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A Crash Course on Trading

Updated on February 14, 2014

A Crash Course on Trading

An investor newbie wrote: I have done some general reading on day trading and I think it suits my temperament. Where do I go from here? How do I learn Day Trading? Any suggestions from the informed will be highly appreciated. I had written a quick reply which was appreciated by others who read it so I decided to write it up for publication.

You need a method to make money out of madness that the markets are. Or, more accurately: what you think will make money. Then you need to do prospective testing of your method. Prospective testing is also known as: Paper Trading. That is you play markets with your method "on paper". You start with one or more "paper" accounts with some hypothetical amount of starting capital in each account. Then everyday morning sit in front of your PC and start analyzing market data and start investing the hypothetical monies of your "paper" accounts. Once you have certain number of trades done "on paper" you can analyse them. When you paper trade try to recognise bid/ask spreads, slippage, random delays that may happen in execution of trade etc. Introduce any other random factors that will affect your trades in real life. Randomization will prevent the effect of "datamining" creep into your result.

The need to randomize to account for real life variations cannot be emphasized too much. For example, one investor thinks that he has a very good "system". The system is as follows: an "indicator" was created by analysing data of stock price in the last hour of previous trading day. Using this indicator a decision to open a long position was taken provided some further indication of an "intraday" bullish turn would be seen. Testing showed out of this world return rates provided "entry" trade can be accomplished in first hour of morning. But when real trading began trader was never able to trade in the first hour. Also trader made fundamentally flawed assumption of being able to open a position at opening price. Trader based his system "development" on historical data. And historical data had only prices for opening and closing transactions and high's and low's. This led to datamining flaw, because in reality he was never able to open long position at opening prices. Also trader did too few "on paper" trades from which he drew conclusions. These "paper" trades are like what Statisticians call "samples" from a "population". Sample size matters in any realistic analysis of trades.

There is one other testing method called retrospective testing. Also known as: Backtesting. Such testing easily becomes problematic because of survivorship bias and also datamining flaw. Also for Day Trading you will need volumes of data. You are sitting in front of your PC in 2011 and rounding up data of stocks which survived and playing with these data. Those companies which went bust are not in your database. This is survivorship bias. You are analysing companies which are good enough to survive. In prospective testing you would work all companies not knowing their future fate. So survivorship bias is absent.

Many day traders use chart oriented techniques. This means you need to learn these techniques. You should learn this techniques by plotting data upto a point. Like for example you can stick a yellow "Post-It" slip on you PC monitor so you can view only price action upto a certain point in time. Then when your method indicates buy or sell you just remove Post-It note to see if trade would have been success or not. If you have volumes of intraday data you can plot upto a point in a charting software then scroll forward to learn fate of your decisions. Advantage of this method is you can teach your method to many people who can parallely play with randomly selected time points and randomly selected stock. In this way in a short period you accumulate data on large number of "paper trades" and so there is quick turnaround for your testing.

Lastly: no system exists which is full proof. This means you need decision rules for everything: entry, exit, size etc. In fact you may incorporate all these in testing phase. That will force you to develop formulas, programs etc for these essential aspects of trading. Many people imagine entry is most important part of trading. But you would be surprised that exit as well as size of investment in individual trades also matter equally or more.


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