While a lot of traders prefer to trade individual stocks, trading the major stock indexes offers some significant benefits, especially for amateurs who need to focus on simplicity.
The great majority of amateur traders struggle mightily, and the biggest challenge for them is to come up with a trading strategy that actually works. While there are a lot of very bad habits that they need to avoid, and some good general principles that they need to follow, like following your plan while in trades, you need a plan worth following first.
There are some good books on trading out there that budding traders can benefit from reading, there is a real lack of good practical advice on how to actually put together an actual winning strategy. Traders are pretty much on their own in their quest to discover what they think are the secrets that good traders use, and while there are some benefits to their needing to do a lot themselves, there aren’t any if traders don’t ever get there and just donate all their money to a self-education program that ends up not being successfully completed.
Learning to trade well is a big task at best, even when we try to simplify things as much as we can. However, there are some things that traders can learn which should at least accelerate their self-learning by pointing them in the right direction more, which is what we will provide to you here, and even give you a very simple position trading strategy that works to get you started.
The first thing we need to learn is what trading is actually seeking to accomplish. This might seem obvious to us, to make more with our winners on a net basis than we lose with our losing trades, but that’s not specific, and we will need to flesh this out a lot better than that to have something we can actually use.
Trading involves holding securities for a certain amount of time to earn a profit, and we can think of a continuum with buy and never sell being on one side, and extremely short-term trades being on the other. We can think of these extremely short-term trades as holding for a minute or so on average, and between this point and the never sell crowd, everyone is trading to some degree.
We can therefore define trading as holding positions where we plan on exiting based upon some market-driven circumstances, as opposed to exiting based upon non-market events such as our closing our positions because we need the money. Anything else is trading, on various horizons from seconds to years.
Those who refer to themselves as traders generally do not hold for years like investors do, although those who we call investors do engage in trading when they watch the progress of their positions and decide when to exit based upon this performance. If we’re using performance to decide, the principles that apply to short-term traders will be the same as those that imply to investors who trade strategically, and even those who use some sort of performance criteria such as getting out if the bears grow too big are using trading principles.
The next question we need to ask is why anyone would exit a position for performance reasons. The only sensible reason to do this is to look to avoid situations which have a lower expectancy than either staying in the position provides or moving the money to another asset which is expected to do better over a certain period has.
We want to do all we can to simplify all this, so we could state this as remaining in something while the trend is positive and exiting when it is negative. As obvious as this appears, far too many traders don’t get this and will remain in positions after they turn negative, or get out when things are still positive, and both are big mistakes.
When we trade, we are playing the odds, as nothing is certain with the movement of stocks or stock indexes, and the best we can do is seek out the probable. If it is probable that something may go up, like we see with investing in stocks generally, and the potential for profit is significant enough to cover the risk involved, we should want a position in it, a bet in other words, while this probability remains high enough.
We always need to view our positions from the point of the present, meaning that while we do want to account for what has already happened, this is only useful in seeking to predict what is going on now. We don’t want or need to even look ahead past the next bar, and this is another huge mistake that a lot of traders make.
If, for instance, your position is struggling but you think that things may improve later, it is later that you want to be in this, not now. It does not make sense to ever ride out storms, as we can just run for cover, and if and when we see the positivity that we are expecting, we can re-enter with more confidence and sense.
Stock prices always move in cycles, and these cycles manifest themselves on all timeframes, from one second bars to monthly bars. The first decision that we need to make is to select our timeframe that we wish to trade in, and then look to play the cycles that emerge within it.
How much time that we have to spend on trading is the most important criterion here, as we can’t trade 1-minute bars if we can only check our positions once a day. If this is the case, we’re really limited to daily or weekly bars, because if you trade a certain bar length you have to check every bar.
For the sake of inclusiveness, we’ll focus on a position trading strategy, which anyone has time to do, and if some wish to trade more actively, the same principles will apply anyway. Position trading involves holding trades for weeks to months and is the ideal entry point to mastering trading since it’s so simple to execute.
We do need to make sure that if we do move to shorter timeframes from here, we are doing so in order to achieve better results, and we should make sure that we have a reasonable expectation of this before we commit meaningful money to shorter timeframes or any timeframe for that matter.
When we shorten our timeframe, we do reduce our risk as well as increasing the potential for efficiency. This applies even with long-term trading timeframes, where for instance we may plan on staying in as long as the long-term trend is up and get out during significant bear markets.
The idea here is that if the bear market continues, our positions will decline, and given that the expectation here is against us, this means betting with the odds against us, which is a bad idea. We’re going to need to be prepared to get back in when the weather improves though, and this is the part that a lot of investors who try this sort of thing don’t do well at.
This does not mean that shorter timeframes are to be preferred, as this only represents the potential for greater efficiency in general, so if we trade well enough, we will make more money than on the longer timeframe.
This is All About Playing the Odds at Any Given Point in Time
There are limitations to this and this involves first making sure that the length of the trends that we wish to trade are of a sufficient magnitude to make the trade make sense. What we’re really looking to do is to bet on a trend continuing, and cash in at the point where this no longer is a good bet.
We therefore need to trade to failure, and if we view trading as leveraging advantages with probabilities, the sense of this should be clear. There are traders who get out while things still look good, or stay in when things turn too sour, but if the odds haven’t turned against us, they are still with us, when the odds do turn against us, this makes hanging on a losing proposition.
A potential trade will therefore have to move enough in the direction we are seeking to bet on it to trigger a buy, and it will also need to move against us enough to tell us that it is time to go. There is a very good analogy in the trading business that instructs us not to try to eat either the head or the tail of the fish, because there are too many bones, and we instead should look to eat the body of it, where the good eating is.
The head needs to form first, which involves a certain movement, and the formation of the tail will also take up some room. We cannot therefore measure a move from top to bottom and think that we’ll ever be able to capture such a thing, so we need to subtract the slippage on both sides from the move that our strategy requires to discover our potential profit.
We then apply this to charts on desired timeframes to decide whether the tradeable cycles that manifest can be traded efficiently or even at all. Even daily bars may not be suitable to trade some assets, and this calculation also needs to be used not only between timeframes but also between tradeable securities.
We’re picking the Nasdaq on weekly bars for you as our position trading strategy example in this article, and there are several very good reasons why the Nasdaq is a good choice here. While there is more potential in trading individual stocks, they also tend to be less predictable and more volatile, and the only reason why you would ever want to trade individual stocks is to shoot for greater volatility.
It’s a mistake to just look for the most volatile things to trade, and if this is your thing, you should be trading cryptocurrencies because they hold the title. You can learn to trade Bitcoin profitably, but the level of skill required is much higher, and we want to make ease of trading our priority right now.
Since indexes represent averages of stocks, this does dial down the volatility enough while still providing very good potential for returns. The other important element besides being volatile enough but not too volatile is predictability, and this is the more important of the two but something that isn’t talked about much.
It’s not even hard to get a good sense of how predictable an asset trades, because you just look at the chart and look at the trends. Seeing something move a lot but bounce up and down in a way that is hard to predict is not something we want, but something that is less volatile but moves more predictably is exactly what we want. We are trying to predict moves, and the more predictable they tend to be, the easier they will be to trade and the more money we can make from them.
Keeping it Simple and Safe is the Key When Learning to Trade
Selecting a single asset is ideal from a simplicity point of view. For starters, this puts an end to searching for things to trade as you’re only trading one. This also allows us to become much more familiar with what we are trading, and this is like dating a different person every night versus marrying someone, where you will develop a much more intimate familiarity.
This tends to be vastly unappreciated by a lot of traders, the ones that play the field, and very few indeed limit themselves to one asset. If you can’t master trading one thing though, it will be more difficult to juggle more, and we want to learn how to juggle one pin before we try this with many of them.
If you only trade one thing, it needs to be a good one, but we can select from all of them so there’s lots of potential candidates. Indexes just work a lot better than stocks do in the areas that are important to us with this particular mission, and if we’re going to pick one, we might as well pick the best, the Nasdaq.
The biggest benefit of trading is the ability to multiply our advantage so much over unleveraged positions. With indexes, we can multiply our potential gain by up to 20 times, because they trade on the futures market as well as with contracts for difference trading. We do not want to start by multiplying anything until we are ready though, but as we get more ready, we can be in a position to take the 30% that investors are so happy about last year and multiply that number by quite a bit indeed.
We might think that all we would then need to do is to leverage the longer-term approach this way, but that would be suicide, as these leveraged positions cannot accommodate the same sort of drawdown or anything remotely close. If you are leveraged 20:1 and your position drops by 5%, you have lost all your money, and you need to give this plays at least that much room, so you will need a lot better plan than that.
Top traders will tell you that trading is mostly about managing risk, and this is actually what trading in itself does. We first multiply the risk if we’re leveraged and then manage it more carefully so that we can multiply our returns without a corresponding multiplication of risk, by keeping risk low enough.
You can’t use much leveraging with trading daily bars, and none with weekly bars, The rule of thumb with trading is that you should never risk more than 2% of your capital on any one trade, which will in itself keep us from getting too greedy or using leverage with positions that need too much room to breathe.
Managing risk this way is reflected in the wisdom of cutting your losses while letting your winners run, where we look to be out when trends reverse, and if we are just trading long this will have us in for most of the gains from the up cycles and out during most of the losses of the down cycles.
If we look to play both sides, which is another advantage of trading indexes, we then need to want to be in for most of both cycles and be in on the right side more than not. We need to set aside our reluctance to trade downward if we really want to do well at this game, otherwise we’re just trading it part time and will be left watching instead of playing when down moves occur.
We now need to be able to distinguish trends and also know how to tell when one is ending and a new one in the other direction has formed enough to turn the tide of probability for us. There are various ways that traders measure this, but we need to confine ourselves to means that do not make the head and the tail of our cycles too big and make the body of our fish too small.
There are some indicators that do well at this, in contrast to some of the things that people use such as moving average crossovers that are simply ridiculously bad. Even if you make money from such a thing, you could be making a lot more because the head and tail of this fish is simply huge.
Candlesticks may be king, but Heiken Ashi is the bar style of kings, or at least what they would pick if they knew enough about them. Once you see these in action though, you will probably never go back. These bars have built-in averaging that make trends much easier to spot, and if you still can’t spot them easily, you are trading the wrong thing.
Looking at the Nasdaq on the weekly with these bars should really make our eyebrows raise, although this alone won’t be enough as the smoothing isn’t quite sufficient even though this in itself is pretty close. The idea with this is to make trends more noticeable though, but when we throw in a 5-period simple moving average that is the same color as the up bars when it is going up and the same color as our down bars when it is going down, now we’ve got something that should really put a smile on your face.
When we also put all this up on a chart with monthly bars, and make sure that our actual trades are limited to the direction of the monthly chart, and this really puts the cherry on top of our plan.
This may not be the optimal way to trade this index, but is plenty good enough for our purposes in seeking to illustrate a simple idea that works well on a position trading horizon. There will be some stops and starts like there always needs to be, but the trends that reverse back quickly allow us to also exit quickly, and the ones that keep going involve a significantly bigger amount.
That’s not enough though, because we also want to be on the right side of the trend, and this is why using the monthly as a reference is a powerful add-on. This in itself will cut out a lot of the failed moves because most of this occurs against the bigger trend.
We won’t be using leverage with this but we can capture the lion’s share of the bull runs while enjoying more protection against bear attacks. This whole thing is actually a hedge, but it’s one that we can use to both enjoy good returns without anywhere near the risk and also learn to trade, which can end up being a very valuable skill indeed in time.
This isn’t even a matter of their beating the buy and hold strategy with this, and even if we do sacrifice a little return, what we buy with this is pretty valuable. Many investors are afraid of bears and will do all sorts of things to deal with this problem, but we have a built-in hedge that takes care of this much more efficiently than other popular tactics.
This strategy delivers competitive returns over just holding in bull markets. In choppier markets though, our strategy really shines more, and completely dominates during major pullbacks by not only providing the hedge but allowing us to profit from such a thing if we are up for it and the circumstances warrant it.
There are times where we will be out, and the recent market pullback shows us that we are indeed protected here, where recent activity has produced a big down candle and one well in excess of what we need to stand down for a while. This is where our plan really shines, where so many others are wondering what to do and look like deer caught in headlights when we see pullbacks like this.
When trading like this, it is not really about when you are in but rather when you are out, and while uncertain times can have us entering and exiting a few times during a move, like being out during some of the initial coronavirus fears, getting back in after things settled down, and back out when we broke down even more, this is not a bad thing and we’re not going to be protected from these things by just being a spectator.
As we get better at this, we can seek out more refinements and look to leverage our advantages, but we need to establish them first. We can pick all sorts of alternatives once we know what sorts of things we are looking for, but this does serve to demonstrate what a sensible trading strategy looks like. There is a lot of potential with trading, if you are a good trader, but first you need to know what good trading actually is.