If you are hoping to become an investor in any major capital market, there are a number of different important variables that you will need to keep in mind. While many people primarily concern themselves about which stocks they should be investing in, one variable that is often overlooked is the importance of deciding how long you hope to invest for.
At the end of the day, successfully trading on the stock market is allow about timing. Even if you have chosen to invest in a company that is financially sound in the status quo, this choice will mean very little unless you are able to know when to enter and exit the market. Rather than focusing on things such as market capitalization, you may be much better off by teaching yourself to identify when a given stock’s price is about to increase or when a given stock’s price is about to decrease.
In this brief guide, we will discuss the fundamentals of short-term stock trading and how you can develop a strategy that will minimize risk while maximizing your potential for reward. By taking the time to understand how short-term stock trading is different from general stock trading as a whole, you will be able to eventually exploit volatile markets and increase your portfolio’s overall return on investment.
The Fundamentals of Short-Term Stock Trading
While long-term stock trading strategies are usually much more heavily focused on determining the objective value of a given company, short-term strategies are primarily centered on identifying when an immediate change may be about to occur. Even if you believe that a stock is generally overvalued, that doesn’t necessarily mean that the price of this stock will not still increase by the end of the day.
Usually, the stocks that make for the best short-term investment candidates are the ones that have demonstrated a history of price volatility. Regardless of their general (long-term) trend lines, most stocks will experience both increases and decreases in their value throughout the day. In order to earn a return from your investment, you will need to enter the market right before a price an increase and exit the market right before a price decrease.
No matter what industry (or market) you may be considering investing in, it is important to recognize that most stock prices move in a somewhat cyclical pattern. For example, over the past fifty years, markets have been significantly more volatile during the winter months than they have been during the summer months. This may have a major impact on when you should employ a short-term approach to trading and when you should assume long versus short positions.
You should also take a careful look at moving average patterns before investing in a specific stock. These averages indicate how a given stock has performed over a specific period of time (usually 15, 30, 50, or 100 days). When moving averages have clearly been trending upwards, it may be a good opportunity for you to make an investment. Furthermore, because many stocks move in conjunction with others, it is important a close look at current market trends as a whole.
Short-Term Stock Trading Indicators and Patterns
While long-term investing may involve closely examining the news, economic policies, and annual financial statements, short-term investing strategies are usually much more reliant on technical analysis.
- Triangles: this term refers to when the range between a stock’s highs and lows are narrowing. Ironically, triangles typically occur right before a stock is about to experience a major change in price.
- Head and shoulders: this term refers to a pattern characterized by three peaks—two lower peaks on the outside and one higher peak in the middle—that roughly resembles the shape of a person’s upper body. Often times this pattern is one of the strongest indicators that an upward trend is about to reverse.
- Double tops and double bottoms: these patterns involve an observation of both trading volumes (high, then low) as well as trending patterns. Usually when either a double top or a double bottom occurs, that means a trend reversal may be nearing.
By taking the time to comprehensively look at these graphing patterns and to also consider important indicators such as the relative strength index (RSI) or the stochastic oscillator, you will be able to change your positions and exploit natural market volatility.
Minimizing the Risk of Short-Term Stock Trading
Because assuming a short-term position in the stock market has a number of different costs (opportunity costs, trading costs, etc.) associated with it, you should recognize that short term trading is something that is inherently risky. However, despite this, there are still several things you can do to help decrease your portfolio’s overall risk.
One of the best ways to decrease risk is to use both stop losses and stop limits. Stop limits can help you avoid missing out on guaranteed earnings and stop losses can help you cut your losses before a specific investment loses too much value. Usually, the stop order that will be most appropriate is about 10% to 20% from your original entry price.
Other ways to help decrease risk include assuming both long and short positions simultaneously and also investing in a variety of different industries. Though diversification is generally considered to be more important for long-term investment strategies, it is still a principle that remains fundamental in the short-term as well.
Developing a Stock-Trading Strategy that Works for You
Once you have taken the time to understand the fundamentals, key indicators, and the various techniques for avoiding risk, you will be in a position to create a short-term trading strategy. However, before you begin committing any portion of your financial portfolio to a specific stock, there are a few questions you should ask yourself.
- What is my current cost of trading? If you plan on frequently changing positions, this may have a negative effect on your portfolio’s rate of return.
- What are my current risk preferences?
- What portion of my portfolio am I willing to commit to short-term stock investments? What portion of my portfolio am I willing to commit to long-term stock investments?
- How many hours a day can I commit to stock trading?
It is also important to recognize that “short-term” stock trading may mean different things to different investors. For example, while some day traders will actively enter and exit hundreds of positions in a 24-hour period, other “short-term” traders may prefer to operate on a weekly, or even a monthly basis. Naturally, this will affect which moving averages, cyclical patterns, and other essential indicators will be most relevant to you.
As is the case with long-term investing strategies, becoming a successful short-term stock trader involves recognizing opportunities for growth while simultaneously taking action to minimize your exposure to risk. Fortunately, the stock market is surprisingly predictable and easy to navigate over time. Familiarizing yourself with moving averages, various price graphing patterns, the use of stop order trading, and other essential mechanisms can help you improve your overall performance.