HOW TO TRADE Learn how to trade the way most successful traders that I know have become financially

independent. This guide is the beginning of a series of articles that show you the most common path I know of to successful trading. There are a lot of people who want you to learn how to trade using their new discovery of a secret way of trading. I have seen many of these secret trading methods come and go over the last 14 years which I have been trading. The principals shown here worked 14 years ago and they work today. This Learn How to Trade guide is designed to get aspiring traders pointed in the right direction. It is linked to additional articles on learning how to trade that will continue the journey. Beginning traders are sometimes dead set in their direction on learning how to trade using the misinformation that they have ac uired from sources other than successful traders. I have been trading for well over a decade now and I know a number of good traders. The people I meet who are new to trading usually have a lot of misconceptions about trading that need to be cleared up before they can learn how to trade successfully. !hat makes a person successful in trading is setting correct e"pectations# doing some homework and practicing the needed skills. Trading is not gambling although some of the Game Theory mathematics that applies to gambling can be of some use in trading. $on%professional gamblers will generally not make good traders unless they approach trading differently than gambling. &rofessional gamblers sometimes approach gambling with a careful study of the game they are playing and 'ame Theory mathematics to get consistent results( these gamblers can be good traders. Trading may trigger some of the same addictive reactions that gambling does in some people but not for me. I hate to gamble but I love to trade. I view most forms of gambling as a waste of money but I view trading like a great game of golf. !hen I go to Las )egas I see a lot of people putting their money on bets without really knowing much about what they are doing. They are untrained in the proper techni ues that are needed to win at what they are playing. The casinos take their money without much difficulty. If one of these Las )egas gamblers turns to science and becomes skilled at it then they will be permanently thrown out of the casinos. &eople who approach trading the way they lose money in Las )egas are just throwing their money away. Being a trader is being a skilled professional. *owever# trading is like being a skilled sports professional rather than a typical skilled craftsperson. + skilled craftsperson gets it right nearly every time in that his success rate is near 1,,-. If you play a professional sport you would not e"pect to achieve such high success rates# just having a winning season is often cause for much satisfaction. .nce you know how to trade you can e"pect to achieve /0%/1- winners. *owever# learning how to trade is learning how to accept your losses as well# which are 41%42- of your trades. Losing 41%42- of the time is not always easy because the losses are not always distributed evenly. There are times when you will have nine losers in a row and you still need to keep your cool and be confident that you know how to trade the ne"t trade. 3ou need to trade with careful risk management so that when you have a string of se uential losers you don4t blow out your account. !e will discuss proper risk management many times in this how to trade series because it is very important to your ultimate success. 5ost people who are unfamiliar with risk management strategies such as the Kelly Strategy will risk too much. 6orty &*.74s were asked to play a gambling game where they would be guaranteed to win 8,- of the time but at the end of 1,, rounds only two had more then they started with because of poor risk management. 3ou can get everything else right and still lose money unless you manage risk correctly. Learning how to trade is easier than many highly skilled professions but you will need to do your homework before you trade real money. &aper trade first and only after you have mastered paper trading should you slowly transition to real money 9mi"ing some paper and some real:. &aper trading today is done in an electronic simulation environment# not with real paper. !hen you trade you must do what needs to be done even though you may not want to do it. *uman instincts are often wrong and you must learn to resist these feelings that will lose you money. The way probability works is important to trading but is different than your natural instincts will lead you to believe. The 'ambler4s fallacy# also known as the fallacy of the maturity of chances is the belief that your odds improve when an unusual series of losses occur or that your odds of winning rises when you have a losing streak. ;ome slot machine players will prefer slot machines that have not paid out in a while in the belief that the chance of a payout has now improved. Let4s look at a coin flip e"ample< if you are flipping a coin and you get =heads= four times in a row then your chances of getting =tails= on the ne"t coin toss has improved. *owever# each coin toss is an independent event that is ignorant of every previous coin toss. ;ince the coin does not remember the previous string of heads it is not

biased in the ne"t toss. If fifty different people toss a coin in the air eight different times then the probability of at least one person getting all heads or tails is 2>.44-. That person with all heads 9or tails: probably had difficulty accepting the outcome but it is no less probable that the person who had e"actly >/ heads and >/ tails which were evenly distributed. +nother e"ample of how human intuition is wrong is the Monte Hall paradox and Bertrand's box paradox. 3ou are in a game show# and you4re given the choice of three doors< Behind one door is ?1#,,,( behind the others# ?1. 3ou pick door $o. 1# and the host 9who knows the right answer: opens door $o. 2# which has ?1. *e then says to you# =7o you want to pick door $o. >@= ;hould you switch your choice from 7oor $o. 1 to 7oor $o. >@ 5ost people would say no because their chance has not seemingly changed and 7oor $o. > does not seem to offer any improvement in their chance of winning. &eople are more inclined to stay with their choice once made. ;taying with your choice leaves you with a 1A2 chance of winning but changing to door $o.> increases your chances to >A2. It is surprising and not at all intuitive but it has been shown to be true 9hence the term =parado"=:. +s a trader you should learn what is true and re%train yourself to these truths while avoiding use of your natural human instinct. !hy something works in trading is unimportant# that is an academic e"ercise for the curious( the fact that it works is all you need to know. 6or many people it is hard to e"it a losing trade and accept defeat. &eople who have been reasonably successful in their life would rather hang in there and work that defeat into a victory. This is a recipe for disaster in trading. +fter several disasters the aspiring trader then over reacts and starts e"iting to soon. They want to e"it a trade if there is any loss showing at all because the pain of past disasters puts them in a panic. Bnowing how to trade means limiting your losers and giving your winners room to run 9we will discuss this more later:. 6or this discussion =being long= means to own a stock# bond# or whatever. If you are =short= then you have sold it after borrowing it from your broker such that you can only profit on it if it drops in price. How to trade your Opportunities +t this point I am assuming that you want to learn how to trade so we won4t e"tol the virtues of the independent private trader. 3ou need to pick what kind of trading you would like to do. This is very important because you need to match your circumstances and interests to one or more of the various trading opportunities. 7o not assume that anything you think you know or anything anyone has told you is accurate# because it often is not with new traders. Carefully weigh each trading opportunity listed below with an open mind before deciding. &eople sometimes get into trading on the wrong instrument or method for their financial situation# time schedule or personality and then they struggle to make it work. The instruments of trading There are four asset classes that are commonly traded< ;tocks .ptions

Bonds 6ore" 6utures

Stocks/Shares Trading stock shares is the most familiar and most commonly traded of the asset classes. This does not mean that it is easier or safer or better than the other asset classes to learn how to trade( do not confuse familiarity with safety or ease. ;tocks trade during the Dastern Time business day and in some cases for a few hours before and after the regular market hours. &art time west coast traders can usually get a few hours of trading in before going to work due to the time Eone differences. ;tocks represent indirect ownership of a business# including the most familiar ones in our daily life. 7o not confuse a good stock with a good trading stock. 6or trading purposes you must be emotionally indifferent to the stock( just trade the facts of the situation.

Beginning traders often have a false sense of security when they trade a stock that they have researched because their stud gives them a more comfortable feeling of familiarity. 6amiliarity is never the same as less risk. If you drive a *arley 7avidson motorcycle and are in love with it then do not trade the stock because you are too biased. If you have more than ?>/#,,, to trade then this is probably a good asset for you to begin to learn how to trade. ;tock 9and option: trading has the drawback of re uiring an account siEe of more than ?>/#,,, to trade more than four times in five days in a margin account 9=pattern day trade rule=:. To trade you need a margin account or you will need to wait three days after closing a trade before the the funds are cleared so you can trade again. Dven if you hold your trades for longer periods of time# like weeks at a time# sooner or later you will want to make more than four trades 9entering or e"iting trades: within a five day period because stocks tend to move together 0,- of the time and you may need to e"it or reverse several positions in your portfolio in the same week. + sub%category of stock trading is penny stocks. These are =pink sheet= stocks which are essentially worthless empty shells. If a stock selling for five cents goes up to fifteen cents then you could tripled your money. These stocks are worthless and none have ever emerged 9to my knowledge: to become a real company. This market is ruled by pump%and%dump schemes where someone puts out false information via emailAfa" spam that some penny stock is about to take off and become a real stock with some new positive development at the company. The distributor of this information buys the stock ahead of time and then sells into the suckers who are reacting to the false news by purchasing the stock. Options .ptions are very popular and can be very profitable. I recently made ?F#,,, in four days on some ;G& /,, DT6 option trades using just ?1>#,,, of my account balance# but that doesn4t happen very often. 5y options had lower risk because they were deep in the money and several months out in e"piration. It was a synthetic stock position with a lot more leverage than a normal stock trade would give me. This is called a stock replacement strategy or a synthetic position 9depending on how it is done:. !e will discuss this more later. .ptions can be the most comple" of the assets to trade. .ptions are based on another asset# like stocks or futures so you need to understand both the option and it4s underlying asset. Its best to learn how to trade options after you learn how to trade the underlying asset first. .ptions are also subject to the ?>/#,,, re uirement of the pattern day trade rule. onds This is an area best left to specialty brokerages. +ny one corporate bond issue is thinly traded and not suitable for independent traders working from home. These bonds should not be confused with H; Treasury bond futures# which are futures contracts %not the bonds themselves 9see below:. 6or long term investors it is better to buy bonds than to buy bond funds. +s long as you own a real bond 9not a fund:# you will get all your money back with interest 9unless they go bankrupt:. 3ou may permanently lose money in a bond fund no matter how long you invest in it. !ore" 6ore" trading is the trading of the e"change rate of currency pairs# like the Duro vs. 7ollar. This seems easy to understand and is not subject to the pattern day trade rule so you can open an account with ?1,, and start trading tomorrow. *owever# currency e"change rates change rapidly and these pairs can cause your trade to swing wildly in value# which I find difficult to trade successfully. In my unscientific sampling of traders I have found fewer people being successful with fore" than stocks# options# or futures trading. If your trading budget is tight then you may need to go this route# in which case you need to follow the lead of someone who is successful# like Todd 'ordon of +spen Trading. !utures I4ve saved the best for last. 6utures trading is usually the last asset to be considered by novice traders. I4ve known people who have traded stocks for more than ten years and have never seriously considered futures trading. + big part of the reason is that it is unfamiliar and mysterious to most people. I did not make my first futures trade until five years after I had started trading stocks and then found that it was a lot easier than I thought. Like any type of trading# you need to know what you are doing. 6utures trade >4 hours per day from ;unday night to 6riday afternoon and are not subject to the pattern day trade rule.

Tom 'risafi 9pictured at right: makes his living trading agricultural futures# primarily in grains# in his house in Indiana.

Futures are a contract for future delivery. For example, if you own a German car dealership you can buy a futures contract that will lock in the price of the Euro vs. Dollar for next quarter's car purchases to protect yourself from an adverse chan e in the exchan e rate. !he levera e in futures contracts is very hi h so a little money oes a lon way. "ver use of levera e can lead to excessive losses #remember the $%&$'( of your trades will be losers). Futures contracts can be had for stocks, stock indexes, commodities #corn, wheat, soybeans, etc.), *+ !reasury bonds, and much more. Futures offer a wide ran e of uncorrelated instruments to trade but caution should be exercised when holdin contracts overni ht as their value can chan e dramatically while you sleep. Futures contracts are rarely traded outside the *nited +tates but forei n investors who have *+ tradin accounts will kick up the action around $am Eastern !ime. ,ovice traders often ravitate to the +-. /00 futures electronic contract #E+), which is not the best choice most of the time due to the relatively hi h tick value and narrow daily ran e #more on this later). 1y favorite futures contracts are ,2, 31, E1D, and 4*!. 5 know some traders who swear by the FD67 #German stock index) but 5 would have to wake up too early to trade that one.

#ethods of Trading &atterns ;upport G Iesistance

5omentum Ieversion to 5ean Tells 6undamentals ;entiment

$atterns &atterns are one of the oldest and most widely used methods for forecasting price movement. The idea behind patterns is that people react in similar ways in certain well defined circumstances. &atterns have specific entry points and sometimes specific e"it points. There are a number of patterns and types of patterns available to use. +t the right are two common chart patterns that traders rely on. There are also patterns based on one or two 9or more: candlestick patterns# such as the 7oji patterns 9below:. There are also more obscure patterns like those used on point%and%figure charts 9not my cup of tea:.

Support % Resistance Trading support and resistance is a core method for me. If a stock# futures contract# or currency pair does not show good adherence to principles of support 9doesn4t want to go below a certain price without a fight: and resistance 9price levels that are somewhat hard to get through: then I am not interested in trading it. ;upport and Iesistance 9;AI: can be calculated for different time frames. 6or intra%day trading of stocks or stock inde"es 9including futures on stock inde"es: I find the 6loor Trader &ivot calculations to work best. .n daily charts you can usually see the Eones of support and resistance by looking back several months. 6ibonacci ratios are often used by traders to forecast ;AI levels and evaluate the likelihood that a pullback will be buyable.

*oriEontal lines are used for ;AI. ;loped lines are called trend lines and channels# which are different 9see below:. !e will discuss this more in a later segment. #omentum 5omentum trading is when an instrument 9stock# futures contract# bond# currency pair: is moving at a steady pace and in a clear direction# often cutting through the ;AI levels with relative ease. Time of day is often critical in that mornings and afternoons are best for momentum but midday is usually a bad time to trade momentum. +bnormally high volume is a sign that momentum is strong. 7eclining volume is a sign that the momentum is fading. !e have a proprietary tool for trading stock inde"es that looks at a bunch of underlying stocks from that inde" to see when momentum is strong or fading 9you can get a free trial at TradingComputers.com# it is the 6alcon Ieversal Indicator:. Re&ersion to #ean Ieversion to mean is a method that appeals to engineers and scientific traders a lot. It uses some fancy scientific math like standard deviation. The concept is the assumption that both a stock4s high and low prices are temporary and the stock4s price will tend to move back to the average price over time. Bollinger bands# trend lines# channels G the 5cClellan .scillator follow this assumption in one way or another. 5ean reversion works well in markets that have low momentum. If the market has too much momentum then you will lose every trade until the momentum slows.

Te''s Tells are a small group of stocks that you watch to discover early warning signs that momentum is fading# building# or reversing. The method of picking tells is the key to making them work but it is too long a discussion for this segment. Capital 5anagement Institute 9of which I have an interest: uses Tells a lot and they can teach you how to use them. The idea is that you can discern the mood of the market through the Tells. Let4s say 5icrosoft has just reported earnings and the top and bottom line numbers were good. *owever# on the earnings call they only beat on the bottom line because of a one%time ta" credit loophole. I would watch that stock the ne"t day as a Tell< is the market a glass half full market or a glass half empty market@ If 5icrosoft gets whacked the ne"t day then long trades that day would be much more risky because the market is in an unforgiving mood. !undamenta's 6undamentals are the classic !all ;treet fund manager4s tool for deciding when to buy or sell. Jim Cramer uses it along with most of the people on the C$BC show ast Money. 6undamentals are hard to fully understand as a professional fund manager# much less a private trader. I prefer technical analysis with a some fundamentals thrown in. It is better to be long fine companies and short bad ones than the other way around. 5ost fund managers pay for highly educated analysts opinions and they still get it wrong far too often# so don4t spend too much time on it but don4t be totally ignorant of it either. The problem with fundamentals can be compared to buying a classic car. 5ost car guys in their /,4s or older know that the .lds 44> was a hot muscle car in its time and should be valuable and collectable. *owever# an .ld4s 44> is only valuable to collectors if it has a manual transmission 9no matter how good the rest of the

car is:. 5ost amateur muscle car buyers don4t know this and might overpay for a 44> with an automatic transmission. The same is true for for fundamentals. 6or e"ample# in the semiconductor business the book% to%bill ratio is the most important thing to know when earnings are released. 6or telecom stocks you need to know the =churn rate= 9how many customer are lost to competitors: and if the churn is a little high then you need to look at the C+C 9customer ac uisition cost: to replace the churn losses. It is hard to reasonably know everything about fundamentals in sufficient detail for all the stocks you want to trade. It is a fine approach to improve your results for long term retirement investing# but for trading you should use technical analysis 9the other stuff in this list of methods:. Sentiment ;entiment is a gauge of the overall attitude of market participants. If everyone is bullish then they are probably all fully invested and there are no buyers left. It is contrarian logic in that if everyone is on the same side of the trade then it will reverse the other way. 5arket bottoms are made when everyone is so bearish that there are no sellers left. ;entiment does not give a precise entry point but can help you manage risk or embolden you to stay long even though the market seems overbought or the fundamentals seem weak. .n !all ;treet they say that the market =climbs a wall of worry= which is a sentiment statement< If everyone is worried then there is still plenty of uncommitted money left to buy more stocks. There are many ways to measure sentiment# such as how much money is loaned out on margin to traders# or surveys of bullishnessAbearishness. 7oug Bass at Ieal5oney.com uses sentiment to successfully decide his ratio of longs to shorts at his hedge fund. It is an important additional tool but often is delayed in its effect.

Time !rame ;calping 7ay Trading

;wing Trading +ctive Investing

Sca'ping ;calping is trading on very short time frames# like 4%1, minutes. The profits are much smaller but more fre uent. ;calping suffers from the fact that the fees paid to your broker will usually take a big percentage of your total profits. To be successful at scalping you need to have more than an F,- winning percentage. This sounds impossible but I have done it and so have others. *owever# even at F,- winners I only cleared about ?>, net profit after 4, trades due to the effect of trading costs and the >,- of losers 9losers are usually bigger than winners to get to F,-K:. Traders who scalp are probably better served by other trading methods but are either too impatient to wait longer or they prefer the e"citement of this type of trading. Day Trading 7ay trading is the buying and selling of securities on the same day such that at the end of the day your account is back in cash with no positions carried overnight. 7ay trading is common and many people have achieved financial independence with it. ;calping 9mentioned above: is a type of very short term day trading. 5any day traders are breakeven traders because they don4t manage losers properly and they fail to let winners reach proper profitability 9we will discuss this more later:. In my e"perience day trading is the least risky 9no overnight risk: and most profitable 9percent profit per day: of the time frames but it may take you a while 9monthsAyears: to master it.

3ou should always paper trade for a long time and then slowly transition to real money by alternating real and paper money. +lso# the first year that you do real money you should keep you trade siEe small because large trade siEes will be psychologically difficult. If you go to real money too soon or you increase your trade siEe too soon then you will trade like scared money# which will lose you money. $ot practicing with paper money and scaling up the real money trade siEe too soon is the most common cause of traders failing 9in my opinion:. If you are jobless and think that you can use your last little bit of money to become a day trader then forget it# that is too much pressure. ;et the money aside and stabiliEe your living situation first# then start to learn without that pressure. Swing Trading ;wing trading of stocks is the most common of trading styles and the one where new traders often find the greatest early success. In swing trading you hold most positions overnight and for several nights# weeks# or even months 9but not years:. It is very useful for retired people who have a substantial amount invested. To make a living by swing trading you should have more than ?1/,#,,, to trade with. Ieturns of more than >,- per year are hard to achieve consistently unless you are good at boosting your swing trading with the selling of options. 3ou should plan on making no more than 1/- per year after you are good at it. .nce you have a track record of more than two years then you can use that to plan your budget. 3ou can also mi" in a little day trading to improve your income. Acti&e (n&esting +ctive investing is where you hold positions for long periods of time for purely fundamental reasons and do not try to cash in on the ups and downs of the market. In active investing you monitor the health of your holding and make revisions as needed to stay with the best stocks. It is the type most commonly advocated by typical !all ;treet types and yields a rate of return generally below 11- per year. $osition Trading &osition trading of stocks is used e"tensively by hedge funds to manage their portfolios. It is in between swing trading and active investing in that any one position is usually held for a long time 9active investing: but there are many revisions to that position as the market prices rise and fall 9swing trading:. + position trader has =core holdings= that almost never are completely sold out but he sells some of it into rallies and buys it back on subse uent dips. 7epending on your skill level you can probably get returns at least as high as in swing trading because swing traders usually sell too soon# leaving behind additional profit that could have been made had he stayed in longer. 3ou can also effectively hedge your long positions with short positions or options to reduce the effect of selloffs. 5ore on this later. #arket )eutra' Trading This is a type of swing or position trading where you seek to remove the price action in the overall market by pairs trading or being otherwise fully hedged. *edging is where you create an offsetting position# such as being long !almart and short JC &enny. If !almart is a bullish stock and JC &enny is having a hard time then you will make money on them as the difference in value widens over time 9!almart going higher and JC &enny going lower:. This strategy removes much of the effect of the overall market fluctuations and will lower your overall return but it makes that return more reliable. E*uipment Just a uick note on e uipment here 9we will discuss it more in the ne"t part of this How to Trade trilogy:. Trading software 9also ne"t section: is very powerful stuff and there is a river of market data that will flow to your computer during the trading day such that ine"pensive home and office computers are not up to the job. 3ou also want e"pandability to add more monitors later. 6ull time traders almost always use more than two monitors and usually si" or eight. That may seem beyond your ability to grasp now but after you have been trading for a while it will seem very natural and comfortable. Imagine driving a car with just one window< it might work fine when you are a new driver and don4t want the distractions of side and rear windows but once you are good at driving you will want all the windows so you don4t have a crash with an unseen obstacle when you are making your moves on the road. Check out the computers at TradingComputers.com# they have what you need at reasonable prices.