Firststands : Technical analysis part 2
In the first part of technical analysis we did learn when and with how much capital should we start trading? Core differences between investing and trading? Why stock prices move. Heard behavior in the stock market. And now in this part we will learn what a beginner approach toward trading should be. Once done we will learn how to analyze charts as well as technical analysis. So let's get going already.
OPERATION OF TRADING ACCOUNT
How do we make a system? To make a system, there are 2 things we need, you need a trading account and a D-materialized account (it is the actual version of the actual shares that you own)
DISCRETIONARY VS SYSTEMATIC TRADING
Trading is of 2 types, one is systematic, which we talked about in Technical analysis part 1 - you have set rules and following day in day out - just like business, which we will learn in depth later on. On the other hand Discretionary is when you trade on your feelings, something will go up or down you then enter and exit to make a profit and " YOUR GUT MAY NOT ALWAYS BE RIGHT". There is also a key for this is money management, even if you are wrong most of the time, you can use this technique called money management and still make money.
*Quantified rules based on entry and exit. * No emotions. *No need to monitor the market at all. * No need for years of experience to become profitable. * Can be automated
* Gut based entry and exit. * Involves human emotions. * Need to monitor the market all the time. * Need years of market experience to become profitable. * Can’t be automated.
WHAT IS SYSTEMATIC TRADING ?
To understand this lets use an example of a casino. In this case I'm the owner of the casino, and it is interesting because people are going to gamble at casinos. But how do casinos survive if so many people are getting payouts and making money? It must be a business, right?. How are they making money out of chance? There are several machines, slot machines are running, and the Roulette wheel is there.
How are they making money out of pure chance? What if someone wins a million dollars and they go bankrupt? There must be some logic to it? So, this is a roulette wheel.
Now guess we have 2 colors, let's say I bet on black. But what is the probability of winning? It's 50-50, right. I bet on black but unfortunately, I lost. Now the interesting thing is there is another color here and now just one green color green changes the probability completely. It’s not 50-50 now, it’s now 48.6%. The margin of that 1.4% is the edge of the casino to make money. So, normally when you have a trading system, generally the win ratio of profit is 50 to 55 %, which is fine, the extra 5% is what actually makes you the money. And there is a second dimension to this, one is like the win-loss ratio is slightly higher. The second dimension is when you are making money, forget about this example, you as a reader making money as a profit, that profit should be 100 dollars when you are losing it shouldn’t be less than 50 dollars. If you’ve taken let's say 10 trades, you have a 55% win-loss ratio, you know, 55% of the time you get at least 1 profitable trade. But this time, you lost all 10 out of 10 trades, okay. What do you think it means statistically? I would say now it’s my time to win the next time. If the system says I'll win 55 out of 100 and I lost 10 trades, I still have another 45 trades to win. So you are not measuring trading on a per trade level, you are messing it on a system level.
IS TRADING A BUSINESS OR A GAMBLING?
In India there was a time when cafè coffee day was on a rampage, each day they opened their new shop. How did they know they could do that? Because through 3-4 cafè they realized that using certain variables, they can sell certain items. So, they have a standard procedure to find a location, There should be geography, and they do that analyzes, How to serve, How much is the bill and many things more, and at the end there will be someone saying the revenue received 1 lakh rupees, the expense was 5 lakh, profit is 5 lakh. So this is similar to a trading system which is, you find something that works, then you see, can this work on a long term scale at the macro level. Start with a small capital, prove it works with the system, then scale it very slowly just like a business.
We will take a bunch of rules, when this happens I’ll buy this, based on math, we will learn this in technical analysis so that we can define scenarios based on price, and we can say this happens, then I will buy or sell this and you apply this rule to say 10 years in past. This is called backtesting, and it is a repeatable process because you can do it in the future. I will make some changes in my system and I can backtest, again and again, there are experiments. You keep running backtest you will have to backtest stats, which will find how many of your trades were profitable & non-profitable out of 100. So you have an expectation from the backtest, what can I expect when I trade this system. Here is this one example of Backtesting over 10 years.
In the coming parts we will learn how to make our own backstats strategies and technical analysis.
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