Short-term trading can be very lucrative, but also risky. It can last for as little as a few minutes to as long as several days. To succeed at this strategy, traders must understand the risks and the rewards of each trade. They must not only know how to spot good short-term opportunities, but also must be able to protect themselves from unforeseen events. In this article, we'll examine the basics of spotting good short-term trades and show you how to profit from them.
The Fundamentals of Short-Term Trading
Several basic concepts must be understood and mastered for successful short-term trading. These fundamentals can mean the difference between a loss and a profitable trade. Let's take a look at these vital principles.
Recognizing Potential Candidates
Recognizing the right possible trade will mean that you know the difference between a good potential situation and the ones to avoid. Too often, investors get caught up in the moment and believe that if they watch the evening news and read the financial pages they will be on top of what's happening in the markets. The truth is, by the time we hear about it, the markets are already reacting. So, some basic steps must be followed to find the right trades at the right times.
Step 1: Watch the Moving Averages
A moving average is the average price of a stock over a specific period of time. The most common time frames are 15, 20, 30, 50, 100 and 200 days. The overall idea is to show whether a stock is trending upward or downward. Generally, a good candidate will have an increasing moving average that is sloping upward. If you are looking for a good short, you want to find an area where the moving average is flattening out or declining. (To learn more, read Moving Averages.)
Step 2: Understand Overall Cycles or Patterns
Generally, the markets trade in cycles, which makes it important to watch the calendar at particular times. Since 1950, most of the stock markets gains have occurred in the November to April time frame, while during the May to October period, the averages have been relatively static. Cycles can be used to traders' advantage to determine good times to enter into long or short positions. (For more insight, see Understanding Cycles - The Key To Market Timing.)
Step 3: Get a Sense of Market Trends
If the trend is negative, you might consider shorting and do very little buying. If the trend is positive, you may want to consider buying with very little shorting. The reason for this is that when the overall market trend is against you, the odds of having a successful trade drop even more. (For related reading, check out Short- Intermediate- and Long-Term Trends.)
Following some of these basic steps will give you an understanding of how and when to spot some of the right potential trades.
Controlling risk is one of the most important aspects of trading successfully. Short-term trading involves risk, so it is essential to minimize risk and maximize return. This requires the use of sell stops or buy stops as protection from market reversals. (For background reading, see The Stop-Loss Order - Make Sure You Use It.)
A sell stop is a sell order to sell a stock once it reaches a predetermined price. Once this price is reached, it becomes an order to sell at the market price. A buy stop is the opposite. It is used in a short when the stock rises to a particular price and it becomes a buy order.
Both of these are designed to limit your downside. As a general rule in short term trading, you want to set your sell stop or buy stop within 10-15% of where you bought the stock or initiated the short. The basic idea here is to keep the losses manageable so that the gains can always be considerably more than any losses you may incur.
There is an old saying on Wall Street: "never fight the tape". Whether most admit it or not, the markets are always looking forward and pricing in what is happening. This means that everything we know about earnings, the management and other factors is already priced into the stock. Staying ahead of everyone else requires that you use technical analysis to understand what is going on.
Technical analysis is a process of evaluating and studying the stock or markets using previous prices and patterns to predict what will happen in the future. In short-term trading, this is an important tool to help you understand how to make profits while others are unsure. Below we will uncover some of the various tools and techniques of technical analysis. (For more insight, see Basics Of Technical Analysis.)
The RSI compares the inside strength or weakness of a stock. Generally, a reading of 70 indicates a topping pattern, while a reading below 30 shows that the stock has been oversold. (Learn more about this indicator in Getting To Know Oscillators: Relative Strength Index.)
The stochastic oscillator is used to decide whether a stock is expensive or cheap based on the stock's closing price range over a period of time. You will see a reading of 80 if the stock is overbought (expensive); when the stock is oversold (inexpensive), you will see a reading of 20.
RSI and stochastics can be used as stock-picking tools, but you must use them in conjunction with other tools to spot the best opportunities.
Another tool that can help you find good short-term trading opportunities are patterns. A pattern is a change in direction up or down in the price of stock and reflects changing expectations. Patterns can develop over several days, months or years. While no two patterns are the same, they are very close and can be used to predict price movements.
Several important patterns to watch for include:
- Head-and-Shoulders Patterns: The head and shoulders is considered one of the most reliable patterns. This is considered to be a reversal pattern when a stock is topping out. (For additional insight, see Analyzing Chart Patterns: Head and Shoulders.)
- Triangles: A triangle is when the range between the highs and lows narrows. These occur when prices are bottoming or topping out. As the prices narrow, this will signify that the stock could break out to the up- or downside in a violent fashion. (For more, read Triangles: A Short Study In Continuation Patterns.)
- Double Tops: A double top occurs when prices rise to a certain point on heavy volume and then retreat. You will then see a retest of that point on decreased volume. At this point, a decline will take place and the stock will head lower.
- Double Bottoms: A double bottom is when prices will fall to a certain point on heavy volume. They will then rise and fall back to the original level on lower volume. Unable to break the low point, prices will then start to rise. (To learn about tops and bottoms in FX trading, see The Memory Of Price.)
Short-term trading uses many methods and tools to make money, however, you must know how to apply the tools to achieve success using this type of strategy. If you can do this, you will be able to make money in both bull and bear markets while keeping your losses at a minimum and your profits at a maximum. This is the key to mastering short-term trading.
Mutual Funds & ETFsDiscover the benefits and drawbacks of the ProShares Short MidCap400 ETF, and learn which investors are best suited for the fund's investment strategy.
Active TradingMarket timing is surrounded by controversy, but does it work?
Trading StrategiesActive trading is an investing style that aims to beat the market. Find out how it works, and whether it will work for you.
Active Trading FundamentalsThis article will take an objective look at day trading, who does it and how it is done.
Trading StrategiesFrom picking the right type of stock to setting stop-losses, learn how to trade wisely.
Technical IndicatorsAutocorrelation is the measure of an internal correlation with a given time series.
Chart AdvisorWeekly technical summary of the major U.S. indexes.
Chart AdvisorIt's been a long downtrend for oil stock owners, but there's hope. These four oil and gas stocks have reversed and may keep trending to the upside.
Stock AnalysisExamine the current state of Netflix Inc., and learn about three of the major fundamental risks that the company is currently facing.
Stock AnalysisFind out what investors should know before buying Lumber Liquidators shares. Learn about Lumber Liquidators' financial performance and operational outlook.
While it's always important to assess the overall risk within your own investing strategy, how much historical emphasis you ... Read Full Answer >>
Traders and analysts use the put-call ratio as an indicator of market sentiment. They use the relationship between the demand ... Read Full Answer >>
A company's working capital ratio can be too high in the sense that an excessively high ratio is generally considered an ... Read Full Answer >>
The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
Discounted cash flow (DCF) analysis can be a very helpful tool for analysts and investors in equity valuation. It provides ... Read Full Answer >>
The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>