Hi again! This lesson is going to bring all that we have learnt into a workable trading system. Every epitome of human endeavour had a strong plan behind it. A plan which people followed day in and day out to reach their goals. We all know the story of Edison, ISRO’s Mangalyan, Apple products and Amul – one of the largest milk producers in the world. They all have one thing in common, a relentless approach to finding what works and once they found it, they followed the system incessantly to achieve success. The stock market is no different; it also has to have a business plan, a Trading System.
A Trading System is made up of a predetermined:
1) Entry point (Long or Short)
3) Profit taking point
4) Position Sizing
The system must be tested thoroughly over many years to check for draw-downs, hit rate, risk reward ratios and other performance parameters. We will not be discussing these advanced concepts since this is an introductory course.
This system is a trend following system and, as you may have guessed, uses swing highs and lows to enter and exit markets. Make sure you are crystal clear on Swing Highs and Swing Lows we covered in the previous lesson.
This is the setup, it’s extremely simple –
First you must identify a swing high. Remember a swing high is just a resistance point. Prices went up because of demand and at some point the demand diminished or more supply came in and pushed prices down. That point is your swing high i.e. resistance. Now, wouldn’t it be significant if the markets rose again and went past that resistance point? That means there is renewed demand, right? THIS is our entry point for longs, when we cross a swing high, that is where we buy.
When the stock crosses resistance, it usually makes a significant move up. You know by now that we are merely following the big money, crossing a swing high means there is good reason for the stock to go up. Maybe good earnings, great macro policy or better banking rules – whatever the reason may be, big money is behind the demand and we can see the results in front of us.
On seeing more stocks, we may notice that some trades don’t do so well.
Now, you remember the coin flip example in Lesson 1 where we stated that if the odds are in your favour then you can be profitable? But there is one issue with stocks, if you are 100% invested in a stock and it crashes, you could lose all your previous profits. WE, however, have a system to save us against such situations – called the Stoploss and Position Sizing.
Lets start with the Stoploss. Basically this is the point at which you will exit if the trade goes against you. What would be a logical place for this? We have found that if support breaks, that is the last straw. Therefore, the latest swing low is the initial stoploss; as new swing lows form, you raise the stoploss to a higher level. Remember, the SL order is automatic, so there is an elimination of guesswork and fear – you simply follow the plan and place the order and you will be profitable.
Now that we know how to buy and exit, the question arises – how many shares to buy? To the layman, it may seem pretty straight forward – if you have Rs.1 Lakh, then simply invest that amount when a Swing High breaks, but things are rarely so simple.
You see, you cannot risk more than 1%-1.5% per trade of your entire capital. Therefore, if you have Rs.1 Lakh in your account, you cannot risk more than Rs 1,000 – Rs.1,500 per trade. Notice that this has nothing to do with ‘how much’ to invest. That is irrelevant. What matters the most is how much you stand to lose in a trade – once we have that, we can figure out how much you can make in a profitable trade.
Calculating this is easy. Let’s assume your capital is Rs 5 Lakhs, 1% of that is Rs 5,000 – this is the maximum amount we can risk on any trade.
Now in this trade, here is the entry and this is the stoploss – this is a difference of 15 points. 15 points is the risk in the trade.
Rs 5,000 divided by 15 points = 333 shares
As you can see, if you entered a long position at 215 and the trade turned sour and your prices dropped to 195 – your stoploss at 200 would exit your position. That is a loss of Rs 5,000 plus brokerage. That means YOU are always in control, the profits and losses are in your hands.
The next trade is interesting, we have a difference of 11 points between entry and stoploss – that means Rs. 5,000 / 11 = 450 shares. We got profitably stopped out and cleaned a 53 point profit. If we removed 1.5 points for brokerage, taxes and slippage then that is a profit of Rs. 22,900.
We have a lot of practise charts in the course materials and Quiz.
So there you have it – you just created your first trading system using technical analysis. Congratulations, give yourself a little pat on the back! Believe it or not, what you just learned in these 5 Lessons forms the basic tenets of a system of trading, that is, Technical Analysis, something which many so called ‘experts’ fail to grasp. You have learned the fundamentals of this mode of trading.
In future courses, you will learn about the various types of indicators that can be employed to further enhance your trading systems and, of course, generate a higher return on your investments.
Ride your winners, cut your losses. See you, very soon, in another course on Trade Academy. And of course, don’t forget to check out the Course Materials.