CHAPTER 5:
CRITICAL TRADING SKILLS
Analysis
Economic Analysis
Technical Analysis
Fundamental Analysis
Quantitative Analysis
Proper Position Sizing
ATR - Your New Best Friend
Low Risk Entry
Market Movement
Studying Trends, Support, and Resistance
Strong Moves
Managing and Mitigating Losses
Using Percentage Stops
Using Volatility Stops
Using Time-Based Stops
Using Technically-Based Stops
Scaling
Profit Taking
Re-Entry
Chapter 5 – 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 while 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
This is a hugely important skill, and it’s going to take time and discipline to get it right. Controlling your position size is the key means by which you manage risk.
For new users, the best thing to do is to keep it simple, and the best way to do that is to limit the amount of your investment capital you’re risking to no more than 1-2 percent of whatever total you have available.
The thinking here is that if something goes catastrophically wrong (and it may, at least until you get some experience under your belt), then the worst-case scenario sees you losing only a tiny fraction of your available funds.
The bottom line is that even after you get hands on experience, sometimes, you’ll just read the tea leaves the wrong way. There will be some flaw in your analysis and you’ll make the wrong choice. It happens. It happens even to investors with decades of experience. There’s just no way to avoid it.
What you can do though, is you can minimize the impacts of those wrong decisions, and proper position sizing will play a big role in that.
Remember that CFD brokers only require a tiny margin, which means you can (if you choose to) use a lot of leverage. With a 5% margin requirement, a $1000 investment in a position means you could find yourself controlling $20,000 worth of assets. That can make your investment an exciting ride, but it can also quickly end in disaster, so it pays to consider the matter very carefully so you don’t wind up biting off more than you can chew.
Also remember that it is 100% your responsibility to control the amount of leverage you’re using and the amount of risk you assume. Your broker isn’t going to do that for you.
For more details on money management and a CFD Trading Portfolio with CFD risk management tools such as Position Sizing go here CFD Money Management
ATR – Your New Best Friend
One powerful tool you can use to gain a deeper understanding of the market you’re trading, and the impact of position size in is the Average True Range, or ATR. This is simply a measure of volatility, and it will tell you how risky a given position you’re considering entering into really is.
To calculate ATR, you need to start with True Range. This is the range of price movement of a CFD over any given time period (including any opening gap, which is the price difference between the price at yesterday’s closing bell’s and today’s opening bell). True Range is the greatest of the following measures:
- Current High – Current Low
- Current High – Previous Close
- Current Low – Previous Close
The ATR is the average of the True Range over a specified number of periods.
What this ultimately shows you is the “normal” range of movement in whatever market you’re looking to trade in, and that’s important because it informs you of suitable values to use for your stop loss and profit targets, and then calculate your position size.
ATR can also be used to provide entry and exit signals, because you can see when the market moves to an extreme (i.e., if the price moves to an extreme low, it’s time to buy in. If the price moves to an extreme high, then it’s time to take profits!)
So for instance, if you’re interested in a share CFD that has an average range of movement of $5 a day, think about what that tells you:
If you purchase one share of the stock, you can expect the value of your position to fluctuate by +/- $5 (although in reality, it may fluctuate up to 2-3 times the ATR, which gives you a value of +/- $15.
Now imagine you buy 5000 shares. You can expect to see fluctuation of +/- $25,000 a day (but possibly as much as $75,000 a day). If that number scares you, then you’re beginning to understand the importance of proper position sizing! You’ve got to be willing to tolerate the daily price movement. If you can’t, then reduce the size of your position until the values are something you can handle.
Low-Risk Entry
Finding low-risk market entry points are great for a couple of different reasons. First, by relying on them, you improve your risk-reward ratio and bulk up your portfolio’s overall profitability. Second though, they help keep your losses to a bare minimum, because let’s face it, things aren’t always going to go as planned. If you want to stay in the game, then at every opportunity, you should take as much profit as you can, while reducing your risk (and potential losses) by as much as possible.
Exactly how you calculate your entry point is up to you. The results of the trades you make will tell you very quickly if your analysis is good, or if it needs revising.
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Market Movement
In theory, a company’s stock price should be its value, divided by the number of outstanding shares, but the reality is that market price seldom reflects a company’s true value.
Sure, it may hit that mark for a brief moment, but over the course of any given day, a company is either over or undervalued. The more under or over-valued the price is, compared to the company’s true value, the more likely it is to snap back towards true value. All that to say, if you know what a company’s true value is, and if you know the ATR, you can get a really good sense of which way the price is about to move, before it actually happens.
Will you always be correct? No, because sometimes there are other variables that aren’t accounted for by those measures, but you’ll be right a lot more often than you’re wrong, and that’s how you win trades. That’s how you make money.
Studying Trends, Support, and Resistance
So let’s say you know that the true value of a company is $50 per share. It’s currently trading at $40, and it’s got price support at $38, which means that historically, even with fluctuations, the price almost never drops below that point.
This is a textbook case of a low risk entry point. You know the company is worth more than its current stock price, and you know it’s not likely to drop much lower than it already is. Buying in now will almost surely allow you to ride the price back up toward it’s true value.
On the opposite side of the coin, what if the stock is trading at $70, its True Value is closer to $50, and it’s seen historical price resistance to $72. In this case, it’d be a perfect time to enter a short position, because based on what you know, the price isn’t likely to rise much beyond where it is now, but is very likely to fall back toward True Value. A short sale would allow you to profit as the price heads back down.
Again, it’s possible that there’s something paradigm-shifting going on inside the company, but if that’s the case, then there would have likely been some mention of it in published corporate reports, or in the news. In other words, there’s no reason for something like that to take you by surprise.
The best support and resistance method we can offer you is the Trading Levels check out this free video course.
Strong Moves
Here’s another low-risk entry point. If the price of whatever asset you’re tracking has just made a big move in either direction (something outside the bounds of the ATR), then statistically, the price is almost never going to continue moving in that direction. It’s going to pull back. If it shot notably higher, that’s a safe point to sell short. If it took an unexpected nosedive, that’s a great time to buy!
Use the following as general guidelines:
- If the price has moved more than 2xATR in a single period, OR
- 3-4x ATR over ten periods
Those are big moves, and you should be ready to trade on them.
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Managing and Mitigating Losses
Before you enter a trade, you should have a clear understanding of how you plan to exit the position. Before you make another trade, you should place a stop order to lock that exit in. Don’t wait. Don’t delay, just do it.
We’ve talked about stop orders before, but now that you’re making trades and refining your strategy, it’s time to circle back to that topic, because there’s more to say about them and you really need to understand how to use them well if you want to succeed in the long run.
Remember, when you make a trade, one of two things is GOING to happen:
- Either your analysis was right, the price moves in the direction you expected it to, and you make a profit (if you remember to take profits!)
- Your analysis was wrong, and the trade moves against you, resulting in a loss.
Remember the mantra:
Cut your losses and let your profits run!
That’s how you win success in the long term.
Using Percentage Stops
This is the easiest form of stop loss order to place. Whatever price you buy in at, you place a stop order such that if the price falls more than X% (say, 5%, just to put a number to it), then you’ll close the position.
The problem here is that percentage stops don’t take into account share price volatility, which could be quite high, depending on the stock in question. In other words, if the ATR is more than 5% on a daily basis anyway, then your stop at 5% probably isn’t going to help you much, because the normal price movement is going to trigger it.
Using Volatility Stops
This type of stop order gets around the limitations of the percentage stops, but adjusting as volatility changes. That is to say that when the volatility is low, the stop will be closer to that mark, and when it’s high, the stop will be further away.
You can use the ATR to help determine where the stop should be placed. As a general rule, it’s best to place these 2-3x ATR from the entry price, although in some cases, up to 5x ATR may be more appropriate. Time and experience will guide you there. Until you have that, 2-3X ATR is a safe choice.
Using Time-Based Stops
This one differs from the other types of stop orders you can use. Where those are based one way or the other on price reaching a particular level, this one’s based, as the name suggests, on time. Here’s where and how that may be useful:
If you enter into a trade, and your analysis suggests that the market is going to move in a certain direction, and that move doesn’t happen within a specified time, you could exit the position and look for another opportunity to re-enter the market.
Using Technically-Based Stops
These stops are placed depending on current price action, and at a point where the market has signaled a change in direction (or volatility). Here, think support and resistance points, so for instance, a stop placed above resistance could be used to get you out of a short position, and a stop placed below support could get you out of a long position without much damage to your account.
In every case, the stops placements are chosen based on patterns revealed by the charts you’re using to perform your analysis.
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Scaling
This is an important scale to master once you’ve got a bit of trading experience under your belt. Its value lies in the fact that it helps you manage your risk and/or lock in profits in a logical, well-organized way, depending on how you use it.
This is not something that people who are brand new traders should obsess over, but once you’ve mastered the basics, it’s definitely something you’ll want to add to your growing tool set, as it will help make you a better trader overall.
SCALING IN
In essence, scaling is all about testing the waters. If you’re not 100% sure of a trade you’re considering entering (and being 100% sure will only rarely happen), then scaling allows you to adopt a small position and give you a chance to see which way the wind is blowing before you fully commit.
So for instance, let’s say you’ve identified an opportunity. You don’t want to risk more than 2% of your trading capital, but you’re not really sure about the opportunity.
Rather than investing the full 2% all in one go, you decide to start with 1% to give it some time to see how things shake out.
If you see that the price is trending in the direction you anticipated, you add the other 1% to it to bring your position up to size.
The value here is that if your analysis was wrong and the market moves against you, then you’ve essentially cut your losses in half. If you see the market moving the way you though it would, it’s very easy to round out your position size and carry on as planned.
SCALING OUT
The same principle works in reverse. You can use “scaling out” to begin to exit a position.
In this case, the value is that you don’t want to leave money on the table, and if you’re worried you might be exiting too soon, scale out. Retire half your position, lock in some profits and see what the market does.
If the price begins to fall, you can make a hasty exit and preserve your gains. If the price continues to rise, you’ve still got half your investment in place and can continue to make money on it.
Scaling out becomes an especially attractive option as price begins to approach support or resistance levels, because you know that the odds are against the price moving beyond those points. In these cases, you’re hedging your bets, locking in some profits, but still maintaining a presence in the position in the event that a breakout occurs.
HOLDING
A third potential option here is to hold. Holding takes nerves of steel, because, of course, the price of any asset you invest in is always in a state of flux. Hold a position too long and the price could start falling, either eroding, or completely eliminating any profits you’ve earned. Hold the position overnight, and you’ll eat a small finance charge, which you’ll have to make up for by seeing further price gains the next day.
Even so, not all trades can or should be closed out over the course of a single day, especially if doing so would leave money on the table, so in many instances, nerves of steel or no, holding is the right call.
The reason holding a position is such an important skill to master is simply that price doesn’t move in a straight line from your entry point to your desired exit point. It may go up initially, then drop, then rise again, drop again, etc., all the while heading toward your desired exit point.
While it’s doing that though, if you get cold feet, you may decide to exit the position prematurely, and in doing so, lose out on profits you’d otherwise have reaped.
The most important thing to remember about holding is that it is not a passive activity. It requires that you constantly monitor the market and continuously reevaluate to confirm that your reasons for holding the position remain valid. So long as that’s true, hold. When that’s no longer true, it’s time to exit, but not before.
PYRAMIDING
A variant of simple scaling is Pyramiding, and this is something you will want to strongly consider.
It’s similar to scaling in, in that you’re adding to your total position size, but the execution is somewhat different.
Here’s how it works:
Let’s say you buy into a CFD at $20, and place a stop at $19. Your risk here is $1.
If the position moves to $21, you add to it, and place a stop for the addition at $20. Your risk is still $1 on the newly added element.
You can get all kinds of fancy with this, even going so far as to create a kind of pyramid, starting off with a full-sized investment, then cutting it in half each time you add more to it, but this of course, is strictly up to you. It just goes to show you that there’s no “one right way” to structure any given position. The sky really is the limit!
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Profit Taking
This is something that almost all beginning traders struggle mightily with. Exactly when to take profits.
As with most things trading related, there are no “right” answers here. You’ve got to find your own sweet spot, but wherever that is, it should be rules based, and not governed by emotions or instinct.
It would be great if the market sent up a flag, or posted a neon sign to mark the end of an upward or downward trend, but sadly, this is not the case. Therefore, it falls to you to monitor the situation closely and keep a watchful eye out for signs that a trend is coming to an end.
If you take profits too early, the market continues to move in your favor and you wind up leaving money on the table. Take them too late, and the price starts to move against you (rising, in the case of a short position, or falling in the case of a long one), and begins to erode your profits.
It’s a quandary, and unfortunately, there’s no “right” answer as to precisely when to take profits.
For new traders, the big thing is simply remembering to do it! As you gain more experience, you’ll become more familiar with the ebbs and flows of price fluctuations, and armed with an understanding of resistance and support levels and the asset’s Average True Range, you’ll be able to come close to pinpointing your optimal profit taking window.
Although it’s true that there are no easy answers where profit taking is concerned, there are some tools that can help you clarify when you want to, and we’ll talk about those things next!
UNDERSTANDING YOUR PROFIT TARGET
Remember before, when we said that you should never enter a trade without a clearly defined exit strategy? Most people think of that in terms of mitigating losses, but it’s also true where profits are concerned.
You’ll hear the mantra time and time again: “Cut your losses early and let your profits ride.”
There’s truth in that, but it’s not always as straightforward as it first seems. There’s tremendous value in locking your profits in after a specified target, then, if the market is still moving in your favor, re-entering and continuing to build more.
This is especially true if the market has moved strongly in your favor (say, 2-3x ATR). Lock that in, then re-evaluate and see if it makes sense to re-enter. This approach also makes sense if you have a particular profit target (say, 10%, just to put a number to it) in mind. Once you’ve hit your target, exit, lock in the profits, then re-evaluate for possible re-entry.
Another possibility is to use trend lines to determine profitable exits. Remember, prices don’t move in a straight line, but rather, in a saw tooth fashion, filled with surges and retreats. If the share price has been trending up, and then suffers a reversal, if you can exit profitably, that’s a good time to do so. Then you can re-evaluate to see if you should adopt the opposite position (short or long), or re-enter and continue realizing gains.
Some people also use count-back lines. A count-back-based exit uses the lowest price in the last “X” number of days to determine an exit point from a long trade, or the highest price to exit from a short one.
To exit a long trade, find the lowest point in the last “X” days and place your stop at this level.
If you typically hold your positions for short periods of time, a good rule of thumb is to use a 3-day countback, while people who hold their positions for medium terms are well-served by using a 20-day. Again, there’s nothing magic about these numbers. They’re just general guidelines. Use them as-is or tweak as needed to better fit your particular strategy.
One final point here is this: Don’t overlook the value of price gaps, as these can provide some strong indications that the direction of the trading wind is changing.
A price gap is the difference between the closing price of an asset at the end of a trading day, and the price the asset opens at when the next trading day begins.
Generally speaking, these gaps appear because while the market is closed, new information appears on the horizon that impacts price, but the market (being closed) was unable to react in real time, thus creating a gap on your chart.
These gaps can signal the start (or end) of a move, and as such, gaps are excellent places to enter a stop order. If the market gaps “up,” then a good place for a stop order is just below the new, higher price. If the market gaps “down,” then you’ll want to place a stop just above the high. That way, if the move reverses, you’ll exit the trade with a nice profit, and if it keeps going, you’ll still be in and can ride the curve to even greater profits!
At the end of the day, every trade is different, so every profit-taking exit strategy should be different in order to reflect that. Don’t get locked into cookie cutter solutions where profit taking is concerned.
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Re-Entry
If you exited a trade too early, that doesn’t necessarily mean the end! Yes, it can be frustrating, but if, on further analysis, you conclude that there’s still life left in the price movement, re-entering the position is certainly a valid option, and often well worth considering.
Think about it: You’ve already locked in your profits. If you’re correct about the price movement continuing, then you’re effectively getting the best of both worlds. Your profits are safe, and you can dive back into the pool and rack up some more!
A lot of people say that re-entry is a tough skill to master, but it really isn’t.
You initially exited the trade to either cut your losses or take profits, both good things. At that point, you should consider the trade concluded and conduct analysis again, as though you were considering a brand-new trade. When viewed through that lens, re-entry is no easier or harder than any other trade you make.
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Chapter 5 – 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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