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An Introduction to Trading
What is trading?
Trading is the exchange of an asset, expecting the fall or rise of that asset’s price in the future in order to profit. Some traders trade as a full time career, others trade in their retirement and some trade for an hour or so a day.
Traders generally trade multiple markets and as such can follow equities, futures, CFD’s, options or foreign exchange. The beauty of trading is that with such a wide choice of markets, there is almost always an opportunity to profit. For instance, the foreign exchange market is open 24 hours a day from first thing Monday morning to very early Saturday morning (Australian time) while many international futures markets are open while our local bourse is closed.
Trading versus investing
Many people confuse trading with investing, but there are at least three simple differences between the two styles of money making:
1. Time-Frame - Generally, trading is of a shorter term time frame. A trader could be in and out of a position in five minutes, while an investor might hold a position for years. This means that traders are looking for shorter time period moves, rather than larger moves.
2. Markets traded - Additionally, traders generally hold a more “macro” or big picture view of the world and as such may trade currencies or stock index futures, whereas many investors simply invest in Australian stocks. This broader view and ability to trade multiple markets ensures that a trader will always have a profit opportunity, whereas investors generally wait for the broader equity market to rise.
3. System - Finally, traders often use a more “technical” trading system, while investors usually use a “fundamental” trading methodology. This is mainly due to the shorter-term nature of trading and technical analysis’s ability to predict short-term price movements.
Buying long and short selling
Generally, investors have a “buy and hold” methodology to their investing. This means that investors only make money when the assets that they hold appreciate in value.
Traders on the other hand can make money in both directions; they can make money by buying an asset “long” in the same way that investors do and waiting for it to appreciate, but can also make money by selling an asset “short” and waiting for the price to fall.
Short-selling is probably the least understood aspect to trading. Many investors cannot get out the “make money when price goes up” mind set, but traders should understand that money can be made in both directions.
How to trade
All successful traders have a trading system that they utilise to initiate their trades. This helps to streamline the decision making process and ensures a repeatable system for entering trades. The three cornerstones or a trading system are shown in the graphic below:
Trading psychology
Psychology is more important in trading than investing, because in general, more decisions are made for a given time frame. Just like in anything else in life, your psychology (or “mind frame”) is a very important determinant to the outcome.
If you are in the wrong mind frame to trade (not feeling confident for instance) if will hurt the outcome of your trading endeavours.
Money management
Any good money management system will have two major calculations:
1. Trade Size – how much capital to allocate to each trade, and
2. Risk to Reward – how much we are willing to risk per trade, compared to how much we will seek to win
Limiting your trade size per trade ensures that you won’t get “whipped out.” A trade size system is to only allocate 5% of your account balance per trade; this will ensure that a bad run of trades won’t completely empty your account.
The Risk to Reward ratio is one of the least understood facets of a trading plan. In short, most successful traders would expect two units of reward for one unit of risk. This is a risk:reward of 1:2. My ensuring that we always return twice as much as we lose on our losers, we only need to be right slightly better than half the time to make money in the market.
Entry and exit systems
This part of your trading system has three components:
1. Trade Entry – which market to trade, in what direction (short or long) and at what price
2. Trade Exit (loss) – where to place our stop loss orders
3. Trade exit (profit) – where to take our profits on a successful trade
This part of the trading system has multiple answers, many work, some do not and it is here where guidance from an experienced broker can help.
Most traders focus on this component of the system, but it is obvious that each of the components of the trading system are equally important.
IC Markets is a specialises in helping our clients build complete trading systems. Download our FREE CFD trading guide today.
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