Short Term Trading Principles

There are primarily three types of traders/investors in the stock market:
Investors: Those who expect minimum 30-40% appreciation and are willing to hold between two months to a few years. They enter only long positions and usually select a scrip based on fundamental analysis. Medium-long term investors can utilise technical analysis to time their entry and profit booking better.

Day traders: Day traders enter long/short trades to square up the same day. They usually base decisions on technicals, information or at times, gut feel.

Short-term traders: Short-term traders expect 5-20% returns within 2 days to 3 weeks. They enter long as well as short positions. These include:

1. Position trading, where one either buys a stock and holds for the required appreciation, or sells from an existing long (or borrowed) position to cover at a lower level.

2. Futures & options trading

The popularity of Short-term trading, is on the rise due to the following reasons:
It provides an opportunity to make substantial profits in a short period and ensures continuous rotation of capital.

As against long-term investment, short-term trading has limited downside because of strict stoplosses.

Short-term trading has less demand on the traders time, while day trading requires full-time attention at the terminal. Hence, even those who pursue other professions can do short-term trading.

One can leverage on margin in case of short-term trading in futures.

Short-term trading in options requires smaller investment and has limited risk.
Like every discipline, short-term trading also has its Dos and Donts. These are not well understood by all. This article outlines these rules, which would make short-term trading a relatively safe and satisfying experience.
Basic Principles of Short-term Trading:

The first principle is to do few trades. At any point, one should not have more than 6 trades outstanding. A good number is 3-5.

Equal capital allocation: Divide your short term trading capital equally into each trade. Ideally if one has Rs 1 lac of capital, one should put around Rs 20,000 in each trade.

Clear Targets and profit booking: While entering a trade, one should be clear about the target price he expects to achieve. Once the target is reached, profits should be booked promptly. Here, some traders often fall to the greed-syndrome and hold on for more profits. This, more often than not, leads to losses in the long run.

Strict stoplosses: No strategy, however good, can ensure 100% success. A strategy that yields above 65% success rate is reasonably good. But there is a catch here! 65% success means you achieve your targets in 2 out of every 3 trades. But how much do you lose in the third? This is what determines your overall profitability.

The following example illustrates this: Suppose one invests Rs 10,000 in each of the 3 trades. The 2 successful trades fetch a profit of RS 1000 (RS 500 each) at 5%. Now, if the stoploss on the third unprofitable trade were also around 5% (including brokerage), he would lose RS 500 on it. Thus, his net profit across the 3 trades is RS 1000 RS 500 = RS 500. This is around 1.67% net return on the total capital of RS 30000. And considering that this is short term trading, the average holding period may be a fortnight. Therefore, the annualised return would still amount to 1.67% x 26 (26 fortnights in a year) = 43% per annum. Not a mean achievement by any standards.

But in the same example, if the trader does not have a stoploss, he continues to hold the loss-making trade. Finally, when he realises that he is in an irretrievable situation, he squares up the trade at say 15% loss. (In my experience, this is what happens to many traders when market suddenly turns bearish). In this case, he makes RS 1500 loss on this trade, which eats the RS 1000 profit he has made in the other two. Thus, he ends up with a net loss of RS 500 (-1.67%) on his 3 trades. At this rate, he would wipe out his entire capital in 2.5 years.

That should forever, put to rest the doubt whether stoplosses are needed in short-term (or for that matter in any type of) trading! Trading is like a war, you need to lose small battles to see another day and eventually win the war!
Dont "buy time": Often traders mix up various types of trading. For example, a trader entering a day trade carries his position overnight if the trade turns against him. Or, a short-term trader does not exit at a stoploss and converts it to a long-term investment. He hopes some day it will fetch him profit. These traders are just "buying time". Unfortunately, this works as rarely as you would find refrigerator in an igloo. Stick to your trading style and importantly; dont convert trades from one type to another.

Track your performance: A trader should monitor performance on every trade, as well as, across all trades. Remember, if trading is your business, run it like a business. Rigorously perform the forecasting, planning and monitoring that goes into it.

In a nutshell
Short-term trading has its advantages when compared with day-trading and long-term investment. It is suited for both full-time and part-time traders. When performed in accordance with the basic principles, it can be an engrossing and potentially lucrative activity/profession.