In our article today we are going to pull back the covers (so to speak) and look at some of the most basic concepts that we need to use when trading. It is very easy to get overwhelmed with trading. There are so many different indicators out there that many traders, especially new ones, will find themselves drowning in a sea of un-needed trading tools. While these indicators may be useful, oftentimes they cause us to ignore the most important things – the basics.

If we go back to the core of what trading is all about we will find that price is at the center of it all. It won’t matter what the indicators say or what the “analysts” say is going to happen. What matters most is what the price does. If we remember that price is the king of all movement then we can use it to help us trade the best we can. Once we start to place indicators on a chart and put their importance above that of the price action we will find that our trading is not as effective. So regardless of what a specific indictor is doing, if price does not move in the right direction it won’t help us. We need to put price in the correct order of importance and if we are going to use indicators make sure we are using them to confirm what the price is doing.

With that in mind we will look at three things that are basic to almost all successful trader. These things revolve around the idea that price is the most important thing to look at. These three things are: trend, momentum and support/resistance.

First let’s talk about the trend. Many traders will rely on the trend to determine the direction they are going to be trading. In order to effectively use the trend we need to have a way to determine if the trend is bullish or bearish. Looking at the price can easily show us if the trend is up or down. The way most traders will look for the trend is to see if the highs and lows are going higher or lower. This is a quick way to know where the price is likely to be moving in the future.

The second thing, and closely related to the first, is the momentum of the chart. The trend is usually looked at as a longer term directional move while the momentum is the current price movement on the chart. You can sometimes see where the trend is bullish but the momentum is bearish. Putting these first two things together in the right relationship will help you identify better entry areas.

Finally, using areas of price support and resistance will give you added information as to the direction the price may be going. These areas can act as a barrier to price movements as well as identify areas where the price may be getting ready to run. Know your support and resistance and you will also have a better idea of where to place your stops and targets.

Take some time to make sure you are putting price first in your trading. By looking at these three basic thing first you can then use indicators to help confirm what the price is showing you.

Price patterns can be a powerful way to identify the strength or weakness of the current momentum. The head and shoulders price pattern is a good example of a reversal pattern that shows weakness in the current trend and the precursor to a potential market reversal. Let’s discuss how the head and shoulders pattern works and identify some examples so you can quickly and easily identify them and use them in your trading. The first thing to understand is that when a market reversal in underway, a head and shoulders pattern will not always be present however, if a head and shoulders pattern is present the probability of a reversal is much higher but not guaranteed. The key to using the head and shoulders pattern is to identify weakness in the current trend and identify when the reversal is underway.

Figure 1: Head and Shoulders Pattern

In figure 1 above, the pattern first starts in a good overall uptrend. Then you will notice the first swing high which we will refer to as the left shoulder, then the market will push down and then back up to a new swing high above the left shoulder forming the head. (this can be one or several candle).Then you will have a move back down to the approximate bottom support level forming the neckline with final move back up to another swing high at approximately the same price level as the left shoulder, forming the completion of the right shoulder. Note the left shoulder and the right shoulder are about the same level, with the head at the high point in the market. The key to the whole head and shoulders pattern is the neckline level, which is the support level at the bottom of the two shoulders. You will notice that the levels are not perfect but are at similar points. The most important level for the whole pattern and the key to the reversal pattern is the general support level setup at the bottom of the pattern which is referred to as the neckline. Now you have a nice reversal pattern; but how can we use this pattern to trade the market. The answer is this: Once the price breaks below the neckline after the pattern has completed, the generally you will notice the uptrend is now over and we are at a good level to look at getting in short now that the market has confirmed lower after the uptrend is over.

If the market is in a downtrend as opposed to an uptrend, you can look for a upside down head and shoulders pattern or what is generally referred to a an “inverted head and shoulder pattern,” which works exactly the same way just reverse. See figure 2 below for an example of an inverted head and shoulders reversal pattern.

Figure 2: Inverted Head and Shoulders Pattern

In Figure 2, you will notice that we have the same pattern just reversed. The main difference is that the neckline is now the top resistance level instead of the bottom support.

Often times, when this pattern shows up, you will notice a strong possibility that the trend may change on the change in momentum. Look for these head and shoulder patterns on your charts and test them out.

If you are an active trader, it is entirely possible that you have a favorite time frame that you regularly trade on. Some traders will want to trade based on daily charts, while others prefer to trade on an intraday basis, trading smaller time frames. A common question that I am asked is, “Which time frame is the best and most profitable time frame to trade?” Of course, there is no right answer to this question – it is entirely based on personal preference, trading goals, and trading style; however, traders may consider trading on multiple time frames simultaneously. I am not saying to consider making trades based on a daily chart and also based on a 4-hour or 1-hour chart at the same time. What I am saying is that, since every time frame is comprised of several bars or candles from a smaller time frame (a daily candle is comprised of six 4-hour candles etc.), when you get a signal from whatever time frame it is that you like to trade on, you may consider looking for confirmation of the direction or the signal itself by consulting the smaller time frames. Just because a candle appears as though it may be going in a given direction, the underlying time frames may be telling a completely different story. If that is the case, there is a very good chance that the trade you are looking to make may fail or go sideways for an extended period of time.

There have been times in the past when I have detected a good opportunity to enter the market on a daily chart, meaning that all of my setup conditions had been met. I was able to trace that setup back on smaller time frames to its point of origin several time frames back. The same setup that I was looking for on a daily chart appeared first on a 4-hour chart, before that, on a 1-hour chart, etc., going down to a 5-minute chart in some cases. I wasn’t looking at this for fun or entertainment, though it was pretty interesting, I was actually looking to see if I could get into my daily trade sooner; I wanted to see if I could get in at a better price. What I ended up finding is that the lower time frames are often times a precursor to what the longer-term time frame will produce, which, of course, led me to a new thought process. If I am watching for my setup on a smaller time frame and I see that it has occurred, can I enter the market based on that signal and then look for the same signal on the next higher time frame, which would tell me that I should stay in the position following through the higher time frames until it comes to its natural fruition.

Some of the setups that do occur on the lower time frames will not progress further to the next time frame, but many of them will. Many of the setups that are seen on the longer time frames came from somewhere. If the market is moving in a fashion that created a setup, seeing lower time frames creating that setup earlier or, at least, moving in the same direction as the setup on the longer time frame, may help to differentiate between what is likely to be a successful trade and what may be a challenging one. If one of the things that you are looking for on a chart is something as simple as a swing bar, and if you see a swing bar on a longer-term chart, that same high or low will appear on the lower charts, which may, very well, be the genesis of the longer-term move that you are following. The trick is recognizing this early in its development.

I don’t necessarily know that moving to smaller time frames to trade on, hoping the setups move through the longer time frames to become a very large trade is a strategy that everyone should follow, but I do believe that looking at lower time frames may be a very helpful strategy.

Sometimes, the most simple things can be made difficult by a trader’s own inability to follow what they know they should do. In trading, one of the simplest things that a trader should be able to do is close out of losing trades. All they need to do is determine where the exit point should be and then place their stop loss to get out. As simple as that seems, there are several things that seem to complicate doing this.

The first thing is that traders, oftentimes, won’t have a defined and written plan on how to take their loss. They will try to put the stop loss in at a place that they “feel” will be good. Without a well-defined and written set of exit rules, they are likely going to find that they are not consistent with how they exit. In fact, they will likely try to avoid taking the loss altogether. With this mindset of loss aversion, they will find themselves in a situation where they may experience large drawdowns and large losses. In order to better control their trading and risk, they must have their stop loss in place prior to making their trade.

A second reason some traders don’t use stop losses is that they don’t want to be wrong. In our upbringing, we learn that it is important to be right. In school, we are trying to get A’s and in our jobs, we are trying to show that we can do everything the right way. In trading, this can be a problem because we will not always be right. In fact, we may be wrong a significant amount of time. If traders take the same mindset about being right all the time to trading, they will be making decisions that may cause them to lose big. By trying to be right and not take a loss, they can find themselves in a situation where they are holding on to losing trades way too long causing them to have too big of losses. In trading, it is okay to take a loss and we need to make sure we understand that it is okay.

A third reason that traders oftentimes don’t take a loss is that they think they can outsmart the market by looking to add to their position size. They think that by buying more at a “better price” they don’t need to see as big of a move to get back to break-even. This is sometimes called ‘Dollar-Cost Averaging’, which can put them quickly in a higher leveraged position. This higher leverage can cause them to get margined out of their trades. If you add to your positions, you need to make sure you have a rule saying when and how you will do it. You don’t want to add just to add.

Take some time to think about why you avoid losses in your trading and what you can do to overcome this problem. In trading, knowing when to take a loss is just as important as knowing when to take a win. If you are having problems closing losing trades, make sure you have your exit rules written down and practice following your rules. You never want to be in a losing position longer than absolutely necessary.

Many new stock traders, when learning about the markets, are introduced to the term “short the market” or shorting the stock. Most traders are familiar with the “buy low, sell high” concept because it is very intuitive that things appreciate in value over time. Short selling is not too complicated, but many investors have a difficult time understanding the how and why of shorting a security. When shorting a security, you are selling high and buying low. Shorting the market is about the sale of a security that you do not own, but is borrowed. If you believe that the security’s price is going to fall, you will be able to buy it back in the future at a lower price and make a profit. Following are the steps in the process to short sell a security.

1. Identify bearish price pattern. When shorting the market, you are anticipating that the security will go down. So if you have a confirmed bearish price pattern, like a double/triple top, a head and shoulders pattern, or bearish divergence, for example, this leads you to believe that the security will be going down in value, then you can take advantage of that price movement by shorting the stock.

2. Borrow shares from brokerage. When you want to short a stock at your broker, you need to have a margin account, which means the broker can lend you assets and hold your cash as collateral. If you are going to short a stock, the broker will need to lend this to your brokerage account, either from their inventory or another client’s account. (When you open a margin account, you give the broker permission to borrow securities you hold in your account for the purpose of lending to other clients.)

3. Sell borrowed shares. The broker sells the borrowed shares on the open market and then puts the proceeds into your margin account.

4. Wait for the price to fall. One of two things are going to happen – the price is going to go down or it may go up. Remember the anticipation is that the price is going to fall; however, there is always the risk that the price goes up. It is really important to structure your trade where you put in a protective stop loss order, so that if it moves too far against you, you will be closed out to protect your account from the infamous “margin call”.

5. Buy back shares (buy to cover) at a lower price. When the price goes down, you have the brokerage buy the share back at the lower price with the money in your account. You get to keep the difference, less any interest and fee from the broker. This closes the position and the brokerage puts the shares back in their inventory or the clients from whom they were borrowed.

In unsettled market times, the prices can move down rapidly and shorting the market is a way to profit from those moves. In fact, there is a great deal of profit to be made by shorting the market if the price goes down; however, you need to weigh carefully the risk if you are wrong and the price moves against you. CAUTION: Never leave your position naked or exposed without a protective buy to close order (stop loss), as you will need to then pay back the borrowed stock at a higher price than you sold it for and the broker will use your cash account to settle the deal.

Many traders begin trading with the idea that it is going to be easy to make lots of money very quickly when trading. Now it is possible to make lots of money, but, sometimes, it might take awhile to get there. Sometimes the best approach is to take it nice and slow. This doesn’t mean you cannot move quickly, but if we go too fast at first, it might put us back a bit.

One of the things that attracts many traders to the forex market is that they can control a lot of money with very little. This is known as leverage. This is a great concept as long as we can control what we are doing with that leverage. One way that we control how much leverage we are using it through the process of position sizing. Typically, a trader will decide on how much they are willing to risk on each trade they are going to take. For example, a commonly heard percentage of risk is that of 2%, meaning that the most, or the maximum, amount of risk in any single trade would never be more than 2% of the account value. While this is a reasonable amount, we need to recognize that this should be the most, not the minimum, we should be risking.

By starting off slower and risking less, we can begin to develop the confidence we need to successfully trade our strategy. Let’s say that you risked 2% per trade, this would mean that if you had a $10,000 account, you would be willing to lose $200 on each trade you took. Now that doesn’t seem too crazy, but what would happen if you had 10 losing trades in a row? If you have traded in the past, you know that this might not be an unrealistic scenario. If it did you would be down 20% of your account, or $2,000. This becomes an almost overwhelming problem for many traders. In fact, many traders find themselves in drawdowns of more than 50% of their accounts at some point. Not only is this problematic from the standpoint of losing money, but, emotionally, it can become devastating.

Now, what would happen if you started off trading position sizes that were 1/10^th of that maximum amount? Your maximum loss per trade would drop from $200 down to $20 per trade. This would allow you to avoid having big losses as you develop your trading method. Sometimes we get so excited about the potential for making money that we begin risking too much too soon. The fact is if we can learn to trade while risking smaller amounts at first, we will be able to develop the confidence we need to trade bigger position sizes later.

Take some time to review your trading sizes to make sure you are putting yourself in the best situation as you learn to trade your method. Once you do this, you will have the confidence to increase your trade size to the most appropriate level, allowing you to make the most in each trade.

Many traders have been trading stocks and are now looking for other markets to trade. Foreign Exchange trading or FOREX for short is a good market to trade if you are looking to diversify your trading. If you are new to FOREX trading here are some rules for beginners as well as experienced FOREX traders if you are not having the success you would like to have. Forex trading is best done using some simple goals.

When discussing goals, many traders easily slip in the trap of setting goals related to results or performance. This can be very short sighted as the best beginning goals should focus on the mean of trading or the trading process before you focus on performance. Doing this leads to the proverbial “cart before the horse,” if we are focusing on results before we get the trading process down.

Develop a good trading process
Your plan should include things like how much you will fund your trading account with. What rules you will use to enter and exit your trades, how many trades will you have at a time. How will you manage your risk (Forex is traded on margin and therefore can be risky if you are overleveraged). Also, the simpler your trading plan the easier it will be to follow.

Here are 3 easy rules to get started:

1. Trade only ONE position at a time.
Whatever your exit or entry rules are, to begin with, it would be best to enter one position and then see it through to that position’s conclusion. This will help you focus on your entry rules to get in and your trade management rules to get out. With too many positions, especially as a beginner, you can more easily make mistakes that you can avoid. This will also help you from being over leverage with too much risk. Also you will find that you be able to control your trading emotions to avoid big mistakes if your are just trading one position at a time.

2. Trade in only ONE Direction (with the trend).
What I mean by this is only trade in the direction with the current trend. Do not get suckered into trading a counter trend or against the trend move. Trading counter trend is much trickier and requires perfect timing to get right. If always looks easier to trade both ways, when you look back at the charts but is much more difficult in real time.

3. Trade with only ONE percent risk.
Now many traders will argue that they can trade more risk than one percent at a time, and perhaps they can, however as a novice FOREX trader, you should start on the low side. (I would never recommend more than 2% per trade however.) The lower your risk, the lower your anxiety will be when a trade doesn’t go in your favor and you have to take a loss.

In conclusion, as a first step, focus on a good, easy-to-follow process. As part of your process, follow these simple rules: trade only one trade at a time, in one direction at a time, and only risk 1% of you account on any specific trade. These rules will help you follow and refine your process and will allow you to sleep at night in the meantime.

In a way, if you really stop and think about it, each of the equity markets can be seen as living breathing entities that have good days and bad days, emotional upheaval and solemn times just like a human being. It may make some sense to think of them in this manner since they were created, maintained and sustained by people that exhibit these same traits. Since the people that have created the markets and participate in them have a full range of emotions why wouldn’t some of the things that we create show signs of having similar emotions? We clearly put allot of our energy, emotions and attitudes into money which is why it acts as it does sometimes flowing to us and sometimes flowing away from us but regardless of its direction it is always flowing just like a living entity. We put similar energy, emotions and expectations on the individual securities that make up the equity markets so it just makes sense that they can react almost emotionally in a similar fashion simply reflecting back what has been put into them.

We put all kinds of energy and emotions into individual securities; we are concerned with everything from their direction to when we should get into them and when we should get out of them. When we have open positions in securities we become cheer leaders doing as much as we can to will our positions to go in the direction that we want them to go in. When we do not have open positions we want prices to move to levels that will provide us with the best entry points possible and when we do have open positions we want the issues that we are holding to move as fast and as far as possible in our direction rooting for them just like fans at a championship sporting event. With all of the rooting and the cheering that we do, regardless of if it is silently or aloud, we put a tremendous amount of energy on our positions to move them in our direction so our money will increase as much as possible as fast as possible. With all of the energy that is directed at the markets and the individusl securirites that make them up how could they not reflect at least some of the energy that is constantly directed at them?

Why do different types of securities move differently than other types, why do stocks move differently than each other and why do the currency pairs move so much differently than each other? Basically the currency pairs are just made up of two opposing currencies and stock just represents the value of a company at a given time. What makes these things change is the people that own them along with our attitudes, hopes and expectations around them in addition to the fundamental and technical factors.

Markets are really designed with a specific directional bias; there are expectations around what the issues that comprise a market will do. Stock markets generally have an upward bias or an upward expectation. Though stocks move up and down and you can make allot of money taking short positions the overall bias is long which makes sense since we generally expect corporate earnings, dividends and market share to increase. The overall expectation is that over time a stock market and the issues that comprise it will go up. The Forex market by comparison has no upward or downward expectation; it’s a little like being in space in that there is really no up or down. The currency pairs move up and down against each other but the way that market is created with two opposing currencies pitted against each other, sometimes one of the two in the pair is the stronger of the two and sometimes the other currency is the stronger of the two but none of this really matters when trading in the Forex market. The expectation is for just as much downward or short movement as there is upward movement. This could be due to the fact that there really is no zero. If a stock goes to zero it means that the shares are worthless and the company that issued the shares likely is as well but with the Forex market there is only the measure of the strength of one currency against another, currencies that are in the Forex pairs will have value as long as the country and the government that issued the currency exists.

Regardless of the market that you are trading or investing in it is human nature to become a cheerleader for the issues that you are involved in; we want our positions to go in the direction that we want them to go in and we will do whatever we need to do to ensure that happens. When we cheer for an issues direction we put energy, expectations, hopes, dreams, desires etc… into the issue and therefore into the market itself. By doing so we place allot of energy on it just like we do with money which gives the security a personality and therefore almost a life of its own in some ways acting similar to how people act.