TRADING STRATEGIES (EQUITY) – PART 1
TABLE OF CONTENTS
- Introduction to Trading Strategy
- Understanding Trading Strategy
- Need for a Solid Trading Strategy
- What determines a winning trading strategy?
- Understanding Active versus Passive strategy
- Top Level Trading Strategies
- Spectrum of Trading Techniques – From Seconds to Years
- Detailed Strategy Analysis – Pair Trading
- Detailed Strategy Analysis – Range Trading
- Detailed Strategy Analysis – Momentum Trading
- Annexure 1 – Essential Rules of Trading
- Annexure 2 – Six Signals to take profits off the table
- Annexure 3 – Trading strategy for volatile markets
- Annexure 4 – How to effectively use stop loss in trading strategy
- Annexure 5 –Trading strategy distinguishes trading from gambling
- Annexure 6 – Why Buy-and-Hold strategy has worked in India?
Your participation in any market has to be backed by a proper trading strategy. This applies to all the markets; be it equities, futures, options, commodities or currencies. At the core of trading strategy is the logic for the trade because at the end of the day trading is all about methodology and discipline. While the chapter will predominantly talk about trading strategy with reference to equities, the broad rules of trading can be applied to all asset classes that are traded on the stock exchanges.
Trading strategy is the method of buying and selling in markets that is essentially based on predefined techniques that are applied to make trading decisions. If we expand that a little further, the trading strategy includes a well-considered investing and trading plan that specifies investing objectives, risk tolerance, time horizon and tax implications. Ideas and best practices need to be researched and tested empirically. Planning for trading includes developing methods for buying or selling stocks and other asset classes.
Placing trades can be done offline or online using the internet trading module such as Rocket or even the app interface on your mobile like Rocket App . Before we formulate a trading strategy, it is essential to understand that trading costs in terms of brokerage, which is 0 at Tradeplus for Equity Delivery and Rupees 199 per month for F&O, Commodity and Currency. NRIs enjoy a different set of brokerage which is highly competitive. Other charges are demat charges, statutory charges, opportunity costs etc. Any strategy has to factor all these to be practical and usable. Trading strategy is not just about execution. It also includes the monitoring and the follow up action. Of course, other considerations like liquidity and tax efficiency cannot be ignored.
Key takeaways from our understanding of trading strategy
A trading strategy can be compared to a trading plan that takes into account various factors and exigencies for an investor. It includes the pre-trade, actual trade and the post-trade. Strategy is not a one-time affair but a continuous process. Here are the takeaways.
- The first step in trading strategy is planning. This entails what stocks to trade, why that particular stock and why long / short trade?
- The second state is placing the trade. This includes whether it should be a bulk order, sliced order, market order, limit order etc.
- The third stage is monitoring the execution. Whether you need to expand the stop loss or whether you need to change the price / quantity.
- The fourth stage is monitoring the trade. Once it is executed, you need to revisit stop loss levels, profit targets and risk limits etc.
- Lastly, it is about follow up action. Should you exit the position or add more. Should you book profits or use trailing stop losses? Should you average the position?
Various approaches to trading strategy
Your approach to trading strategy is largely determined by what approach you pick to formulate the trading strategy. It is a myth that traders only look at charts because most traders also look at a plethora of other factors. Here are some approaches to trading strategy.
- Technical trading strategies rely on technical indicators to generate trading signals. They believe that all information is in the price and hence the past is a reliable indicator. At Tradeplus, TradeSenze does this job of generating Buy, Sell and Exit signals for you using purely price data without indicators.
- Fundamental trading strategies take fundamental factors into account like profit growth, sales growth, efficiency ratios, shift in margins, news flows etc.
- The third type of trading strategy is a quantitative trading strategy which uses a combination of technical charts and fundamental news flows, but model driven.
- Then there are data driven strategies which are purely based on the key data points like A/D ratio, delivery ratio, futures OI accumulation, implied volatility movement etc.
- While trading strategy aims to eliminate behavioural biases, there is a behavioural approach to trading, which tries to capitalize on fear and greed in the market.
- Finally, the most popular strategies are eclectic in nature, in the sense that they use a bit of all the above before executing a trade.
Before getting into the specifics of strategies, let us first look at why we need a solid trading strategy. A trading strategy allows trading in a systematic and disciplined manner. Here is why it is so important.
- Sticking to a trading strategy allows you to focus in the midst of all the noise including news flows, data flows etc. Your analysis of a trade can be a lot more analytical.
- Markets are unpredictable and the purpose of trading is to be profitable through all the vagaries of the market. That is where trading strategy comes in handy.
- Trading performance can be measured only when there is a plan to benchmark against. Thus the trading strategy makes your trading activity more actionable and meaningful.
- By consistently using a trading system for a long period of time you have enough data points to evaluate your strategy and take corrective action based on data.
- Trading strategy allows you to simulate the future performance based on past data. This is very important if you have to convince clients about your strategy.
- Normally trading is driven by greed and fear. Trading strategy adopts a rule-based approach and hence enables you to keep emotions at bay.
- Trading strategy sets clear risk control measures in terms of every trade, every day and your overall capital. This can pre-empt huge losses in trading.
Characteristics of a solid trading strategy
It is really hard to define a good strategy because as Mao said, “A cat is a good cat, as long as it catches mice”. Similarly, a trading strategy is good if it delivers returns. Here are some characteristics of a good trading strategy.
- Unlike what people believe, simple strategies work best. A very complex trading strategy, which intertwines a great variety of rules for different market conditions, would be difficult to execute and profit from. It would be harder to monitor.
- A good strategy requires thorough back-testing before being employed. A great trading strategy on paper may not work in the real market conditions. Similarly, a strategy that works for stocks might not work for currencies. That is where back testing comes in.
- A trading strategy has to be dynamic and self-learning because all trading strategies become obsolete. Efficacy of a trading strategy will diminish over time. A good trading strategy is one that is willing to change with the times.
- A trading strategy must have an in-built logic to maximize profits when your trade is correct. If you buy RIL at Rs.1800 with target of Rs.1900, you don’t have to exit if your view is Rs.2500. You have to make the best of your bang-on trades.
- All strategies are vulnerable to draw-downs. What does that mean? Every strategy has a failure percentage; it could be 20% or 40%. What is critical is that your trading strategy is designed to hold profits long and cut losses short. That is the golden rule
- A good trading strategy is one that generates more winning than losing positions, and the average win is greater than the average loss. It is OK to have more losing positions but the average win must exceed the average loss.
- Every trading strategy must be built around the break-even point. Break-even point is not just about profits but the net profit after considering transaction costs, statutory costs, opportunity costs and the compensation for risk undertaken.
- A good trading strategy always works with a back-up plan. Your strategy may be perfect but something like COVID-19 or the Lehman crash may just turn the tables. Have a Plan-B that you can action as soon as such Black-Swan events occur.
- Believe it or not but trading strategy also needs diversification, not just long term investments. The trading strategy should be diversified to the extent that a single event or announcement does not disrupt your trade performance.
What exactly is a winning trading strategy? It is a strategy that delivers the best risk-adjusted returns to the trader. If you were to summarize this in actionable terms, it would mean that the trader is able to make profits at the few specific situations that offer profitable opportunities. In most of the other situations, the trading strategy would be good enough just managing the risk. How do you identify the handful of situations where profits can actually be made by trading strategy?
- Focus on price pivot areas: Price pivots are all about determining those points where there is a high probability of the market or stock changing direction. Price pivots can be identified using supports, resistances and oscillators. They paint the opportunity. Tradesenze positional calls works around Pivot points
- How to ride the momentum: Remember, that not all price movements are equal because some price movements have greater momentum or traction in their favour. Gauging momentum into potential pivot areas helps anticipate if area will hold or break.
- Use of multiple time frames: This is relatively more complicated. Normally, trading strategy focuses on two time-frames. The relatively long term chart is used to identify and understand the set-up. The smaller chart pin-points the entry and exit levels.
- Clear focus on price targets: You make money in trading when you close your position so ultimately it is about clear profit targets. Here you decide whether you want to use fixed profit target, percentage based profit targets or dynamic profit targets.
- Long versus short strategy: If you are looking to go long or short, but don’t know when to pull the trigger, this aspect will help you out. An entry strategy is simply a set of rules that tells you when to pull the trigger and where to place your entry and stop.
- High Probability Trade Setups: This is in fact a summation of the previous five points. Once all of the above points are combined; you create what is called "High probability trade setup". This repeatable, defined pattern can give you an edge over the market. It tells you that each time you pull the trigger you are more likely to win that to lose.
One of the less spoken about features of a winning trading strategy is consistency. When you find something that works, just stick with it. The more you hop around trying out new strategies, the less likely you are going to have a winning strategy.
These can be done with learning testing and over a period of time. However, if you want a ready-made tool that follows all the above said points just follow Tradesenze. After all, it revolves around Pivot points, gives you clear Intra-day and Positional, Entry and Exits and performs on consistent basis.
We shall not dwell too much on passive investing because that is not the focus here. The thrust is on active trading strategies where the trader consciously creates a pre-determined strategy. Passive trading or investing is normally done with the help of ETFs and indexed assets. Check out the various ETFs that you can directly invest in and this is exactly Passive Trading. On the other hand, active investing has two aspects. At the long end it focuses more on spotting underpriced or overpriced assets. At the shorter end, the intent is more to exploit fluctuations in price, momentum and direction to make profits. Here we focus on active strategies more from the perspective of short term trading.
How to do Pair Trading
Pair trade is also popularly known as long / short trade as it entails simultaneously buy and sell positions in two stocks that are correlated. Pair trading mitigates overall risk. If the market as a whole, or the segment you are invested in, falls then your short sales will mitigate your losses. In reality, pair trades profit off the spread. Your long positions will increase in value while your short positions decline, leading to a spread in asset values.
Example 1 - Say you are short on ONGC and long on Asian Paints. You expect a fall in crude oil prices so you are negative on ONGC but expect Asian Paints to benefit as crude oil is an important input for them. Here you are betting that Asian Paints will outperform ONGC. So if ONGC is up 2% and Asian Paints is up 6%, make profits. If Asian Paints is down 3% and ONGC is done 7%, you still make profits. It is all about the spread.
Leveraging the power of Day Trading
Intraday trading is based on the rule to never hold positions overnight. In day trading you purchase and sell assets within the same business day, sometimes within a few hours or even minutes. The goal is to profit from short-term fluctuations in the market. You set tighter stop losses and tighter profit targets. Here the focus is on the risk-reward ratio on each intraday trade. Intraday trading can be initiated either long or short. The only condition is that it must be closed intraday. It is useful in capturing intraday momentum.
Example 2 – Intraday trading can be useful to play news flows. If Infosys is expected to announce growth in profits, a trader can target an intraday long position in Infosys. Similarly, if the trader observes Bharti breaking below the support with volumes, then a short intraday trade can be initiated. Since it is an MIS order, the margins are much lower but the condition is that the trade must be closed the same day. Normally, if the trader does not close the trade by 3.15, then the broker’s MIS will automatically terminate the trade.
Trading the News Flows
This is one of the most common forms of active investing and is based on publicly available information. For example, expectation of a rate cut may lead to long positions in NBFCs and realty stocks. Expectations of a cure for COVID may be positive for pharma companies. Lower than expected profits or higher than expected losses can be a negative. Trading on news flows is not just for intraday but can also be a short period of time till the time you expect the news to play out. The good monsoon projections in India have been a strong justification for buying into the rural India story. This includes stocks in sectors like tractors, agrochemicals, fertilizers, hybrid seeds etc.
Trading based on fundamentals
Trading based on fundamentals can be based on a variety of parameters like an improving profit margin, better OPMs, lower leverage, Improved P/E ratio, higher ROE / ROCE etc. Quite often it is a difficult strategy to profit from in the short term. This may call for holding period but the idea of the trading strategy based on fundamentals is to buy as close to the event or trigger as possible.
Example 3: The decision to become zero-net debt was a game changer in the case of Reliance Industries. However, traders were skeptical about the ability of the company to raise a large amount in these tough markets. However, when RIL demonstrated its ability to monetize its digital stake, it made a case for a fundamental rethink for traders on RIL.
Chart pattern based trading
This type of active investing is based on an assessment of market data of a stock. Technical analysis looks at how shares have performed historically and then plot patterns that will repeat in the future. This is very popular form of active trading strategy. For example, you trade based on trend lines and price movement using charts and graphs. The goal of technical analysis based trading strategy is to predict trends from existing data and then to trade on the basis of those extrapolated trends.
Arbitrage as a trading strategy
The arbitrage trading strategy tries to make profits off the same asset having two different prices in two different markets at the same time. By exploiting these price gaps, the trader makes small but assured profits. Arbitrage strategies are largely assured return strategies and these opportunities do not exist for too long. You can do arbitrage between two markets,between spot and futures, between futures and options and also between two Exchanges, NSE and BSE. To do an arbitrage trade between NSE and BSE, use Rocket. This has a handy facility to toggle between NSE and BSE and provides you an online platform to buy at one Exchange and square off the same in other Exchange thus providing an online interoperability option. Arbitrage is also possible between commodities and stocks, although it not necessarily a perfect arbitrage.
Example 4: If Infosys is quoting in the spot market at Rs.940 and in the futures market at Rs.950, then you can create an arbitrage strategy by buying in spot and selling in futures. The Rs.10 profit is your assured return after costs. That translates into returns of 10/940 = 1.06%; which is extremely attractive on a per-month basis. Similarly, if the futures contract on Infosys is quoting at Rs.950 and the 940 call options is quoting at Rs.30, one can buy the underpriced future and sell the overpriced option. Here again the profits are locked in. Likewise, if Infy quotes at 950 in NSE and at 960 at BSE, using Rocket Trading Platform, you may buy at NSE and square it off in BSE taking back the profits.
Executing trading strategies have become a lot more time sensitive these days with the use of HFT, low latency trading, algorithmic trading, artificial intelligence based trading etc.
What do we understand by top level trading strategies? These are called top level trading strategies because they just offer the macro framework. Each of these has a number of sub-groupings and sub-strategies, which would be outside the scope of this discussion. Here is a look at four popular top-level trading strategies.
Trend trading as a Strategy
Trend trading strategy uses charts and technical analysis to identify the direction of market momentum and its undertone. For example, as shown in the chart above, higher highs and higher lows can be seen as a signal of an uptrend in the stock or index. On the other hand lower tops and lower bottoms is a clear signal of a downtrend in the market. Trend trading is considered a medium-term strategy and is best suited to swing traders as the trend will define their broad strategy and they can maintain their direction till the uptrend or downtrend is on.
Some popular technical analysis tools included in trend-following strategies include moving averages, relative strength index (RSI) and the average directional index (ADX). It is said that this is the trend that the trader must never defy and always craft trading strategy within this broad trend.
Range Trading as a strategy
Range trading is a strategy that takes advantage of consolidating markets. In other words, it provides a strategy to trade the market which is in a specified range. It is observed that for long periods, markets remain in a range and hence range trading can be extremely productive for a trader.
As can be seen from the above chart, range traders will focus on the short-term oscillations in price. They will open long positions when the price is moving between two clear levels and is not breaking above or below either. They would typically buy a little above the support with stop loss below the support levels. Alternatively, they sell below the resistance level with stop loss above the resistance level. This is more popular among forex traders or commodity traders where prices normally remain in a range.
There is an array of indicators used in range trading and the traders will normally use stochastic oscillator or RSI, which identify overbought and oversold signals. Range traders will also use tools, such as the Bollinger band or fractals indicators, to identify situations when the market price might break from this range; to take a contrarian position. These type of charts can be plotted and indicators can be studied in Rocket Trading Platform. You can also soon trade directly from Charts in Rocket as and when you find an opportunity arising using these indicators.
Breakout trading as a strategy
Breakout trading is the strategy of entering a given trend as early as possible, ready for the price to break out of its range. Such a break out can be on the upside or the downside. Breakout traders will normally look for price points that indicate the start of a period of volatility or a change in market sentiment. Timing is very important in break-out trading to really generate profits.
Most breakout trading strategies are based on volume levels as you will see in the chart above that the break-down below the trend line is support by a spurt in volumes. The logic is that when volume levels start to increase, there will soon be a breakout from a support or resistance level. As such, popular indicators include the money flow index (MFI), on-balance volume and the volume-weighted moving average in this case.
Reversal trading a strategy
Reversal trading strategy boils down to identifying when a current trend is going to change direction. That means an uptrend shift to a downtrend or a downtrend shifting into an uptrend. Once the reversal has happened, the strategy takes on the characteristics of a trend trading strategy. Here it is identifying the triggers of the reversal and to eliminate the false signals that are very critical. A reversal can occur in both directions, as it is simply a turning point in market sentiment. Normally, a bullish reversal indicates that the market is at the bottom of a downtrend and will soon turn into an uptrend. On the other hand, a bearish reversal indicates that the market is at the top of an uptrend and will turn into a downtrend.
You need to take care of the false signals here. When trading reversals, it is important to make sure that the market is not simply retracing. The Fibonacci retracement is a common tool, used to confirm whether the market actually surpasses known retracement levels or not.
These are often referred to as either trading techniques or even as trading styles. They are extremely short term to very long term in nature based. They are classified into four categories based on the length of holding and the trading style deployed. At the shortest end of the spectrum you have scalpers who typically scalp profits in a matter of seconds or minutes. Then you have the day traders who hold positions for a few hours and avoid overnight positions. Thirdly, there are swing traders who take a view for a few weeks to even a few months. Finally, at the longest end there are positional traders whose traders may have a time frame ranging from a few months to a few years.
How Scalpers operate in seconds
Scalping would typically look at a number of trading opportunities within the day and would look to churn the positions at least 5-6 times during a single day. These scalpers are the most common in the forex market where it is possible to trade in huge quantities with small margins and small spreads. A typical scalp trader would only hold positions open for seconds or minutes at most. These short-lived trades capture small intraday price movements. These scalp traders are very important for the market as they provide fine trade spreads and contribute to the liquidity in the market. These are normally proprietary traders who trade on very large volumes.
Scalpers normally require tight spreads and highly liquid markets. That is why they are very common only in the forex markets where such liquidity and tight spreads are possible. In the F&O market in India, scalpers do operate on the Nifty and Bank Nifty futures as well as on some extremely liquid stocks like Reliance, ICICI Bank, Infosys etc. These scalpers normally restrict their trading only to the busiest times of the trading day and prefer to take it easy rest of the time.
How day traders avoid overnight risk
For traders not comfortable with the speed and intensity of scalp trading, but still don't wish to hold positions overnight, day trading may suit. Day traders enter and exit their positions on the same day (unlike swing and position traders). Thus these day traders eliminate the overnight risk completely from their strategy. Trades are usually held for a period of minutes or hours and hence the focus is always is on momentum. Day traders use a mix of technical charts and news flows to execute their day trading strategy. Day traders typically use the technical indicators such as MACD (Moving Average Convergence Divergence), the Relative Strength Index (RSI) and Stochastic Oscillator, to identify trends and trading signals.
Betting longer with Swing Trading
Swing traders take on overnight risk, unlike day traders. Swing traders hold positions for several days, although sometimes as long as a few weeks. They are not exactly the long term investors that we hear about but look to making the best of delivery positions over a few days to few weeks. Monitoring swing trades is not as intense as monitoring scalp trades or intraday trades.
Swing traders use trading strategies such as trend trading, counter-trend trading, momentum and even break-out trading. However, the basic idea is that they try and play out a complete short to intermediate trend even if it means holding on to the position for a few weeks or at times even for a few months.
Position trading at the longest end
Position traders are located and also focused on long-term price movement. The idea is that once they see a long term trend, they try and play it to the maximum extent possible. As can be seen from the chart above, the trader holds this position for a long time despite 3 intermediate retracements. He holds on to the position as long as the underlying trade trend is still intact. The position is exited only when the price chart breaks decisively below the long term trend line. Such position trades do not have any fixed time frame but can last from a few weeks to even a few years. Position traders use weekly and monthly price charts to analyse and evaluate the markets using a combination of technical indicators and fundamental factor analysis. It is only based on a combination of all these factors that the entry and exit level are agreed upon and executed.
One thing that is clear from the chart above is that position traders are not bothered about minor price fluctuations or pullbacks. Unlike scalpers and intraday traders or even swing traders, their open positions do not have to be monitored so closely and intensely. Their monitoring is normally restricted to any major trend or disruption that could change the logic of holding on to the position. Such long term positions can be on the long side and also on the short side. How do you do short side position trading. It can be done by selling in cash and re-entering the stock at a later date. Alternatively position trades on the short side can also be executed with short futures rolled over or with long term put options.
Pair trading is a non-directional, relative value investment strategy. The basis of any pair trade is the price ratio which is the ratio of one stock price to another. Normally, the pair trades tend to bet either on sharpening of a trend or they bet on prices reverting towards the average (mean reversion). For a pair trade, you need two stocks or assets that are correlated. For example, you cannot have a pair trade between unrelated assets. Pair trade essentially entails buying the undervalued security while short-selling the overvalued security. Its beauty is that it is substantially market neutral.
How is the price ratio used?
The relationship between two assets is measured through the price ratio. To measure these relationships, pair traders use statistics, fundamentals, technical analysis and probabilities. You can just apply price ratio anywhere. It can only be applied where there is a strong correlation between financial instruments.
How the pair trader bets on the pair?
Pair trading works on the premise that two or more securities will diverge or converge in price. For example, let us consider two banking stocks quoting at Rs.800 and Rs.850 respectively. The pair trader bets that the spread of Rs.50 will either increase to 100 or reduce to zero and will structure the pair trade accordingly. There are two types of bets on pairs. Divergence traders will prefer to see the spread increase while convergence traders prefer to see the spread decrease.
5 important steps in a pair trade
There are 5 key steps that constitute a pair trade.
- To begin with, set the pair selection criteria. You must zero in on your trading universe, create a pair trade model and test and set clear buy and sell guidelines. An individual trader's available capital resources and expected duration will impact the nature of the pair trade but the structure is functionally the same in all cases.
- Once the selection is complete, zero in on the specific stocks for pair trade. Such selection can either be manual or model driven. A trader intending to hold pair trades for several hours to several days will have to generate trade candidates with far greater frequency than a trader whose average holding period runs into weeks and months.
- The next step is to execute the Pair Trade. The thumb rule is that the short side of a trade should be executed and filled before the long order is placed. For large orders and for complex pair strategies it is advisable to use models. Like in any trade, the idea is to reduce the spread costs and opportunity costs to the bare minimum while executing.
- The next step is to manage the pair trade depending on the changes in the fundamentals of the stock, the technical charts and the overall macro market conditions. For example, if a pair trade with an expected duration of 6 weeks were to achieve 50% of its profit objective in 3 days, it is time to re-evaluate the potential reward to keep the trade open.
- Finally, close the trade and take profits off the table. Also be willing to take a loss if required. Normally, for any pair trade, the discipline must be at the core of trade closure. If your view is going wrong, don’t wait too long. It is ok to take a hit because the best of markets can be irrationally longer than you can be solvent. Remember that!
The bottom line is that pairs trading can be profitable and extremely useful in identifying spread opportunities. In fact, returns can be substantial in a short span of time when there is mean reversion. But a successful pair trade entails significant research, close monitoring, clear rules and discipline to top it all.
Range trading is a strategy wherein the trader identifies overbought and oversold zones (also known as support and resistance areas). Range traders typically buy at the oversold area (support) and sell at the overbought area (resistance). As the name suggests, the range trading strategy works best when the market is in a range. That means; markets are meandering up and down with no discernible long-term trend. However, range trading is less effective in a trending market; like a directional bull market or a directional bear market.
Range trading using moving averages
The most popular way to determine a stock’s average price is through the moving average method. For example, a 5-day moving average shows the market's average price for the past 5 days while a 20-day moving average shows the average for the past 20 days. When these points are connected you create a moving average line. This moving average is the base for mean reversion. For example, when the price moves substantially above or below the moving average, there's a good chance of mean reversion and you can trade accordingly.
Support and resistances
This is the bread and butter for any range trader. Apart from identifying the support and resistance, the range trader also takes a view on the strength and reliability of the support and resistance line. Identifying and measuring the strength of support and resistance is essential to interpreting price charts. Normally, the support is the price at which buying is strong enough to interrupt or reverse a downtrend. On the other hand, resistance is a price level where selling is strong enough to interrupt or reverse an uptrend. Range traders buy above the support with stop loss below the support. Alternatively, they sell below the resistance line with stop loss above the resistance line. This is exactly what Tradesenze positional calls alerts you about where to buy and where to sell.
How is the range trade set up?
The whole purpose of a range trade is to find a point at which price has stretched too far above or below the average price and hence there is a high probability that it will snap back and therefore find a point where resistance or support is formed. Normally, the markets will oscillate trending (range expansion) periods and non-trending (range contraction) periods. Range trading begins with determining whether the market is in a trend or otherwise. If no trend exists in the time frame, the odds are high that a range trading will succeed.
In a pure range-bound market, the trader can place a buy order close to the market's established support level or at an oversold point when the price has moved well below the market's moving average. As a protection, a stop can be placed just below the support area or at a point well below the entry price of the trade depending on your risk appetite. Similarly, a sell order can be placed around the market's established resistance level or at a point well above the market’s moving average. Remember, not every trade is a winner and the focus should be on getting more trades right than wrong and having a net credit.
Risks to a range trading strategy
There are a number of distinct risks in a range trading strategy. Firstly, a steep fall or rise in the market may shift the moving average substantially from the real picture and ranges may prove wrong. Secondly, there are false supports and resistances to beware of. Lastly, markets alternate between range expansion and range contraction. In the event of a break-out, range traders may end up losing a lot of money.
Momentum traders trade on the premise that the trend will continue to head in the same direction because of the momentum that is already behind them. Momentum is the acceleration of a trend. You can have a stock in an uptrend but unless you have momentum in its favour, the stock cannot give great returns.
If you are looking at price momentum, you must focus on stocks that have been continuously going up, day after day, week after week, and maybe even several months in a row. For example, a stock making new highs every day or every week is a stock with strong price momentum in its favour. It is important for momentum traders to trade on the long side unless there is adequate reason to believe that the momentum has changed or shifted to the negative side. A similar short strategy can also be applied on the downside when the stock is continuously making new lows.
This is normally an affirmation or ratification for price momentum. Just rising price is not a good momentum indicator if it is not supported by rising volumes. Typically the best momentum plays are found when the price momentum is supported by volume momentum also. You don’t just look at the new price highs and new price lows. You also look at the volume gainers and volume losers.
This is a unique form of playing momentum where you bet on rising volatility. This is more popular in options when you do delta trades. Typically, traders will go long on delta when volatility is going to rise or when momentum is in favour of higher volatility. This is not a price direction strategy but you just bet on increasing volatility and this can work both ways.
Risks of momentum trading
Remember, momentum trading is a high risk game because you are betting on a set of assumptions to hold true and that may not be true. Therefore, momentum trading involves a good deal of risk. In momentum trading you are essentially making a decision to invest in a stock based on recent buying by other market participants. However, that is no guarantee that buying pressures will continue to push the price higher. It is entirely possible that profit-taking on existing positions will overpower new buyers coming into the market, forcing prices down. Loss of momentum is the big risk in momentum trading.
Trading rules are a set of guidelines that traders must follow to be successful in the long run. Here are some basic trading rules that traders in any market must follow. These form the core of the success of your trading strategy.
- Never trade without a trading plan in place. What exactly is a trading plan? It is a written set of rules that specifies a trader's entry, exit and money management criteria for every purchase. The key to any trading plan is the back testing based on live data. Today it is easy to test a trading idea before risking real money with the use of backtesting.
- If you want to be successful in trading, treat it like a Business. That means; you must approach trading as a full-time business, not as a hobby or a part-time job. Trading can be frustrating as there is no regular pay-cheque but that is why you must treat it like a business with all the concomitant uncertainties.
- To gain competitive edge in trading, make the best of technology from stock selection to execution to back testing and monitoring. Set alerts to make you job easier. User-friendly charting platforms give an infinite variety of ways to analyze markets. Using technology to your advantage can be profitably in the long run.
- Your first job is to protect your Trading Capital. Ensure that you are trading with money you can afford to lose without worrying about paying your kid’s school fees. Protecting capital entails not taking unnecessary risks and doing everything you can to preserve your trading business. You need to set stop losses at multiple levels.
- If you want to be a good trader, you must be a continuous student of the markets. It is important to remember that understanding the markets, and all of their intricacies, is an ongoing, lifelong process. Above all, at the core of any successful trading strategy is the tacit admission that the market is always smarter than you.
- This may be a repetition, but risk only what you can afford to lose without losing your sleep. Make sure that all of the money in that trading account is truly expendable. Traders must never allow themselves to think they are simply borrowing money from these other important obligations.
- Develop and fine tune a methodology that is based on pure facts and data and it is worth the effort. Consider this: if you plan a new career, you would study at a college or university for at least a year or two before you were qualified to even apply for a position in the new field. Your approach to trading should also be along similar lines.
- Never trade without a stop loss; that is the raw material of any trade. Stop loss is based on the amount of risk the trader is willing to accept with each trade. Stop loss can be a price level or a percentage but it must limit your losses to manageable levels. Not having a stop loss is bad practice, even if it leads to a winning trade.
- There are times when you must hang your hat and stop Trading. It could either be because you have an ineffective trading plan or you are being an ineffective trader. There are different reasons and these could be external or internal. But when things go wrong beyond a point, just remove your batting gloves, hang up your boots and rethink.
- Let your head rule over your heart; always. Stay focused on the big picture when trading but don’t allow a losing trade to surprise you. It is the cumulative profits that make a difference over time. When in doubt use data rather than being led by greed and fear. Emotions can be quite expensive in trading. Above all, set realistic goals.
Trading is not the golden key to any treasure. Like any business, your focus should be to earn a reasonable return in a reasonable amount of time. The key to reaching that goal is the cardinal rule that you must learn to manage your risk.
In any trading, you make money only when you book profits. There is no point in keeping book profits. Ultimately these profits have to be booked so that they can be realized and add to your capital wealth. We all know that profit must be booked when the profit target is hit but there are other important indicators to take profits off the table. Let us look at six such important signals.
- Is the stock losing momentum? This is the first signal to watch out for and take profits off the table. The golden rule is that bull rallies do not come to an end when selling emerges. On the contrary, bull rallies come to an end when buying vanishes. That is called loss of momentum. These signals are hard to miss. Normally, loss of momentum is visible in lack of buying interest altogether. When the stock is consistently losing momentum at higher price levels, it is a signal to take profits off the table. You can apply this rule at a Nifty / Sensex level of even at a stock level.
- Should I churn or should I hold? Here you apply the rule of 72 to determine if it is worthwhile holding on or it is better to book profits. In finance parlance the Rule of 72 is used to calculate how many years it takes for money to double. If you earned 12% on equities last year then it will take you 6 years (72/12) to double your money. Assume that you got into a trading position and made 40% profits in a month. It has happened so many times. That means you will double your money in 1.8 months if the trend sustains. That looks fairly unreal. If that does not look feasible, it is a signal to book profits.
- If something is too good to be true; it is probably not true. This can be a kind of an extension of the previous point. For example, you bought a mid cap stock targeting the stock to double in 2 years. Instead if the stock doubles in just 2 months what do you do. Remember mid-caps are intrinsically riskier than large caps. So it is just too good to be true and hence you must take profits off the table.
- Keep an eye on some basic technical chart signals. For example, a rising stock that makes higher tops is a positive signal; more so if it is also supported by higher bottoms. Similarly, a falling stock that is making lower bottoms is a negative signal; more so if it is accompanied by lower tops too. Also stocks that show spurt in volumes when they fall and weak volumes when they bounce are a basket case of underlying weakness. You must look to book out of such stocks. Also, it is time to be cautious when the A/D ratio of the market as a whole is trending negative.
- Is the trade exposing your capital to unnecessary risk? This is not about the market or the price but about you. If you already have 3 out of 6 trading positions in IT stocks then should you hold on profitable positions in Infosys or exit. Ideally, if it exposes you to excess sectoral risk, you need to think with your feet. Constantly evaluate your portfolio. Dos trading positions overly expose your capital to downside risk? Are your trading positions vulnerable to sudden black swan events? Is the worst case loss on your portfolio more than your normal capital cushion? These are all capital risk factors and indications that you must exit the position.
- Finally, look for the liquidity triggers. Here we are not just referring to the liquidity on stocks but on the flows of cash into the system. Watch out for factors that constrain liquidity in the markets. If FII flows and DFI flows are slowing, it is a sign of tightening liquidity in the markets. Similarly, RBI tightening liquidity or increasing rates is a sign that liquidity in the system could reduce. Back in 2013 we saw how the Fed tapering led to a sharp sell-off in the Indian markets as it expected liquidity to dry up. Post Mar-20, the Nifty has rallied nearly 50% despite COVID-19 due to the $6 trillion liquidity infusion. For a market like India, liquidity flows matter a big deal.
As a good trader your job is to listen to these signals thrown by the market and act on them. Exit signals come in various forms and if you closely follow and act on these signals, then trading returns will follow as a logical corollary!
In a volatile market, the markets become a lot more unpredictable and hence the risk factor in trading goes up. This makes it difficult to formulate a trading strategy since ultimately you are dealing with finite capital. Therefore it is essential that traders and investors need to start preparing themselves with a clear strategy on how to handle volatility in markets. While there are volatile strategies to play the market, there are also some larger changes you need to make to your overall trading strategy. Here are 6 things that can help you.
Cash has always been the king of volatile times; and always will be
Normally, the advice to investors is that volatility should be used as an opportunity to add to your positions in quality stocks. One of the major challenges in a sudden market correction is having sufficient liquidity at your disposal to capitalize on the opportunities that a correction offers. Missing out such opportunities has a huge opportunity cost and that must be factored in. You must have enough cash or at least be able to liquidate at short notice to make the best of lower prices. That is a key preparatory step in volatile markets.
It is tough time markets in volatile times, so don’t try too hard
This has to be an essential part of your trading strategy. Timing is tough at all times but it becomes tougher in volatile markets. How do you generate alpha. That is where volatility gives you an opportunity. That is where benchmarks come in handy. Look at previous cases of such volatile markets and check how much the P/E of the index has corrected. Normally, patterns repeat at a macro level. You can apply such macro patterns in volatile markets.
Phase your investments and make it more disciplined
Don’t rush to buy when the market corrects. For example, allocate 20% of what you want to allocate, nothing more. When the markets correct sharply, like they did post COVID, you never get a V-shaped recovery. The recovery is more gradual and requires a lot of effort. A more passive strategy will be regular and periodic investing. You can call it a SIP or any other name; but the moral of the story is that a phased approach works best in a volatile scenario. Let us go back to history. Between 2007 and 2020; the Nifty would have hardly given a return of 3-4% annualized in absolute compounded terms. But a SIP would have given 14-15% returns. Make volatility work for you.
Forget volatility, stick to your trading plan
Ensure that you stick to your trading plan; and all the more so. The chances of hitting a stop loss are much more in volatile markets and hence you must trade with stricter stop losses and lower risk tolerance. Also, in volatile markets you must rely more on limit orders rather than on market orders. Don’t change your trading plan just because markets are volatile. Most trading plans are good enough to see you through tough times.
Focus on preserving capital; first and foremost
Losses are inevitable but they cannot wipe away too much of your capital. However, if you lose too much capital then that may restrict your trading capacity once volatility reduces and normalcy returns to markets. Traders often try to outsmart the market by trading aggressively. In reality that hardly works for you, so it is best avoided.
Volatile markets are all the more reason to take profits out
This may apply to all kinds of market situations, but all the more so in volatile markets. Keep taking profits at regular intervals. In volatile markets you run a high level of overnight risk and weekend risk. This is happened so often in volatile mid-cap stocks. The best trading strategy is to keep taking profits, perhaps even a tad more aggressively.
Stop loss is about protecting your capital and hence it must apply whether you trade equities, futures, options, commodities or even currencies. As a trader, you always want to risk only a small portion of your capital on each trade. Since your capital is finite, your risk must also be finite and that is where stop-losses step in. Stop losses ensure that you can actually survive as a trader for a long time. Let us how to effectively put stop losses.
Stop loss levels – The affordability clause
This is simple and very easy to understand. This is called the affordability clause. For example, you can set a rule saying that you will not risk more than 0.5% of your capital in a single position. Your stop loss should be set accordingly. The most important purpose of a stop loss is to ensure that your capital is protected; that is how much you can afford to lose on a trade. If affordability conflicts with technical levels, then rely on affordability.
Stop loss levels – Based on charting techniques
Affordability is the first concept in setting stop losses. Then we come to the popular use of charges, supports and resistances for setting stop loss. If you are long on the stock then set the stop loss below the next support. If you are short on the stock then set the stop loss slightly above the next resistance level. This small gap is provided to take care of spikes in volatility. Remember, technical stop losses are not foolproof but are just empirically proven.
Stop loss setting – just indicative or imputed in the system?
Should stop loss be a flexible range or should it be a rigid level. Ideal, it should be a specific level and must be imputed in the system. Don’t wait thinking that you will put the stop loss later. It defeats the basic purpose of the stop loss. Remember that stop loss is a discipline and hence you must never have discretion on this subject.
Stop loss is insurance – not a guarantee of protection
Even with your best intentions, your stop loss may not get triggered at the exact price and hence may enhance your losses. On volatile days we have seen the bid-ask spreads widen sharply and that means your actual execution price may be worse than the price you are looking for. That is a risk you are exposed to in volatile markets and there is no insurance.
Effective use of trailing stop losses
When to use a trailing stop loss? When you are sitting on a profit but see the momentum continuing longer, it is time to use trailing stop losses. If you are bullish, keep gradually resetting your stop profits higher so that you have protection for profits and yet ride the volatility to the fullest. Position traders use trailing stop losses quite effectively.
Stock markets behave like a slotting machine in the short run but they are a weighing machine in the long run. Since short term trading is based on volatility and risk, people often equate short term trading with gambling. That is not true. The difference is that gambling has no strategy, but works on odds. On the hand, it is possible and essential to only trade with a clear trading strategy. Let us look at how trading vastly differs from gambling.
Trading focuses on facts and figures
Trading is risky but you also have the advantage of a huge database of numbers and data to fall back upon. You can study the volume and price trends in the market. You can take a look at how advances / declines are progressing in the market. You also know how much of market activity is delivery based and how much is speculative. It is this data that makes trading different from speculation or gambling.
In gambling there is the house advantage; unlike in trading
When you are gambling at a Las Vegas or Macau, the casino is the counterparty. Therefore the casino is an interested party as they need to ensure you do not make so much money as to bring the house down. That 's why it is tougher to make money in gambling. In trading, the stock exchange is not an interested party and only facilitates the execution. Stock exchange is not worried about who makes and who loses money. Hence strategies work here.
Gambling is normally a zero sum game, trading is not
The casino will ensure that gambling is a zero sum game for most of the participants so that the casino can earn the money. That is how the casino survives in the long run. Trading need not be a zero sum game as you can be in the money consistently by maintaining certain basic discipline and abiding by some basic rules of trading. That makes trading more predictable compared to gambling.
Trading is less about adrenaline and more about discipline
If your adrenaline runs up in a casino, you are exactly what the casino wants. You are the perfect gambler who will keep committing money till you lose all of it. Trading, on the other hand, is boring and disciplined. Adrenaline can be a disadvantage in trading as it forces you into irrational decisions. Discipline is much more important than trading genius.
Trading gives greater control over the outcome
If you throw a dice, the only thing you know is that there is a 1/6 probability of getting any of the numbers. But, you have limited control over the event. You try to play by the odds and hope that the cycle of probability will work in your favour. As a trader, you have more control. In fact, you can determine outcomes with strategy and discipline.
One thing position traders want to be sure is if a buy-and-hold strategy really works in India. If you look back at stocks like Eicher, Havells, Reliance, Infosys or Wipro, the merits of a buy-and-hold over a long period of time would have been huge. Here let us look at why exactly does buy-and-hold strategies work in India. This is relevant in a market where the Sensex itself have given average annual returns of 17% over 40 years. Here is why it works in India.
Why buy-and-hold strategy works in India?
- Huge investments in infrastructure over the last 30 years actually unshackled the growth potential of India. Stocks linked to GDP growth and income levels have been obvious buy-and-hold stocks.
- Scale is another important factor. India has companies like TCS, Reliance Industries, Tata Motors and L&T which are of global scale. Buy-and-hold works very well when scale is in your favour. That is when companies graduate from being mid cap to large caps.
- Consumption is always a great theme in a country with 1.3 billion people and where purchasing power is growing by leaps and bounds. Consumer stocks have outperformed in India because per capita income levels in India are still way below other countries.
- True wealth has been created by new economy companies that were either technology based or technology driven. Today digital plays like Reliance, TCS and HDFC Bank are among the most valuable. The buy-and-hold idea has worked really worked here.
- Structurally, India is moving from high interest rate economy to low interest rate economy. This has been driven by lower inflation and RBI action. When rates come down, there is long term wealth creation to a great extent that happens.
- India has an array of high quality mid caps. Bharti Airtel to Lupin to Sun Pharma to Infosys; were all erstwhile mid-caps that transformed into large caps. That is a kind of virtual assurance that buy-and-hold strategy will continue to work in India.
- Global and domestic liquidity means that there is lot of money in the sidelines and these can boost buy-and-hold strategy for a long time to come. Retail investors are getting into equity in a big way. This combination will support buy-and-hold strategy.
Indian markets are poised almost similar to US markets in the 1980s when structural shifts created new sources of wealth. For now, Indian buy-and-hold strategy looks set to continue!