Published on February 12, 2014
THE CMC MARKETS TRADING SMART SERIES Intraday Trading Challenges
Possibly the most difficult type of trading to come to terms with is intraday trading (also known simply as ‘day trading’). Yet intraday trading carries with it the most romantic connotations: traders frequently aspire to it as they see it as the area where most of the action happens. In this guide, we discuss various strategies you can use to make trading in short timeframes more precise. Proudly No. 1 for FX education Results from Investment Trends September 2011 Singapore FX & CFD Report, based on ratings given by 12,000 investors CMC Markets | Intraday Trading 2
Trading strategy and intraday trading The idea of intraday trading is, essentially, to utilise strategies that will keep traders in positions for a short period of time while generating consistent profits. The other upside – apart from the potential-forprofit side of things – is that it is possible to remain exposed to the market for the shortest period of time possible. The point of this is that you will not be so exposed to news-driven ructions that can adversely impact longer term position-holders. The final piece of upside for you is that, as a day trader, you can simply close your positions and not have a care in the world about what will happen in the market overnight. While the upsides of day trading need little in the way of introduction, the downsides do need to be discussed, because prospective traders (being the optimists that they are) do not spend nearly enough time thinking about them when confronted with a long list of benefits. The first issue to deal with is that the level of risk that you take on a pertrade basis still needs to be small relative to your returns. This may not sound like a big issue, but when you are trying to make your returns in a short space of time then the upsides are going to be a lot smaller as well. At the same time, because of your timeframe you need to have the ability to find new positions frequently. While a trend trader can carry a good position for months, this is not possible for the day trader who needs to lock in profits nice and quickly. Some would argue that this list of requirements is simply impossible to achieve, but the results of traders who specialise in this area would beg to differ. In this guide we will look at the way in which you need to manage your trading book, and also at how you can reduce the timeframe of existing methodologies you already use to suit this type of trading. Starting your day Once upon a time, the idea of day trading would mean that you were largely focused on the hours in which the local share market was open for trade. While this is still an option for traders, it is probably not the most practical for you to be looking at. This is because the share market is exposed to gapping at the open of each session where news and sentiment from overnight is immediately priced in. While this doesn’t mean that opportunities aren’t still available for traders, it does potentially lessen the amount of potential upside. For this reason, this guide focuses on indices and foreign exchange markets which trade either extended hours or 24 hours a day. While you shouldn’t feel limited to these, or even feel that these are the best options, they allow very effective stop placement and also allow traders to deal at any time that suits them, which is naturally advantageous. The first step that you are likely to take is to work out the broad trends you are interested in. This will mean looking to determine if you are near inflection points on the more macro market trends. For instance, if you take a look at the EUR/USD and see that it has moved toward a key support level, then this will likely be one of the potential trades you will look at. If you are trading a bearish reversal on a daily chart then this will likely put you a bearish bias even if you are dealing on an intraday basis. The rationale would be that the prevailing trend is now negative, so you would typically be looking to trade the broad trends and even the short-term trends that occur in that direction. If you have identified the prevailing trend of a market, then it makes good sense to align your overall strategy in that direction and not just the long term. It is a fairly logical conclusion that this will be the prevailing direction of the market. This means that your first step of the day must be to determine the direction of trends of instruments that you plan to deal in on the day. If you are dealing in foreign exchange, the impact of news releases throughout the day can have a very large impact on the performance of currency pairs. Unfortunately, this performance happens in the blink of an eye, so it means that unless your position is already set when the news is released, then you can largely say that you have missed out. A common strategy is to avoid intraday trading over the release of economic data because of the extreme volatility that can take place immediately after it is released – particularly if the data is significantly different to that of expectations. In the lead-up to major data releases, news services such as Bloomberg and Reuters survey a large number of economists in order to get their views on the levels at which the data will be released. The market will generally start to price itself based on these expectations, so when the actual data is released it may mean that prices will adjust significantly in order to be correctly priced based on reality. Traders are often able to see prices move in the lead-up to data releases, and this can show that sentiment is shifting ahead of the data release. Given the size of the FX market, it is safe to assume that it is not one or two people moving the market so the move in sentiment must be quite wide reaching. This is not to say that it is necessarily correct, but it gives you a good idea as to which way money is moving, which is very important. Long and short positions One of the strategies that a lot of novice traders get into involves taking a long and a short position in the same currency (sometimes using more than one account) right before the news release and placing a close stop loss on both of them. Once the data is released, the hope is that market will move rapidly in one direction, which will see one trade stopped out and the other significantly in profit. Sounds simple – but here’s the rub. Even though gaps in the FX market are significantly less common than equity markets, when they happen the impact is the same: no trading occurs with them. This means that if the move in price is significant, there will likely be a very large gap in price, which means that the trader trying to use this strategy will see significant slippage on the stop loss that they have placed. In reality, this has nothing to do with the CFD provider that you use and is instead a function of the ways in which markets operate. Something that can also occur when news is released is the market will move sharply in one direction, and then swing aggressively and reverse at least a portion of the price movement. This means that a strong CMC Markets | Intraday Trading 3
profit can evaporate quickly if you are not very careful. Depending on where you are in the world, it may mean a late night – but it is well worth watching the charts one night when the US Non-Farm Payroll data is released. This is the biggest piece of economic data in the world and has the power to seriously shift markets as well as forecasts for where the US and the global economy is headed. For this reason, it is the one to watch out for because you will likely get a decent response from the FX market even if the figures come out largely in line with expectation. Be sure that you know at the start of the day exactly what data is being released and decide whether or not you are going to be carrying positions while this data is released. Know how sentiment has changed during the night were generally lower, then this would certainly add evidence to your assessment. No matter what you are trading, then, you do not want to neglect the share markets, because as a gauge of sentiment they can be very useful to you. While this all sounds very simple (and as a quick exercise it probably will be) the thing that you need to remember is that all of this sentiment is already priced into the market. So looking at where sentiment has gone doesn’t give you an edge over other traders on its own, but it does allow you to start isolating trends in sentiment. You can start to ascertain what are the key drivers of sentiment at the moment and look at how sensitive the overall markets are to news releases and data. Consequences of reducing your timeframe For people who trade equities, the big gauge of sentiment that people look to is what happened in the US markets. If the markets were higher, then this is generally bullish, and vice versa. This type of information is of use for you regardless of what market you are trading because it starts to provide an idea as to how traders are thinking when it comes to a positive or negative attitude toward risk levels. When you develop technical methods of trading it is very likely that you will be using daily charts as your starting point. While it is the dream of many traders to work intraday, the reality is that it is not likely to be where the first trades are made. A good reason for this is that dealing in the very short term requires extremely well thought-out strategy and no hesitation at all to close out losing positions. Taking a broad brushstroke approach to signals of positive or negative risk attribution, a trader can look to some currencies being pro-risk and others being anti-risk. The idea of ‘risk-on’ and ‘risk-off’ sessions can be seen in the same way. Typically the market will look to the US dollar, the Swiss franc and the Japanese yen as being safe haven currencies. The ‘risk’ currencies are generally seen as things like the Australian dollar, the New Zealand dollar and the Canadian dollar. These last three are also regarded as commodity currencies because of the nature of where much of their sovereign wealth is derived from. Typically, any currency outside of the US dollar will be considered a risk currency to one extent or another. Interestingly, at the time of writing, we have gone through a phase where the US has struggled to increase their debt ceiling, which has again concerned the world about the state of the US dollar as the reserve currency. Nonetheless, the US dollar is not likely to be overtaken anytime soon and stripped of its mantle. Happily, for the most part, the methods you use can likely be kept consistent – you can simply apply them over a shorter timeframe. This sounds very simple, which is why you should be a bit suspicious, because there is a downside to this. CFDs have enabled people to trade very cheaply compared to prices of yesteryear, which is something to be cheerful about in the first place, but the price of dealing isn’t free. This means that if you are dealing in the shorter term then your cost of dealing overall will certainly rise. This happens because you are dealing more frequently, and also because the profits that you will be aiming to make will be significantly smaller relative to those that someone like a trend-follower would be aiming to make. If you are trading currencies, you may think that this is all that you need to look at. However, you can readily gauge sentiment from a number of different sources. The next one to look at is the bonds. In this area you will typically be assessing the price of US bonds and the European bonds. Essentially, when you look at these very solid products (the US government bonds are often seen as a proxy for a risk-free product) you are getting one of the best views of sentiment that you possibly can. In basic terms, if the price of bonds is rising then there is clearly greater demand for a low-risk product, which would suggest that overall sentiment is not particularly strong. Alternatively, if bond prices are falling then it would suggest that money is flowing out of this area and seeking higher returns in assets with higher risk. This is a simple assessment of what is a complex issue, but what it really illustrates to you as the trader is the need to try and determine where money is flowing and what this flow of money suggests about sentiment. In the previous paragraph, you saw the suggestion that an increase in bonds may suggest higher demand for risk assets. If at the same time you looked at the global share markets and saw that they The essence of this is that the shorter the timeframe becomes, the smaller your profit/loss ratio will likely become – which means that your win/loss ratio needs to improve to account for this. This sounds so simple, but anyone who has traded for any length of time will know that to be able to ‘just improve’ is essentially utopia for traders, so to speak flippantly about it is clearly ridiculous. Failing though to have a view to improving this will be to miss a key component of successful short-term trading. While looking at specific methodologies is outside the scope of this guide, the trader does need to establish extremely precise entry and exit methods, because there is simply no room for second guessing when it comes to decisions to open and close positions. While this should really be a feature of any strategy, it is of supreme importance in this case due to the fact that you have a lot less profit margin to be working with. It is on this point of comparison that the trader needs to be very confident in their desire to be an intraday trader, because it is you doing more of the work for your profits and less of the market. With the idea of superior precision in mind, you may find that setups involving things like moving average crossovers are less useful compared to trend reversals and support/resistance levels. The reason for this is that the latter will typically offer you a very clear entry level, and of at least equal importance is the precision of your stop loss CMC Markets | Intraday Trading 4
Chart 1 levels. Importantly, too, the style of setup that has been mentioned here will often allow you to employ very close stop losses too. Traders should be very careful using short-term support/resistance levels in many markets, including foreign exchange. While this is a very well-known means of trading, the breakouts of these levels in the short term can often prove to be bull or bear traps, meaning that you get a minor break and then a quick reversal. This is really frustrating if you have been stalking the trade for hours. Sometime a subsequent break of the level will hold, but if you have already been stopped out once you may (not surprisingly) feel a little bit timid having another go at the same setup. Chart 1 shows an example of how tricky some breakouts can be to deal with. Initially, the breakout occurred to the upside on this hourly chart. However, you can see that the breakout was far from clear, with the price trading on both sides of the S/R line for around four hours. You can see then in the right-hand circle that the price breaches the S/R line to the downside, which would have seen the trader knocked out of the trade if they had moved their stop loss higher. You can see that this price managed to move higher and get up toward a standard profit point based on this type of setup. As you can see, you should be very cautious approaching these setups because they will frequently play out in a much less tidy fashion than you will see on any demonstrative diagram. It also means that your stop loss will likely need to be placed further away from your entry level than you may otherwise have hoped for. You will likely need to reduce your position size accordingly, as you will otherwise be risking above a reasonable amount on a per-trade basis. Striking a risk: reward balance If you are expecting to make a gain of 5% on a trade, do you risk the same amount of capital whether you expect it to take an hour or a month to occur? From a purely philosophical perspective, the answer would be yes. If you have the same risk:reward profile and the same win/loss ratio, then clearly this is the correct course of action to take because you are making the same profit much more quickly. The reality of the situation, however, is that the question being asked is nowhere near this simple. Even beyond the simple fact that making 5% in a day is not going to be nearly as achievable as making it in a month, the intraday trader has to deal with the psychological difficulty of making or losing money much more quickly. Imagine if there is a negative swing in the market and five positions that you opened an hour ago are stopped out in quick succession. The fact that this happened so quickly does not make your trading strategy any more or less viable, but it can weigh very heavily on the trader. Given the speed this can happen, this type of trading is only really suitable for someone who is well conditioned at higher market timeframes. It takes a lot of mental nerve to be able to look beyond the ultra short-term ructions in the market and to persist with a strategy without having your confidence shaken even a little bit. The other side of the coin is also valid: this type of trader cannot allow themselves to get out of control after they have had a good string of winning trades either. Simply they must be able to persist with their plan through positive and negative trading conditions. CMC Markets | Intraday Trading 5
So you can see here that this is largely an illogical argument to be making. If you have a winning strategy, then you should be exploiting it as frequently as possible. Beyond this fairly obvious factor relating to your expected outcomes, you need to be confident that you will behave rationally in the face of adverse trading conditions. Annoyingly, this is an argument that has little to do with the soundness of a trader’s strategy and everything to do with the behaviour of the individual trader. Other alerts for turnarounds When it comes to very short-term timeframes, you will likely need to start focusing more of your market observation of price movement. When you are looking at price you are looking for trading formations that occur and worrying less about confirming tools like indicators and oscillators. You may feel that this is removing one of your major weapons for trading, but the payoff will hopefully be superior risk:reward ratios due to less degrees of confirmation being required before placing trades. You should check out our guide to candlestick patterns and look at the engulfing pattern and tweezers. These two setups can be an ideal starting point to quickly determine points of short-term reversal in price. With these particular setups you will likely be aiming for a very conservative risk:reward ratio, unlikely to be higher than 1:2. This may sound significantly smaller than you are used to, but if you are trying to capture minute gains then this is what you should be prepared for. Thomas Bulkowski, who conducted statistical studies on the high levels of reversal that the engulfing pattern was able to pinpoint, at the same time noted the very weak level of continuation that it pre-empted. You can deduct two things from this. Firstly, that many methods are not designed to capture significant price moves, and secondly that in order to be successful at this type of trading you will need to dedicate significant time to scanning the market and then quickly placing trades when the setups arise. Keep in mind that this type of trading has no resemblance to longer term methods such as trend following so it becomes much more difficult to capture ongoing movements in the market. You may find that you need to develop an alternative focus that is happy with the small gains you can capture rather than lamenting the gains that you left on the table. The old mantra of cut your losses and let your profits run doesn’t apply in the same way when your profits can evaporate very quickly. Summary While, for many, the idea of intraday trading may seem utopian, you need to be very clear that the shorter your trading timeframe becomes, the more precision is required in all facets of your trading. Typically, you will be dealing within a very narrow range of price, so timing of your entry and exits needs to be planned according to a well thought-out strategy and without any hesitation on your part. You will find that you can apply most technical methods to this type of trading, but you should probably focus more on those that require only price confirmation for the setup. The more indicators you apply, the more lag there will be on the entry and the exit. This may be satisfactory, but it may also impact your success – so you need to be mindful of this factor during the testing phase. CMC Markets | Intraday Trading 6
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