The 7 Basic Principles of Trading in Market

Trading is buying something where you anticipate it will get higher than your buy price in a very short span of time.

On the contrary, if you anticipate something will get lower than the current price, you prefer selling now and buy at a later date. Referred to as short selling.

Short selling in the cash market in India is confined to day trading only which means you have to cover your short positions before the market closes for the day. In futures, you can short sell and carry your positions overnight.

If you are trading in options, you have more choices like buying a call and put and selling a call and put. You can read in detail about call and put options here.

Just FYI I neither trade in futures nor in options and don’t recommend it either.

The 7 basic principles of trading in market

Here are the 7 basic principles of trading in market.

1. Stop Loss

The first rule of trading in the market is able to predict a stop loss in market and more importantly able to execute a stop loss.

By executing a stop loss means if you are buying something that is price at 100 and if your stop loss comes to around 80 Rs and if you are not be able to execute your stop loss and loss 20 Rs per share, you should not be buying stock at 100 Rs.

Stop loss is not simply a number that you put forward but depending on the strategy and analysis you get a stop loss for your trade. I use price action strategy to calculate my stop loss.

2 and 3. Target and ROI

Once you have a stop loss, you should also opt for a target. I prefer the target to be at least 1.5 times my stop or at times increase my target levels to twice or thrice my stop.

Allow me to explain this with a simple example.

I purchase a stock at a price of Rs 101 with a stop loss price of 95. So my stop is 6 Rs or in simple terms I am ready to lose 6 Rs on a trade. So my target will at least be 1.5 times my stop of 6 Rs and so target will be to gain at least 9 Rs or price target of Rs 110.

Once we have stop loss and target levels, the other important aspect to look for is how easily the target is achievable.

Target is achievable if there isn’t any major resistance between the purchase price and the target price. So if I see a major resistance in the stock at around 105, I will skip the trade but if resistance is around 110, I will execute the trade.

So I will execute this trade if and only if I am

1. Comfortable executing my stop loss.
2. Target is achievable.

At times, you may see that 110 may not be a very strong resistance level and so you can have partial target of at 1.5 times your stop and then can have other target at 2 or 3 times the stop which is 113 and 119.

4. No margin

Never ever trade with margins and only trade with money you are ready to lose.

Let’s say we start with 10,000 in the trading account and for large cap stocks. You are normally allowed 20 times margin for day trading. So you can buy securities worth of 2L or 200,000. For calculation sake if we take the target of 3% and stop loss of 2% the profit can be 6k Rs but if you hit a stop loss you can lose 4k or 40% of your total amount you opted for trading.

Opt for margin only after considering the stop loss and if you are comfortable losing that amount, you can opt for margin trade.

I have a thumb rule where each of my trade is at the most 1/3rd to 1/4th of my net cash balance in my trading account. So ideally I can have 3 to 4 open trades but normally it is not more than 2.

If I hit a stop loss of 5% I would be losing less than 2% of my cash trading balance.

5. Never Average Down

When trading, you should never ever average down. If the stock you purchased at 100 and is now trading at 60 which is down 40%. Ideally you should have hit a stop loss in such a scenario but even if you have not setup a stop loss for it. Still don’t average it down. Mathematically if a share falls by 20%, it may not be back to the purchase price of 100 if it increases by 20% again.

Let us understand this with a simple example.

Purchase price of a share was 100 and it falls 20% from 100 to 80. Now at 80, if it increases by 20%, it will reach 96 because 20% of 80 is 96 and not 100.

6. Can’t master every pattern

There are many patterns and analysis in market and as an individual, you cannot master every pattern. Focus on few patterns that you think works for you and try to excel in them. I only trade with few price action strategy patterns and my personal favorites are higher top higher bottom and W patterns.

Apart from trading for all the patterns you also cannot focus on all the stocks with the formation of those patterns, have a list of stocks where you can easily identify your preferred choice of patterns regularly.

Once you know you’re limited with the patterns you can master and number of stocks you can track, you should have an ideal number of maximum trades that you can execute as well. I could never trade more than a couple of pair trades (buy and square off) in a day. At the most I could achieve is 1 pair trade and one other trade. I may be slightly conservative in the number of trades I could execute because of being a part-time in market.

7. Break from market

You just cannot trade for 250+ days in a year. You have to be taking a break.

I prefer keeping things really simple and if I start to hit series of stop losses (3 to 5 consecutive stop losses), I take a break from the market for at least a week.

As a trader it is not individual trades that matter but what matters is the series of trades where you have few misses (hit a stop loss) and a lot of hits (hit target) and overall profit out of it.

Conclusion

As a trader, you should be always ready to execute a stop loss and be really systematic in booking profit. I would say as a market participant (trader or investor), you should always be ready to execute a stop loss. Stop losses are the point which proves that you were wrong and anybody can be wrong in market. Warren Buffet has even admitted that he was wrong in identifying some of his stock evaluation and has booked loss of few billions. Market is all about being more right than wrong and make profit.