A stock trader is a person or entity engaged in the trading of equity securities, in the capacity of agent, hedger, arbitrageur, speculator or investor. Several different types of stock trading strategies or approaches exist including scalping, momentum trading, technical trading, fundamental trading, swing trading, day trading, etc. This week’s article will attempt to review three of the above strategies- namely, scalping, momentum trading and technical trading.
Generally speaking, investors make their money by buying a security and then selling it for a profit at some point down the road. It’s not unusual for investors to maintain their positions anywhere from a couple of months to many years.
On the other side of the coin, there are traders. The typical trader holds a stock no more than a few days and often trades in and out of stocks several times per day. ‘Scalpers’ are a specific type of short-term trader. Here we’ll take a look at this type of trading, how it works and how scalpers profit.
Scalpers: Who they are, what they do
A scalper is a type of trader that may dart in and out of a stock or other asset class dozens or in some cases even hundreds of times a day. The reason these individuals are so active is that they hope to reap a small profit on each trade and that these small profits will add up to big dough at the end of the day. A scalpers goal and job description is fairly similar to that of a market maker.
There are several issues that make being a scalper difficult. First, maintaining such a large number of positions can be very time consuming. In fact, it is somewhat safe to say that the scalper will be glued to his or her monitor all day waiting for the slightest moves in order to get in and out of positions.
Being a scalper can also be costly (both in terms of rupees and opportunity cost). That is because the scalper must often keep cash ready so that he or she has the ability to pounce on opportunities at a moment’s notice. And don’t forget about the commissions. In fact, commissions can be a big killer. Just think about all commission payout a scalper might run up in a day and how that could eat into their hard-earned profits.
Tools of trade
Scalpers need some special equipment if they want to be successful. This might include having access to quotes to track bids and asks throughout the trading session. Having access to charting information and a phone line or an internet trading account is also essential. Nowadays, mostly scalpers are trading on penny stocks keeping small margins.
For example, if a scalper bought a stock at Rs.6 and sold it at Rs.6.50, he would reap a profit of Rs.5000 on 10,000 shares (not counting commissions). However, if that same scalper purchased a stock at Rs.6 a share and sold it at Rs.6.10, his profit would be just Rs.1000, which probably may not even cover the commission. Again, the point is that this can be a stumbling block for would-be scalpers and should be considered.
In momentum trading, traders focus on stocks that are moving significantly in one direction on high volume. Momentum traders may hold their positions for a few minutes, a couple of hours or even the entire length of the trading day, depending on how quickly the stock moves and when it changes direction. Here we take a look at momentum trading and examine a typical day in the life of this type of active trader.
A day in life of momentum trader
A good way to illustrate momentum trading is to look at a typical day of a momentum trader:
He gets up an hour before the market opens, switches on his computer, goes online and immediately logs into one of the popular trading chat rooms or equity forums.
When looking at equity forums, our hero focuses on stocks that are generating a significant amount of buzz. He looks at stocks that are the focus of trading alerts based on earnings or analyst recommendations. These are stocks that are rumored to be in play and are anticipated to provide the most significant price movements on high volume for that trading day.
Once the market opens, he watches his initial list of stocks in relation to the rest of the market: Are his stocks going up when the market goes down? Are they significantly increasing in price in relation to the rest of the market? Are they behaving consistently with his expectations based on his pre-market assessment?
He will then narrow his watch list to include only the strongest stocks: The stocks that are increasing more rapidly on higher volume than the rest of the market, the stocks that are trading contrary to the market and the stocks whose movements are clearly being propelled by external factors.
Next, a momentum trader will analyze the list of stocks he has chosen to focus on by examining their charts. The primary technical indicator of interest is the momentum indicator, the accumulated net change of a stock’s closing/ending price over a series of defined time periods. The momentum line is plotted as a tandem line to the price chart and it displays an axis of zero, with positive values indicating a sustained upward movement and negative values indicating a potentially sustained downward movement.
When the trader believes he has identified a breakout, he does not necessarily need to jump immediately into the stock. He is not generally worried about missing the first one or two breakout ticks, but he has his hand on the buy trigger. And he is generally not too concerned about hitting the bid either, as he will have an easier time getting in at the market price. Then he places a market order.
Pitfalls of momentum trading
Jumping into a position too soon, before a momentum move is confirmed.
Closing the position too late, after saturation has been reached.
Failing to keep eyes on the screen, missing changing trends, reversals or signs of news that take the market by surprise.
Keeping a position open overnight. Stocks are particularly susceptible to external factors occurring after the close of that day’s trading - these factors could cause radically different prices and patterns the next day.
Failing to act quickly to close a bad position, thereby riding the momentum train the wrong way down the tracks
In momentum trading, a trader watches for signs that a stock is about to ‘pop’, that is, undertake a significant uni-directional price movement on high volume for a sufficient period of time, which enables a profit.
By virtue of watching the momentum line, the momentum trader has already engaged in technical analysis by examining stock charts for signs of the breakout. But the technical indicators used in momentum trading are only the tip of the proverbial iceberg; they are only a small sampling of the wide range of chart and graph patterns available to the technical trader.
Exploring technical trading
Technical trading is a broader style and is not even necessarily limited to trading; it can indicate a much broader philosophy or approach to investing. In general, a technician is somebody who looks back in history using the recognizable patterns of past trading data to try to predict what might happen to stocks in the future.
This is the same general method practiced by economists and meteorologists: Looking to the past for insight into the future. However, we all know how poor their forecasts can be. We can only hope as technicians that we will be able to do more than a little bit better.
The challenge of technical analysis is that there are literally hundreds of technical indicators available - enough to make even the most advanced statistician’s or mathematician’s eyes bug out. And there is no single indicator that can be considered universally best, as each particular indicator, or group of indicators, may be applicable only to specific circumstances.
Some technical indicators may be useful for certain industries, others only for stocks of a certain classification (e.g. stocks within a certain range of liquidity or market capitalization). Because of the unique patterns that highly traded stocks might exhibit throughout history, some indicators may be relevant only to certain individual stocks.
Technical indicators, like momentum indicators, are not to be used as silver bullet solutions for when to buy or sell. They are poor predictors of exact timing, but they are good at indicating which stocks are candidates for further analysis. As such, technical analysis can be viewed as a starting point - the historical patterns do not necessarily translate into an exact picture of future performance.
Instead of trying to provide an exhaustive study of all of the indicators available to the technical trader, we will go over the most common groupings, attempting to provide a general introduction to each. Also, this discussion is limited to indicators applicable to individual stocks - there are many indicators that might be useful to predict an index or industry group, but that’s not what we’re concerned about here.
Common groups of technical indicators:
Relative strength index
The relative strength index (RSI) measures a stock’s recent performance in relation to its historical strength by comparing the number and magnitude of recent and historical up and down closes. If the RSI rises above 80, it may be indicating an overbought condition, which is a sell signal; below 20 it may be indicating an oversold stock, indicating a buy signal.
A series of high, low and closing prices are plotted on a graph for a certain period of time and support and resistance lines are drawn across the bottom and top of the range. A breakout occurs when the price sustains a movement, even for a period or two, above or below the range.
This may be the form of technical analysis that is easiest to understand. The same price charts discussed above are analyzed for specific patterns that have historically appeared in the same stock or for common patterns that have been seen in many stocks over time. The most commonly observed patterns are head-and-shoulders patterns, triangle-up or triangle-down patterns, rounded tops or rounded bottoms, cup-and-handle formation and so on.
Highly complex and mathematical, trend analysis looks at short and long-term trends and tries to identify crossovers, where prices cross over their long-term averages. The long-term averages are referred to as moving averages, where a price range is smoothed for a period of time by averaging a series of data points and plotting the smoothed line against the actual price line of the stock. The moving average convergence divergence (MACD) is used to identify crossovers, divergence and convergence and overbought and oversold conditions.
A gap occurs when the opening price of a stock is significantly higher or lower than its closing price the previous day, possibly because of company news released overnight or some other factor. The gap trader is concerned with the performance of the stock above or below its open, which may indicate further movement in either direction. In this sense, the trader’s decisions may be closer in style to that of the momentum trader than the technical analyst.
Novice traders might experiment with each of these techniques, but they should ultimately settle on a single niche, matching their investing knowledge and experience with a style to which they feel they can devote further research, education and practice.