively higher bottoms in up-trending markets, or progressively lower tops in down-trending market. Basically, it just helps to clarify what you’re looking at.

    Trending Market
    A market that is moving consistently in one direction for an extended period of time.

    Turnover
    A measure of the dollars traded each day in a company and is calculated by multiplying the price by the volume.

    Up Trend
    A series of higher lows and higher highs in an asset’s market price.

    Variation Margin
    Profits or losses on open positions on your CFD trades that are debited or credited daily.

    Volatile Breakout Trading
    Trading strategies that attempt to take advantage of short, sharp movements in the market over relatively short periods of time. Many volatile breakout trading strategies use support and resistance levels, trend lines, or pattern-trading techniques to identify opportunities.

    Volatility Stop
    A stop order where the placement of the stop loss adjusts as the volatility of the market adjusts. The ATR stop is an example of a volatility-based stop.

    Volume
    A measure of the number of shares or contracts that change hands during the time period being observed. Volume behavior is independent of price behavior and can be used to improve your analysis.