The Enlightened Stock Trader Certification Program Module 1: Learn the Language Definition of Key Stock Trading Terms When learning any subject, understanding the language is the first step to mastery. Understand these terms will accelerate your learning and improve your understanding as you move through the 5 modules of the program. Review the definitions you are unfamiliar with from the Learn the Language exercise and then post any outstanding questions in the Facebook Group. Let s Get Started Adrian Reid Founder Enlightened Stock Trading PS. Haven t joined my program yet? Want to discover how to become a profitable, empowered trader? Interested in a more systematic approach? Schedule your free consultation and I ll share some important stock trading secrets with you and show you how YOU can become an Enlightened Stock Trader! Enlightened Stock Trading (Trading System Life PTE. LTD.)
Table of Contents Table of Contents... 2 Financial instruments... 5 CFDs (Contracts for Difference)... 5 Mutual Fund... 5 Index Fund... 5 Exchange Traded Fund... 5 Futures... 5 Bonds... 5 Derivative... 5 Call Option... 6 Put Option... 6 Price Charts... 7 Stock Symbol / Ticker / Bar Chart (Hide)... 7 Chart Period... 7 Financial Markets... 7 Long Side / Short Side... 7 Margin / Margin Loan / Leverage... 7 Bull Market / Bear Market / Correction / Pullback / Crash... 7 Correction... 8 Pullback... 8 Crash... 8 Black Swan... 8 Margin Loan / Leverage... 8 Liquidity / Market Depth / Buy-Sell Spread... 9 Beta... 10 Measuring performance... 11 Capital Gains & Dividends... 11 Dividend Yield... 11 Equity... 12 Closed trade equity... 12 Open trade equity... 13 Drawdown... 13 CAGR... 15 R Multiple... 15 Expectancy... 16 Sharpe ratio... 16 % Winners / % Losers... 16 MAR... 16 Maximum adverse excursion (MAE)... 17 Maximum a favourable Excursion (MFE)... 17 Enlightened Stock Trading (Trading System Life PTE. LTD.) 2
Trading system components... 18 Setup... 18 Entry Trigger... 18 Initial stop loss... 18 Exit Trigger... 18 Pyramiding... 18 Position Size... 18 Risk Management... 18 Scale in... 19 Scale out:... 19 Setup terms... 19 Trend... 19 Liquidity... 19 Volatility... 19 Exit Trigger Terms... 19 Time stop... 19 Price pattern... 19 Position Sizing / Risk management... 20 Open trade profit... 20 Portfolio heat... 21 Exposure... 21 Position size... 21 Risk of ruin... 21 Worst case drawdown... 22 Indicators... 23 Volatility breakout... 23 Price Patterns... 23 Trend line... 23 Triangles... 23 ABC Pattern... 24 Order types... 25 Market Order... 25 Limit Order... 25 Stop Order... 26 Stop Limit Order... 26 Managing your trading... 27 Trading Plan... 27 Trading Journal / Trading Diary... 27 Trade Database... 27 Types of price move... 28 Trend... 28 Gap... 28 Bull Market... 28 Bear Market... 28 Enlightened Stock Trading (Trading System Life PTE. LTD.) 3
Ranging Market... 29 Breakout... 29 Pullback... 29 Range expansion... 29 Range contraction... 29 Trading strategies... 30 Trend Trading / Trend Following... 30 Swing Trading... 30 Mean Reversion... 30 Day Trading... 30 Value investing... 30 Buy and hold... 30 High frequency trading... 30 Mathematical terms... 31 Average... 31 Median... 31 Normal Distribution:... 31 Fat Tails... 31 Skew... 31 Standard deviation... 32 Data Range... 32 Correlation... 33 Optimization... 33 Enlightened Stock Trading (Trading System Life PTE. LTD.) 4
Financial instruments CFDs (Contracts for Difference) Contract For Difference is a derivative product which mimics the price movement of the underlying asset (such as a share price) but has leverage built into it. Generally used for short term trading and traded on margin. For example a CFD for ABC stock may have a 15% margin, which means that to control $10,000 worth of that stock you must place a $1500 margin with your broker. Mutual Fund A professionally managed investment vehicle that pools money from a large number of investors to purchase securities or other investments. Index Fund An index fund is a low cost passive investment vehicle which seeks to mimic the performance of a specific stock index by holding the shares that make up the index in the same weightings as the index. Exchange Traded Fund A type of managed fund that has units listed on the stock exchange which trade like regular shares. Futures Contracts to buy or sell certain commodities or financial instruments at a pre-specified price at a certain time in the future. Futures contract place a binding obligation on both buyer and seller of the contract to take physical delivery of the commodity in question if the contract is still held on the settlement date. Futures contracts are traded on margin and generally allow for high leverage. Bonds Bonds are debt investments in which investors loan money to the issuing entity for a predefined timeframe in exchange for regular interest payments. Interest payments may be fixed or variable but are usually pre-specified according to a certain formula. Entities that issue bonds can include federal / state / municipal governments, Corporations. The holders of the bonds are effectively the holders of the debt of the issuing entity. Derivative Derivative is a general term for financial instruments that are contracts between two parties in which the price of the contract is derived from the prices of an underlying financial instrument (usually a stock, bond, commodity, currency or index). Examples of common derivatives include: CFD's Warrants Options Futures Enlightened Stock Trading (Trading System Life PTE. LTD.) 5
Derivatives are usually traded on margin allowing for a high degree of leverage in trading. Derivatives can be used for hedging or trading and can be traded on an exchange or over the counter (OTC). Call Option A contract which gives the contract holder the right, but not the obligation, to buy the underlying security at a certain price (strike price) on or before a certain date (expiration date) Put Option A contract which gives the contract holder the right, but not the obligation, to sell the underlying security at a certain price (strike price) on or before a certain date (expiration date) Haven t joined my program yet? Want to discover how to become a profitable, empowered trader? Interested in a more systematic approach? Schedule your free consultation and I ll share some important stock trading secrets with you and show you how YOU can become an Enlightened Stock Trader! Enlightened Stock Trading (Trading System Life PTE. LTD.) 6
Price Charts Stock Symbol / Ticker / Bar Chart (Hide) Watch the video below for an explanation of the stock symbol, the stock ticker and bar charts. Chart Period The chart period is the amount of time that each bar represents on a bar chart. The most common chart period is the daily chart where each bar represents a single day of trading. Other chart periods you may come across include: M1-1 minute bars M5-5 minute bars H1-1 Hour Bars H4-4 Hour Bars D - Daily Bars W - Weekly Bars M - Monthly Bars Financial Markets Long Side / Short Side Watch the video below for an explanation of what is meant by 'the long side' and 'the short side'. https://youtu.be/ozv2a4ula7s Margin / Margin Loan / Leverage https://youtu.be/tzxnaqnpjyo Bull Market / Bear Market / Correction / Pullback / Crash Watch the video below for an explanation of the following terms: Bull Market: A market that is trending upwards over the long term Bear Market: A decline of >20% from the recent high in the market Pullback: A small move against the main trend usually of less than 10% Enlightened Stock Trading (Trading System Life PTE. LTD.) 7
Correction: A correction is a move against the main trend of more than 10% Crash: A sudden and dramatic drop in share prices in the order of 20-30% or more Correction A correction is a move against the main trend of more than 10%. There is no single person that 'corrects' the price, it is just that the participants in the market cause the price to trade lower. Pullback A small move against the main trend usually of less than 10% (see above) Crash A crash is a large, sudden and unexpected drop in asset values typically caused by broad market panic precipitated by an unexpected event. Typically a stock market crash (Such as occurred in October 1987) results in a drop of 30% or more over just a few days. Note that the financial media use the term 'crash' far more than is actually warranted. Note the difference between a pullback / correction / crash (A pullback is a move of less than 10%, correction is more than 10%). For further explanation please watch the video in the Bull Market / Bear Market section above. Black Swan These are rare but large events that move the market prices by a significant amount. It could be a positive move, but most commonly used in the context of a negative market shock. The term was popularised by Nassim Taleb in his outstanding books "Fooled by Randomness" and "The Black Swan". Margin Loan / Leverage Watch this video for an explanation of margin, margin loans and leverage: Enlightened Stock Trading (Trading System Life PTE. LTD.) 8
Example: I have $100,000 to invest and I get a margin loan from my broker which allows me to borrow another $100,000 this means I now have $200,000 to invest in the market with a loan of $100,000 to my broker. I buy shares with the $200,000. If the value of the shares goes up to $300,000 then I now have $200,000 equity and my loan is still $100,000. So if I sell the shares and pay off my loan then I walk away with $200,000 (before tax) If instead the value of the shares drops to $150,000, I now have $50,000 equity and a $100,000 loan. So if I sell my shares and pay off my loan then I walk away with $50,000 Liquidity / Market Depth / Buy-Sell Spread Liquidity is how much volume of buying and selling occurs. In a more liquid stock a greater value of that stock changes hands every day, so it is easy to buy and sell without changing the market price. With less liquid stocks it is harder to buy and sell without moving the price because there are not many buyers and sellers ready to take your order. Enlightened Stock Trading (Trading System Life PTE. LTD.) 9
Market Depth and Buy / Sell spread are explained in the video above. Beta This is the amount the stock moves compared to the amount the market moves. For Example: If a stock moves by 2% every time the market moves by 1% then it has a Beta of 2. If a stock moves by 0.5% when the market moves by 1% then it has a Beta of 0.5 Haven t joined my program yet? Want to discover how to become a profitable, empowered trader? Interested in a more systematic approach? Schedule your free consultation and I ll share some important stock trading secrets with you and show you how YOU can become an Enlightened Stock Trader! Enlightened Stock Trading (Trading System Life PTE. LTD.) 10
Measuring performance Capital Gains & Dividends Watch the video below for an explanation of capital gains and dividends Dividend Yield Dividend yield is the sum total of the dividends paid per year as a percentage of the stock price. For Example: If ABC stock pays a dividend of $0.06 per share each year and the share price is $2.5 then the dividend yield is: Enlightened Stock Trading (Trading System Life PTE. LTD.) 11
Equity Your Equity is the total value of your cash + positions - loans in your trading account. Closed trade equity Closed trade equity is the equity you have in your account if you do exclude open trade profits. (See also closed trade profit below) Enlightened Stock Trading (Trading System Life PTE. LTD.) 12
Open trade equity Total profits from all positions that are not locked in with stop loss order. For Example, if your trade in ABC stock has a share price of $10.50 and you will exit the trade at your stop loss of $9.50, then you have an open profit of $1.00 per share in that position. To get the open trade equity you must add this together across all positions. (See open trade profit below) Drawdown A drawdown is simply a decline in your total equity from a previous peak. It is caused by trades moving against you and trading losses. Enlightened Stock Trading (Trading System Life PTE. LTD.) 13
Drawdown is usually measured as a percentage decline from the previous high. The formula is: Drawdown% = (Highest Historical Equity Current Equity) 100 Highest Historical Equity For example, if your highest equity in the past was $100000 and your equity now is $80000 then your drawdown currently is 20% Factors that contribute to drawdown: Risk per trade Correlation of trades Size of losses vs wins % of trades that lose Number of losing trades in a row Enlightened Stock Trading (Trading System Life PTE. LTD.) 14
CAGR CAGR is short for Compound Annual Growth Rate. This is the hypothetical rate at which your investment would have grown if it grew at a steady rate throughout the entire period being measured. CAGR is usually quoted as an annual % growth rate. R Multiple This is the Return on a trade divided by the risk for that trade: (Exit Price Entry Price) R Multiple = (Entry Price Initial Stop Loss) For example: If you enter a trade at $5.00, and you place your initial stop loss at $4.50 and later exit the trade at $10, then the R-Multiple for that trade is 10 If you enter a trade at $5.00, and you place your initial stop loss at $4.50 and later exit the trade at $4.75, then the R-Multiple for that trade is -0.5 Enlightened Stock Trading (Trading System Life PTE. LTD.) 15
Expectancy Expectancy is the amount of profit you expect to make per dollar you risk in the market over many trades. Expectancy is the average R-Multiple over many trades. This number must be positive. More positive means your system has a bigger edge. For example, a system with expectancy of 0.5 is profitable, but a system with an expectancy of -0.08 is not profitable. Sharpe ratio The sharpe ratio is a way of measuring performance of an investment relative to the risk free benchmark taking into account the risk (or variability) of the returns. The sharpe ratio measures how well the investment compensates the investor for the risk taken. As the excess returns increase, sharpe ratio increases. But if the standard deviation of returns increases then the sharpe ratio decreases because the investment is considered more risky (due to the variation in returns). The formula for Sharpe Ratio is: Sharpe Ratio = E[R A R B ] VAR(R A R B ) Where: E[R A R B ] = The expected return over the benchmark VAR(R A R B ) = The standard deviation of this excess return Note: This is not often used by traders to measure their own trading system performance because it has several flaws which are beyond the scope of this discussion, but it is commonly used in the investment industry so it is important to have an understanding of the concept. % Winners / % Losers Trading systems will have both winning and losing trades. The % winners refers to the percentage of trades you make which are profitable. The % losers refers to the percentage of trades you make which lose money. While many new traders focus on getting a high percentage of their trades profitable, this is in fact one of the least important components of profitable trading. The expectancy is much more important than the percentage of trades which are profitable. MAR The MAR ratio is a measure of trading system performance which divides the annual return generated by the system by the largest drawdown. This is a very useful measure of how good a system's performance is because it allows you to quickly eliminate systems with large drawdowns relative to the returns generated. I personally use the maximum percentage drawdown when calculating MAR. A MAR ratio of 1 or more is good - it means that the maximum drawdown is less than the average annual rate of return (CAGR) The higher the MAR the better the strategy or trading system is performing. Enlightened Stock Trading (Trading System Life PTE. LTD.) 16
Maximum adverse excursion (MAE) MAE is a measure of how far a trade moves against you over the course of the trade. It is useful to know how far individual trades drawdown before moving into profit to help refine where initial stops are set and improve the reliability (% wins) of the trading system. Maximum a favourable Excursion (MFE) Similar to MAE, MFE is a measure of the maximum distance that a trade moves in your favour during the entire trade lifetime. Exits are often not made at the absolute high of a trade, so the MFE allows you to figure out how much potential profit is being given up on each trade by the exit rules. Haven t joined my program yet? Want to discover how to become a profitable, empowered trader? Interested in a more systematic approach? Schedule your free consultation and I ll share some important stock trading secrets with you and show you how YOU can become an Enlightened Stock Trader! Enlightened Stock Trading (Trading System Life PTE. LTD.) 17
Trading system components Setup These are the conditions under which you would consider entering a trade. For example in long side trend following, you may have a setup that requires a strong trend to be in place, low volatility and a slight pullback in prices. Entry Trigger The exact conditions under which you would enter the trade. Initial stop loss The level at which you would admit you are wrong and close a trade if it moves against you. Usually calculated in one of three ways: Logical chart based stop using support or resistance levels Volatility based stop using a certain multiple of ATR or Standard Deviation from the entry price Percentage based stop set to be a certain percentage away from the entry price. Indicator based stop set using an indicator such as a moving average, Parabolic SAR or other indicator to calculate the stop value. Exit Trigger The exit trigger is the exact rule(s) under which you will exit / close a trade. Exit triggers may be any of the following: Trailing stop Time stop Profit stop Indicator exit Price Pattern Pyramiding This is when you add to your position as it moves in your favour. This is done to capitalise on the trend that you have identified. Position Size The number of units or shares that you buy for the trade. We calculate the position size to ensure we don't risk too much per trade Risk Management These are collectively all the actions you take to protect and preserve your capital. Risk management levers include (but are not limited to): Risk per trade Maximum exposure per instrument Maximum number of open trades Maximum number of new trades per day Portfolio Heat Total Exposure Long / Short Exposure Enlightened Stock Trading (Trading System Life PTE. LTD.) 18
Scale in This means to gradually buy shares, usually in regular sized blocks until you have built up your full position in a stock. This can be done at regular time or profit intervals, or by building your position when certain price patterns / indicator signals occur. Scale out: This means to gradually sell shares, usually in regular sized blocks until you have closed your full position in a stock. This can be done at regular time or profit intervals, or by building your position when certain price patterns / indicator signals occur. Setup terms Trend The trend is the general direction of price movements. There are generally three trends - the long term (>3 months); the medium term (1-3 months); and the short term (<1 week) Liquidity Defined earlier Volatility This refers to how much the price of a stock moves around. More volatile stocks have wider fluctuations in the stock price as a percentage of the price. Exit Trigger Terms Time stop A method of exiting which is related to how long since the trade was opened. For example, a 40 day time stop means that the trade will be closed after 40 days no matter what the share price. Price pattern A price pattern is a general term for patterns that can appear in stock price charts. Commonly used by technical analysts, patterns can include triangles, wedges, double tops, double bottoms, head and shoulders patterns and many others. Price patterns can be powerful, however, they are quite subjective unless described precisely and coded into software which identifies the pattern objectively. While they do not typically feature heavily in trading system rules, price patterns can be a useful way to generate price signals if they can be coded. Several price patterns are explained in this document below. In addition, a useful explanation of several common price patterns can be found on Investopedia here: http://www.investopedia.com/articles/technical/112601.asp Enlightened Stock Trading (Trading System Life PTE. LTD.) 19
Position Sizing / Risk management Open trade profit This is the difference between the current share price and the price at which you would sell if it started to move against you. For example, the stock price is $4.50 and your trailing stop is at $3.95, then your open trade risk is $0.55 per share. The closed trade profit is the proportion of the trade profit that is 'locked in' by your exit price / trailing stop: Enlightened Stock Trading (Trading System Life PTE. LTD.) 20
The open trade profit is the proportion of the trade profit that is not yet 'locked in' by your exit price / trailing stop: Portfolio heat Portfolio heat is the total amount of risk your portfolio is exposed to across all positions - both long and short. This is calculated as the distance between the current price of your position and your exit price multiplied by number of shares or contracts summed across all of your open positions. For example, if the current stock price is $100, your stop loss is at $90 and you are holding 500 shares, this trade will add ($100-$90) x 500 = $5000 to your portfolio heat. In practice traders usually don t have to measure this manually as most trading software used for backtesting will have a portfolio heat measure which can be adjusted to stop you from taking on too much risk. Exposure This is the total value of your position. For example, if the stock price is $5.00 and you have 200 shares, then your exposure on that stock is $1000. When used in reference to your overall portfolio it is the exposure of all positions added together. Long exposure and short exposure are often calculated separately because this is useful for managing your risk - equal long and short exposure would give you a lower risk than long only exposure (though returns may not necessarily be better with equal long / short exposure). Position size Your position size is the number of shares or contracts you hold in a particular trade. Managing your position size is one of the most important risk management techniques. Good risk management practice dictates that the risk per trade is kept low (less than 1%). Risk of ruin This is the probability that you will hit your 'ruin' point where you will have to stop trading. This is usually $0 equity or close to zero equity. Determine the risk of hitting that ruin point with historical simulations. Enlightened Stock Trading (Trading System Life PTE. LTD.) 21
Worst case drawdown This is the biggest drawdown that you are expected to have given your historical simulations and everything that is likely to go wrong. Haven t joined my program yet? Want to discover how to become a profitable, empowered trader? Interested in a more systematic approach? Schedule your free consultation and I ll share some important stock trading secrets with you and show you how YOU can become an Enlightened Stock Trader! Enlightened Stock Trading (Trading System Life PTE. LTD.) 22
Indicators Most common indicators are described in the useful book Technical Analysis from A to Z. There is a free online version of this book here that you can use to look up the explanation of the indicators listed in the Learn the Language exercise. Volatility breakout A volatility breakout (also called a range expansion) is a sharp jump in price. Usually after a period of low volatility, the range of price movements during the trading day expands dramatically so the price appears to break out from the previous trading range. Volatility breakouts can be measured by the distance the current price has moved from the price on a previous day. Frequently we talk about the distance the price has moved in Average True Ranges, which is a measure of volatility. For example: The price has jumped 1.5 Average True Ranges since yesterday s close Price Patterns Trend line A trend line is a sloping line drawn on a bar chart which joins the successive higher lows in an up trend, OR the successive lower highs in a down trend. The sloping line shows the prevailing direction of the trend in the timeframe covered by the trend line. Triangles Triangles are technical analysis patterns that can appear on bar charts which are created by two opposing trend lines forming a triangle shape on the chart. The downward sloping trendline is like a declining resistance level and the upward sloping trend line is like an upward sloping support level. These patterns can have some technical analysis value if traded just after the breakout above or below the triangle. A breakout above the triangle in a long term up trend would be viewed as bullish. A breakout below the triangle in a down trending market would be considered bearish. Enlightened Stock Trading (Trading System Life PTE. LTD.) 23
Triangles and other similar chart patterns are quite difficult to identify systematically (using indicators and code) so they are generally used more by subjective technical analysts than system traders. ABC Pattern The ABC pattern is a technical analysis pattern that can occur at major reversal points. It consists of a new low (A), followed by a higher high (B) and finally a higher low (C) Haven t joined my program yet? Want to discover how to become a profitable, empowered trader? Interested in a more systematic approach? Schedule your free consultation and I ll share some important stock trading secrets with you and show you how YOU can become an Enlightened Stock Trader! Enlightened Stock Trading (Trading System Life PTE. LTD.) 24
Order types Market Order A market order is simply an order that will be filled at the prevailing price in the market at the time the trade is placed. Market orders are generally always filled, however, you may not get the price that you really want because the order is filled at whatever the market is currently offering. Let s assume you are buying ABC stock. The current bid is $10.25 and the ask is $10.30. This means at this moment buyers are offering $10.25 per share and sellers are asking for $10.30 per share. If you place a market order to buy then you will be filled at $10.30 (assuming there is enough volume on offer at that price). If you place a market order to sell then you will be filled at $10.25 (again assuming there is enough volume on offer at that level). If you have a highly liquid market and you are trading relatively small quantities then market orders can generally give you a reasonable price under normal circumstances, however, there are many cases where a market order will not give you a good price such as: Your trade size is large The market is moving quickly The instrument you are trading is illiquid without much volume on offer There is a delay in placing your order into the market A market order will execute at the prevailing market price when the order hits the market. This means that if any of the above situations occurs the market order could be filled at a price quite different from what you expect. Most markets and trading platforms will accept market orders. You will find that market orders generate the highest slippage but they are executed more frequently than limit or stop orders. Limit Order Limit orders are an order type that specifies the price you are willing to pay up to (if you are buying) or sell down to (if you are selling). Limit orders are used when you want to be sure you know exactly what the worst price you will pay is assuming your trade gets executed. For example, let s assume you are buying ABC stock. The current bid is $10.25 and the ask is $10.30. You know that the stock can be illiquid and you realize that the current spread is a little wider than normal, so you don t want to incur too much slippage. Instead of placing a market order (which would be filled at $10.30), you decide to place a buy limit order at $10.24. This order sits in the market and will only be executed if the offer (the lowest price the sellers are willing to sell at) drops to $10.24. When this happens you should be executed at this price. In this case you have specified that $10.24 is the highest price you are willing to pay to buy the stock. If the market never comes back to the price of your limit order, your order will not be executed Similarly when using a limit order to sell, you set the minimum price at which you are willing to sell the stock, and if the bid price reaches that level then your order should be executed (provided the bid price stays at that level long enough and there is sufficient volume buying interest at that price). Limit orders generate no slippage because you have specified that you are only willing to trade at a certain price however, your trade may not be executed if the price never hits the level you specify. Enlightened Stock Trading (Trading System Life PTE. LTD.) 25
Stop Order Stop orders are orders that are placed above the current market price for buyers or below the current market price for sellers. These orders are only triggered if the price hits the level specified. Once the level specified is reached, the order is converted to a market order and placed into the market. For example, let s assume you are buying ABC stock. The current bid is $10.25 and the ask is $10.30. You are not sure if it is going to continue on its upward trend, so you place a buy stop order at $10.35. This order remains dormant until the market price rises to $10.35, at which time it is converted to a market order and placed into the market. Now let s say you want to sell ABC stock, which is again trading at $10.25/$10.30, but you only want to sell it if the stock continues to fall to $10.20. So you place a sell stop order at $10.20 which will be dormant until the market drops to $10.20 at which time it will be converted to a market order and placed into the market. Once a stop order is triggered and placed into the market, it has all of the qualities of a normal market order discussed above. The only difference is that you have specified a price at which you want your order to be placed into the market. Stop Limit Order A stop limit order can help you overcome one of the major drawbacks of a traditional stop order or stop loss order Slippage. With a traditional stop order or stop loss order, the trader specifies the price at which they want their order to become active. When the price hits that level the order is placed as an at-market order. The trade will then be executed at the prevailing price. A Stop-Limit Order can help you reduce the effects of slippage compared to a stop order or a stop loss order, but this comes at the cost of certainty of execution. A stop-limit order specifies a stop price which, when hit, converts your order to a limit order. This order will then only be executed at the specified price or better. The two examples below illustrate a buy and sell situation respectively: Example 1: Buy Stop-Limit Order Say you wanted to buy ABC stock (currently trading at $25) if it rises to $30, but you want to ensure you don t pay more than $30. If you place a buy stop limit order to purchase ABC stock at $30 or better. This order will only become active if the price moves up to $30. Once active it will only be executed at $30 or better. Example 2: Sell Stop-Limit Order Say you wanted to sell ABC stock (currently trading at $25) if it falls to $20 to limit your loss, but you want to ensure you don t suffer too much slippage. If you place a sell stop limit order to sell ABC stock at $20 or better. This order will only become active if the price moves down to $20. Once active it will only be executed at $20 or better. Enlightened Stock Trading (Trading System Life PTE. LTD.) 26
Managing your trading Trading Plan A trading plan is a written document that describes everything you need to do to run your trading business. It is much broader than just the rules you use to enter and exit the market. It includes the following 8 components: Trading Journal / Trading Diary A document in which you record all of your market observations and investigations to ensure you have ongoing access to everything that you have looked at and tested in the market. Over time this becomes a very rich repository of information that will become an invaluable resource. Trade Database Your trade database is the record of all trades that you have taken. It includes all relevant details about the trade including: Analysis Date Stock Code Exchange Account (if you have multiple accounts) The system that generated the trade Entry Date Entry Price Initial stop loss level Target price (if relevant) Currency Total equity Risk per trade (%) Risk per trade ($) Number of shares or contracts Exit Date Exit Price Explanation (if your approach is not 100% systematic) As a trader you will need to keep a record of every trade you make for position sizing, risk management, performance improvement and tax purposes. Enlightened Stock Trading (Trading System Life PTE. LTD.) 27
Types of price move Trend A trend is a sustained price move in a single direction (either up or down) over a period of time. Gap A price move in which the entire bar is outside the range of the previous bar. The space between the price bars is called the gap. Bull Market See Above Bear Market See Above Enlightened Stock Trading (Trading System Life PTE. LTD.) 28
Ranging Market A ranging market is a market where the prices are moving sideways with no clear trend. Prices may move up and down gradually but are not clearly trending either up or down over time. Breakout A breakout is a price movement that passes through a key support or resistance level. Pullback See Above Range expansion Range expansion occurs when the distance from the low to the high of the day is wider than previous days. This can be used as a confirmation of trend continuation. Wide range bars are can be an important confirmation tool when trading breakouts from a trend line or a support or resistance level. Range contraction Range contraction is a short term reduction of the daily range. This is often followed by a range expansion in the direction of the prevailing trend and can be a good, low risk point to enter a trade in anticipation of a breakout / range expansion. (Note: Test all ideas and assertions like this for yourself before using) Enlightened Stock Trading (Trading System Life PTE. LTD.) 29
Trading strategies Trend Trading / Trend Following A trading strategy that profits by entering in the direction of the primary trend and then holds onto the trade until the primary trend is over. This strategy is characterised by a large number of small losses and a small number of large winners. Trend following is a stable trading strategy that has worked over a long period of time in many markets. Trend following strategies typically have holding periods from several weeks to several months. Swing Trading A trading strategy that profits by catching the price swings above and below the primary trend. Shorter term in nature with smaller but more frequent wins than trend trading. Swing trading strategies typically have holding periods from several days to several weeks. Mean Reversion A trading strategy that seeks to profit from prices moving back towards some mean or average level after moving to an extreme. Eg, buying a dip in anticipation of price rising back up to the medium term moving average. This is typically short term in nature, but timeframes for mean reversion strategies vary widely Day Trading Day trading is a broad term that includes any trading strategy that enters and exits the market on the same day. Day trading strategies typically do not carry any positions overnight when the market is closed. Value investing Value investing is the purchasing of shares in companies that are cheap relative to some measure of the underlying value of the company. The valuation can be performed in many ways, and is based on the financial performance and prospects of the company. Buy and hold Buy and hold is a passive investing strategy in which the investor identifies shares to include in their portfolio and purchases them with the intention of never selling them (or at least not selling them in the foreseeable future) regardless of how the share price moves over time. High frequency trading Ultra fast trading performed by proprietary trading firms and banks utilising huge investments in computing infrastructure and high speed connections to the exchange. HFT is not a strategy that individuals can compete with directly. Enlightened Stock Trading (Trading System Life PTE. LTD.) 30
Mathematical terms Average The average of a data set is equal to the sum of all components of the data set divided by the number of elements in the data set. Median The median value of a data set is the middle value. If all data points are ordered from lowest to highest, the median is the value which has an equal number of data points above and below it. The median and average (mean) are similar for normally distributed data, but can vary dramatically for heavily skewed distributions. Normal Distribution: Most people know the normal distribution as the bell curve that was used to grade marks in school. A normal distribution is centred around its mean, symmetrical on both sides of the mean. Normal distributions have a relatively higher concentration of results around the mean and relatively few results in the tails which are the extremes away from the mean. In a normal distribution, 68% of the results are within one standard deviation of the mean and approximately 95% of the results are within two standard deviations of the mean. Fat Tails In statistics (and trading), the term fat tails refers to a distribution having a greater population of results at the extremes than would be predicted by a normal distribution. In trading in particular the term fat tails is used to describe extreme moves in the markets which happen with much greater frequency than would be predicted by a normal distribution. Skew Skew is a statistical measure of the symmetry of a distribution around the mean. Enlightened Stock Trading (Trading System Life PTE. LTD.) 31
A positive skew means that the tail on the right side of a distribution is longer and fatter than the tail on the left side. A negative skew distribution means that the tail on the left side is longer and fatter than the tail on the right side of the distribution. When looking at a distribution of trades generated by a trading system a positive skew is more stable for trading because there are unexpectedly large winning trades. In a negative skew trading system there are unexpectedly large losing trades (which is obviously more risky) Standard deviation Standard deviation is a measure of how dispersed a data set is around it s mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance. Data Range Data range is the spread between the highest and lowest value in the data set. Enlightened Stock Trading (Trading System Life PTE. LTD.) 32
Correlation Correlation is a measure of how two or more instruments move together. Instruments that tend to move in the same direction at the same time are positively correlated. Instruments that tend to move in opposite directions are said to be negatively correlated. Instruments who's movement have no relationship are said to have zero correlation. Optimization A method of varying input parameters to find the best output value from a function. For example, we may vary the parameters in a trading system to find the parameter set most likely to generate a profit from future trading. Haven t joined my program yet? Want to discover how to become a profitable, empowered trader? Interested in a more systematic approach? Schedule your free consultation and I ll share some important stock trading secrets with you and show you how YOU can become an Enlightened Stock Trader! Enlightened Stock Trading (Trading System Life PTE. LTD.) 33