Stocks Trading
“Bulls make money, bears make money, pigs get slaughtered.”
– Old Wall Street saying
Stock trading involves buying and selling shares of companies on various stock exchanges with the aim of making a profit in the short term. Traders may capitalise on daily price fluctuations. Traders purchase stocks when they believe the prices are low and sell when they believe the prices are high. Traders may also sell the stock when price is falling and buy it back at a much lower price, this price difference becomes their profit. Popularity of stock trading in India has increased substantially after Covid 19 breakout. Many working age people were trapped in their home with idle time and the long bull run in stock markets in India. Availability of many low fee online platforms, which offer increased accessibility and real-time transactions has made trading stocks effortless. The main attraction of stock trading is the promise of quick profit. However, it comes with inherent risks such as market volatility and the potential for significant financial losses if not managed carefully.
Types of Stock Trading
Stock trading is speculation (fancy word that means betting or gambling). One should understand this very clearly, only then they will be in the right mindset to make profit out of this activity. Following are the most popular types of stock trading.
Scalping: A high-frequency trading strategy that involves making many small profits on minor price changes throughout the trading day. It involves making quick trades that capture small price gaps. It takes advantage of small market changes, usually over minutes or hours.
Day Trading: Buying and selling stocks within the same trading day to capitalise on short-term price movements.
BTST (Buy Today, Sell Tomorrow): This strategy involves purchasing stocks and selling them the next trading day. The goal is to take advantage of overnight price movements, often driven by news or events that could impact stock prices.
STBT (Sell Today, Buy Tomorrow): This is the reverse of BTST. It involves selling stocks one day and buying them back the next day, typically aiming to benefit from a predicted decline in the stock’s price overnight.
Swing Trading: Focuses on taking advantage of short-to-medium term price changes. It involves buying and holding stocks for several days to weeks to profit from expected upward or downward market shifts.
Momentum Trading: Buying stocks that are trending upwards in price and selling them when they lose momentum. This is the method which bets on stocks that are doing well and are expected to continue to do well in the near future.
Position Trading: Holding stocks for longer periods, ranging from months to years, based on long-term market trends. It focuses on large, expected market moves over weeks, months, or years.
News-Based Trading: Making trades based on market-moving news and events, such as earnings reports, economic data, or geopolitical developments.
Pairs Trading: A market-neutral strategy involving buying one stock and simultaneously selling another correlated stock to profit from their price relationship.
Event-Driven Trading: Trading based on specific events, such as mergers, acquisitions, or other corporate actions.
Value Trading: Investing in stocks that appear undervalued based on fundamental analysis, with the expectation that their prices will eventually increase.
Stock Trading Psychology
The importance of psychology in stock trading cannot be overstated, as traders’ emotions and cognitive biases significantly impact their decision-making processes. Market sentiment, which reflects the overall attitude of investors toward a particular stock, often drives price movements beyond fundamental values. Loss aversion, the tendency to fear losses more than valuing gains, can lead to overly cautious behaviour or panic selling. The endowment effect causes traders to overvalue their own holdings, while status quo bias makes them prefer existing investments over new opportunities. The anchoring effect can cause reliance on specific, often arbitrary, reference points, influencing subsequent decisions. Confirmation bias leads traders to seek out information that supports their existing beliefs, ignoring contrary evidence. Moreover, genes and instincts play a role, with some traders naturally more risk-averse or aggressive due to genetic vulnerabilities. Misconceptions, such as believing that past performance guarantees future results, can mislead traders. To improve, traders should cultivate self-awareness, practice disciplined trading, and continuously educate themselves about behavioural aspects of trading decisions to mitigate these psychological pitfalls.
Merit & Demerits of Stock Trading
High Returns
Stock trading offers the potential for significant returns on investment. Stocks are generally more liquid than other investments, meaning investors can easily buy and sell shares without significantly affecting the market price.
Easy Money?
Successful stock trading requires time, research, and ongoing monitoring of market conditions. It can be demanding and time-consuming, especially for active traders who engage in frequent buying and selling.
“Trading actively is the toughest way to make easy money in life.”
– Nithin Kamath, Founder of Zerodha
According to the Zerodha founder, making money through active trading is just as challenging as making profits through running a business, if not more so, because trading is accessible to anyone whereas starting a business requires specific skills and resources. Over a three-year timeframe, fewer than 1% of individuals who actively trade equity futures and options manage to achieve returns surpassing those of bank fixed deposits or an annual 7%.
Trading Addiction
Addictive traders feel compelled to trade, driven by a passion for action and excitement. They often neglect risk management, as the thrill of risk itself is part of the high. Even when facing losses, they continue trading because their primary goal is the excitement, not profit. Such traders cycle between phases of guilt and responsibility and periods of excessive and irresponsible trading. While good traders maintain active trading habits, addictive traders tend to overtrade, chasing the dopamine rush that trading provides.
Getting Started with Stock Trading
Choosing a Brokerage Account
Choosing a brokerage account for stock trading involves carefully evaluating several key factors to ensure it meets your needs. Firstly, consider the fees and commission structure; lower fees are preferable, especially if you plan on frequent transactions, as high fees can significantly erode your profits. Look for brokers that offer competitive pricing and transparent fee schedules. Secondly, assess the trading platform’s features, including ease of use, reliability, and the availability of tools and resources such as real-time data, charting capabilities, and educational materials. A glitch-free platform is essential to avoid technical issues that could interfere with your trades. Additionally, consider the quality of customer service and support, as responsive and knowledgeable assistance can be invaluable. By thoroughly researching and comparing brokers on these criteria, you can find one that aligns with your trading strategy and goals.
Importance of Trading Fee
Trading stocks often incurs transaction costs such as brokerage fees, commissions, and taxes, which can erode profits, particularly for investors with smaller portfolios or those who engage in high-frequency trading.
Many traders are unaware that a significant portion of their capital is spent on expenses. Nithin Kamath, the founder and CEO of Zerodha, has said that active traders must generate returns of more than 20% annually just to break even on their portfolio.
Technical Analysis
Technical analysis is a vital tool for stock traders, using past price and volume data to identify trends and make informed decisions. It helps traders recognise whether a stock is in an uptrend, downtrend, or sideways trend by analysing price charts and trend lines. Key concepts include support and resistance levels, which indicate optimal entry and exit points, and chart patterns that signal potential price movements. Technical indicators like moving averages, RSI, and MACD provide insights into market momentum and sentiment, while volume analysis confirms the strength of price movements. Additionally, backtesting strategies on historical data refines trading approaches, and timing trades using technical signals enhances decision-making. This systematic approach aids traders in navigating market complexities effectively.
Building a Trading Strategy
Developing a personalised trading strategy is essential as it aligns with your investment goals, risk tolerance, and time horizon, helping you stay focused and disciplined. By tailoring your approach, you can maximise potential returns while effectively managing risks. Regular updates are necessary to incorporate new learnings and adapt to market changes, ensuring your strategy remains relevant and effective. Creating your trading plan involves defining your goals, assessing your risk tolerance, choosing a suitable trading strategy, developing clear entry and exit rules, setting up a risk management plan, and continuously monitoring and reviewing your trades. Staying informed about market trends and news is crucial for continuous learning and adapting to changing conditions.
Risk Management in Stock Trading
Risk management in stock trading is essential for ensuring long-term success by minimising potential losses and safeguarding capital. Effective risk management helps traders withstand market volatility and unexpected downturns. Key strategies include having a well-defined trade plan, using stop-loss orders to limit losses, diversifying investments across various assets, employing limit orders to secure favourable trade prices, and utilising trailing stop orders to lock in profits. Proper position sizing is crucial to avoid risking too much on a single trade, and traders should not risk more than 1% of their trading capital per trade. Additionally, regulating emotions and avoiding impulsive decisions are vital, as disciplined trading helps make rational and informed choices. Proper risk management reduces the risk of significant financial setbacks.
Role of AI
AI significantly enhances stock trading by improving decision-making, eliminating emotional biases, and providing 24/7 trading capabilities. It analyses massive data sets to identify trends and opportunities that might be missed by human traders, leading to better investment choices. By making trades based on logic rather than emotions, AI helps maintain consistent trading strategies and reduces the risk of emotional decision-making. Its algorithms operate around the clock, ensuring that traders can capitalise on global market opportunities at any time. Additionally, AI automates risk management by continuously analysing data and adjusting strategies to mitigate potential losses. Enhanced market analysis through AI allows for quick processing of large volumes of data, enabling traders to spot trends and make more informed decisions. Overall, AI is becoming an indispensable tool in stock trading, providing a significant edge to those who utilise its capabilities, and as AI technology advances, it will become increasingly challenging for human traders without AI support to achieve similar success.
Advanced Trading Strategies
Advanced trading strategies are sophisticated approaches used to maximise profits and manage risks in financial markets. These strategies, such as options trading, algorithmic trading, and short selling, leverage advanced techniques to gain a competitive edge. By employing these strategies, experienced traders aim to outperform the market and achieve financial goals while mitigating losses.
Margin Trading
Borrowing funds from a broker to trade. It is a method of leveraged trading. Borrowed funds increase capital available with the trader hence amplifying potential returns as well as risk of losses.
Contrarian Trading
Taking positions opposite to prevailing market sentiment, betting on reversals or corrections. Contrarian traders aim to make profits from temporary mispricing of assets. Traders need to have a great deal of patience to benefit from this strategy.
Futures trading
Futures trading entails buying or selling contracts to transact assets at a predetermined price and date in the future. Both parties must adhere to the contract terms at the specified time, irrespective of market conditions. Speculators traders seek to profit from price changes by trading futures contracts without intending to take physical delivery of the underlying asset.
Option Trading
Options trading involves purchasing contracts (Put or Call) that grant the right to buy or sell an asset at a predetermined price within a set timeframe. This strategy provides substantial leverage, amplifying potential gains while capping losses at the premium paid. Options are more flexible than Futures as buyers have the right, but not the obligation, to execute the contract.
| Option Trading is a very difficult process to make money. A SEBI study focused on equity F&O (Futures & Options) trading has found that around 89% of individual F&O traders lost money, with an average loss exceeding ₹1 lakh. |
Algorithmic Trading
Using mathematical models and algorithms to make trading decisions and execute trades. Traders use automated systems to execute these trades based on predefined criteria, such as price movements, volume changes, or specific market indicators and strategies.
Quantitative trading
It uses statistical and mathematical models to identify and execute trading opportunities based on extensive market data analysis, including historical prices and trading volumes. This approach enables systematic, disciplined decision-making and often results in rapid, precise trade execution.
High-Frequency Trading (HFT)
It is a type of algorithmic trading that executes a large number of trades at extremely high speeds. HFT aims to capitalise on small price discrepancies and fleeting market opportunities, often completing trades in milliseconds. This strategy relies on sophisticated algorithms and high-speed data connections to gain a competitive edge in the financial markets.
Common Mistakes to Avoid
Stock trading can be rewarding, but it’s easy to make mistakes that can significantly impact your financial success. One of the most common errors is overtrading, where frequent buying and selling lead to high transaction costs and potential losses. Emotional decision-making, driven by fear or greed, can also lead to poor choices, such as holding onto losing stocks for too long or selling winning stocks too quickly. Additionally, ignoring market conditions and trends can result in trades that go against the prevailing market direction, leading to losses. Another mistake is trading against the trend, which involves making trades that contradict the current market momentum. This can be risky and often results in substantial losses.
It’s wise to start with low-risk investments, especially if you’re new to trading, and gradually increase your risk tolerance as you gain more experience and confidence.
Continuous learning and staying informed about the market are crucial for making informed decisions. Markets are dynamic, and keeping up with the latest news, trends, and strategies can help you stay ahead.
Short-term trading is particularly challenging and can be difficult to remain consistently profitable. Therefore, it’s essential to understand the importance of long-term investing and patience. Building a diversified portfolio and holding investments over a longer period can help mitigate risks and provide more stable returns.
Conclusion
In summary, stock trading involves buying and selling stocks with the goal of making a profit, but it requires a solid understanding of the market and various trading strategies. Stock trading demands significant time and attention and can generate considerable mental stress. Therefore, it is crucial to do self assessment before getting into trading.
We encourage you to approach stock trading with diligence and a commitment to continuous learning. While trading can be lucrative, it requires a specific set of skills and a disciplined mindset. Our view is that trading should generally be avoided by those without these skills. However, if you decide to pursue trading, keep the insights offered in this article in mind to navigate the complexities of the market more effectively.