There is method in the chaos of intraday trading with careful strategies and rules
Source: Tavaga Research
Retail investors are always being warned by the financial pundits to know better than to dabble directly in the stock market. Financial theories have summarised how prejudices and blind faith trip up the unassuming investor when they attempt to trade in the markets, burning their fingers instead with wrong calls.
The practice drawing the most flak is intraday trading, and retail investors are often encouraged to look elsewhere (such as pooled investment funds) for earnings growth and multiplying wealth. But it would go a long way if we know what is it that we are avoiding than again, blindly following popular advice. Intraday trading in India or day trading is not a taboo but is a strategy which needs to be dealt with the utmost care.
What is intraday trading?
Intraday trading can be defined as buying or selling financial securities in a short time-frame to make profits from the securities’ price movements.
Intraday trading requires two parties for a trade, one to sell and the other to buy the security. Order books are maintained to align buyers and sellers. At present, trades come down to a matter of seconds and most of it is in demat.
The approach which is often advised for retail investors is holding securities with sound fundamentals for a long duration, as opposed to intraday trading. We will call this as investing in the markets, to distinguish it from intraday trading in the article.
Usually, individuals who invest in the market, either on their own or through an advisor, have another full-time job or another source of income to fund their investments. Whereas intraday trading requires more attention and nearly the whole of the trading day of an individual. The latter are often day-traders and intraday trading is their main source of income.
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How to do intraday trading
For intraday trading, we have to first open a demat account with a broker. If we open our trading and demat account with online or discount brokers, we could benefit from their lower-than-average brokerage fee, unlike those at full-time brokers.
Ideally, we should also have a trading IT system in place, with charting platforms that provide live data feeds for a real-time picture of the markets.
Finally, to trade well, we should understand how to use the broker trading terminal to place our intraday trading orders.
Is it safe to do intraday trading?
The risks are greater in intraday trading.
The key difference between investors and traders is that investors allow their assets to grow and accumulate wealth, whereas day traders need to withdraw their earnings on a monthly, weekly, or even a daily basis in order to get by. For most day traders, trading is their primary, full-time occupation.
Hence, intraday trading today can be tricky for a retail investor as they will be going up against the most seasoned traders, who may be the other party for their day trade.
Such traders, many of whom are employed by investment banks or trading houses, have access to such state-of-the-art analytic tools, deep pockets and vast wealth of research that a regular individual investor will be hard-pressed to match.
Can we make money in intraday trading? Yes, of course. Traders earn their bread and butter with intraday trading. But the odds are often stacked against the average investor. Compared to intraday trading, there are other financial strategies and instruments that are less mercurial for the risk-averse. The burden of timing the market, constant technical analysis, unavoidable losses doesn’t need to be borne if one does not wish to.
Intraday trading rules
Intraday trading is a rigorous exercise which requires considerable time and resources of the trader for performing various tasks, ranging from researching and reading the market to executing the trades with the broker.
There are some trade rules which most of the day traders adhere to, because they act as guidelines and may be regarded as intraday trading tips. They are:-
- Which stock is best for intraday trading — Day-traders do not spend their energy analysing all the stocks (or other securities such as commodities) on the exchange. Rather, they focus on selected stocks or securities in which to trade. The criteria for filtering out stocks may be summarised as follows:-
· Liquidity– The stock under question should have ample amount of liquidity in its counter (at the market) so that the trader can take positions without worrying about the impact costs.
· Volatility – Day-traders would be more interested in the stocks which have the potential for sizeable price movements in a trading session. Traders use screeners to filter stocks for volatility.
· Research – Research is imperative for sharpening the strategies of day-traders. Not just the securities and their immediate environment but also macroeconomic events that affect financial markets are likely to be a vital part of such research. Historical trends as analysed by technical analysis are another aspect of research useful for a day-trader. They key for a day-trader to do well is try and anticipate scenarios that give rise to trading opportunities and arm themselves with strategies for those.
· Stocks in the news – Stocks which are in the news are often preferred because news about them could potentially change their demand and supply in the market, affecting price.
2. Risk-return trade-off and profit target — Risk-return trade-off, an important metric for intraday trading, can be done with the help of risk-reward ratio. Risk-reward ratio is the ratio which helps the trader measure the risk they are taking to earn the reward.
A risk-reward ratio of 1:2 will mean the trader is willing to risk Re 1 of investment to earn a return of Rs 2. Traders fix this ratio according to their style and often follow it with discipline.
3.Stop-loss orders – Intraday traders should not trade without stop-loss and target orders (both for selling off the securities). In the absence of stop-loss orders, for example, traders may end up losing a sizeable portion of their capital.
4.Leverage — With most brokers providing leverage five to 10 times the capital brought in by the trade, the onus on the day-trader grows to keep an eye on the margin in which they are trading, so they don’t overstretch their resources.
Leverage acts as a double-edged sword, powerful if used judiciously, dangerous if used indiscriminately. Only the most skillful and experienced traders should ramp up their trades on margin money.
5. Keeping a check on emotions — Behavioural finance is not just for investors. Day-traders should keep in mind the pitfalls of human psychology and behavioural anomalies too. Traders should avoid the behavioral biases that behavioural finance talks about.
The more disciplined a trader wants to be, the more careful they have to be in letting their emotions get the better of them through a trading day. Afterall, in intraday trading today, trading decisions have to be taken in a matter of seconds, especially when algorithms are at work.
Intraday trading strategies
The rules of intraday trading are applicable to any day-trader and will hold them in good stead no matter what they trade in and why. A trading strategy, on the other hand, helps a day trader conduct their business according to a chain of thought and logic to arrive at a targeted result.
A trading strategy is a set of rules a trader uses to decide when to enter and close a trade. Trading strategies utilise trade screeners and trade triggers.
A trade screener is a condition or a set of conditions that must be met for an asset to enter the watch-list of a day-trader. A trade trigger identifies the exact point (mostly price point) at which a trade will be entered. All trading strategies will have rules for entry, exit, risk management, and for position-sizing.
Entries are the moments when conditions converge identified by and for the trader to enter trades. They can be filtered by a number of conditions. For instance, a day-trader can specify an entry position when the stock price hits a 12-months-low.
Exits can specify positions that would minimise a loss, or close a winning position after a target profit has been achieved.
A day-trader chooses a trading strategy mostly with the aim to minimise losses during trades. Risk is not eliminated but strategies allow the trader to cuts the losses early and move on before a lot of damage.
Position-sizing refers to the number of shares or contracts a market participant, such as a trader, risks with each trade. It is dependent upon size of the trading capital. Obviously, traders with more trading capital would be able to take larger positions than traders with less capital.
Over time, intraday trading strategies or approaches have been identified and named. What is the best strategy for intraday trading is difficult to pin down as traders favour strategies based on their risk appetite and objectives. As the markets mature with time, the strategies, too, evolve,
Some of the commonly deployed intraday trading strategies are as follows:-
A crossover intraday trading strategy is when a trade is triggered when two similar, but not the same, market metric intersect.
A crossover strategy is better understood by looking at the two kinds of crossovers — price crossover, and moving average crossover.
A moving average crossover occurs when a short-term moving average of an asset crosses over a longer-term moving average.
For example, say the 5-day moving average of an asset runs below its 10-day counterpart (lower magnitude in price). If the price of the asset significantly increases, the 5-day moving average will rise. It may even intersect, cross and rise above the 10-day moving average, making the crossover a bullish or golden one. Traders following this strategy will engage in trades in this event.
If over time, the same asset sees its price significantly decreases, the 5-day moving average falls, and this time may intersect, cross and fall below the 10-day moving average, making it a bearish crossover and triggering trades.
A price crossover occurs when the price of an asset increases above (or decreases below) a moving average of that asset. For example, the price of an asset may be below its 5-day moving average, but if the price of the asset suddenly increases and exceeds the 5-day moving average, then it will be called a price crossover and it would trigger trades.
Moving average envelope
A moving average envelope is another intraday trading strategy that utilises moving averages. It involves constructing a confidence interval (let’s say a 10-percent confidence interval) for a medium-term moving average (let’s say a 25-day moving average) to identify support and resistance levels. If the price of the asset moves beyond the 10- percent confidence level, it signals the trader to engage in the appropriate trade.
For example, if the price of an asset moved below 5 percent of the 25-day moving average, it could signal that the price of the asset has broken support and experiencing a downward price trend. The trader would then act accordingly.
Bollinger bands are used to make moving average envelopes.
Above is an example of how Bollinger bands can be used for trading, when the price hits the lower end of the band (green color), the trader should go long on the asset and when the price hits upper end (red color) of the band, the trader should go short on the asset.
Event-driven intraday trading strategies
Event-driven intraday trading strategies can be described as strategies which try to profit off events such as earnings announcements, natural disasters, or events of unusual nature.
Whenever such events occur in the marketplace, there is an increased uncertainty, which in turn increases the volatility in the market.
Reversal intraday trading strategy tries to identify changes in the price, and help traders take a bet on the same,.
In the case of an upwards price trend, the reversal would cause a break in the rise, after which the price moves downwards. Indicator tools, which help identify changes in the price direction, abound. A well-known indicator to identify reversals is the RSI (relative strength indicator).
The RSI determines if an asset is overbought or oversold. If the asset is overbought, the trend is going to reverse and the trader should take a short position. Vice versa for an oversold asset, the asset is oversold.
A trader can create their own trading strategy based on their ideology.With an understanding of how the markets work, traders may choose securities to fit in with their ideologies and principles. They may go with forex, equities or stocks, or derivatives. After choosing the market to trade in, they have to create their entry and exit points using filters.
Care should be taken to test their strategy on historical prices first,and if it reaps positive results, it can be deployed in live markets.
If we believe that negative news on Brexit drags down the Pound-sterling (GBP) and props up the Euro (euro), we should choose the market to fit trades that act on such global news — forex.
The trades to execute in such cases would be to go short on GBP and long on the euro whenever there is news on the stalling of Brexit.
The next step would be to test it against historical data and then to deploy the strategy if it corroborates the hypothesis.
Intraday trading timing
There are different operational timings for different securities markets. The table below shows the Indian intraday trading time limits of the markets:-
Intraday trading requires considerable time and effort. Ideally a person who is starting out as a trader should practise on a demo account with mock money, before beginning to trade with real money.
Intraday trading also requires traders to have access to a sizeable amount of capital and is not a get-rich-quick path.