Smart tips on short term trading

There was a research conducted in United States on the average number of days investors hold the stock. The number was 187 (about 6 months) in 1991-1996 period. The median was worse with just 90 days. With internet boom era and overpriced IPOs in 2000s, this came down to about 3 months. There is no data available for Indian market, but looking at the volatility of our stock market the numbers will be very close or even less.

This clearly tells us there are mostly short term traders in the market. So, is there anything wrong with short term trading? Absolutely not, but investors should know the rules of the game before they trade short term.

Apart from knowing the rules, investors should also understand that short term trading mostly relies on luck and on study, which at best can be termed speculative.

In the current volatile market scenario, you could be tempted to try your luck in some short term investment strategies to make the best out of a bad situation. Here is an understanding of some short term trading strategies. And, whatever you do...always proceed with caution.

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Day-trade in stocks

In this trading style, traders buy and sell the stocks on the same day or in a very short period of time. The traders take advantage of daily market volatility to profit.

They buy when the stock prices go down hoping the prices to appreciate in the day. They square-off by the end of the day. This can result in profit or loss depending on whether the price they sold at was higher or lower than their buy price.

This is a very popular way to trade. The popularity stems from the fact that this looks exciting. Even if traders lose money, the loss doesn't seem big as daily variation is not very volatile.

Day-trading, however, is the most popular way to lose money. Majority of day-traders either lose money or do not make better than a long term investor.

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Investors look at daily loss and assume that this is not a big loss but accumulate the losses for the year and they can see the big picture.

Take an example. If I have 1 lakh and I gamble, I will be happy to earn Rs 2,000 from my gamble. However, I will not be too worried if I lose Rs 2,000.

This psychology works against traders. The happiness to get marginal profit is more than the sorrow of suffering a marginal loss. Take another example.

A buyer goes to a showroom and to buy a car worth Rs 300,00. At the last moment, he comes to know that the seller is giving Rs 6,000 coupon free to be spent in lifestyle.

At the same time, another buyer goes to another shop and buys the car at Rs 200,000 Rs 94,000. As they see their cars, who do you think will have a bigger smile?

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Risk mitigation

Investors should not put all their money in day-trading. If you are too excited by daily price volatility and want to try your hands in day-trading, put at most 10 per cent of your total investment for this and play with this. Do not gamble more.

Trading on margin

In margin trading, the investor spends some part from his or her pocket and borrows the rest from the broker at an interest. In this context, investors have to understand the concept of initial and maintenance margin.

Initial margin is the percentage of total investment that investors have to put. When the prices go down, your contribution in terms of percentage will go down.

After it goes below a certain percentage, the broker will ask you to put more money to take it to the initial margin. This "certain percentage" is called maintenance margin.

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Take an example. Let's say an investor, Rakesh buys 100 stock of Airtel at Rs 400 a share. The initial margin is 25 per cent and maintenance margin is 10 per cent. This means Rakesh has to put Rs 10,000 (25 per cent of total investment of Rs 40,000).

The rest Rs 30,000 is borrowed by broker. Suppose the prices start going down and goes to Rs 330 a share. In this case, the total value is Rs 330100 = Rs 33,000.

Let's now calculate what the contribution by investor at this point is. The investor contribution is (Rs 33000- Rs 30000)/33000. This is less than 10 per cent. Hence investor will get a call to put more money so that his or her contribution is 25 per cent of Rs 33,000 which is Rs 8,250. Since his amount is Rs 3,000, he will have to deposit another Rs 5,250.

This is high risk high return strategy. The advantage is that if the prices go up, you earn all the profit minus the interest you pay to the broker on his contribution. However, the loss is equally yours because the broker will anyway charge the interest. This is a double whammy.

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Risk mitigation

The only risk mitigation strategy is that the investors should never put more money when margin call is given by the broker. The investor, instead, should ask the broker to square off the position with whatever loss has happened. Avoid the temptation to put more money after the margin call.

Selling short

In this short term strategy, investors borrow and sell the shares and later they have to buy this from open market and give it back to the lender. The idea is to benefit from decreasing prices.

Investors short-sell stocks because they assume that prices will go down and when it goes down they buy it cheaper and give it back. The difference is the profit to investors.

Take an example. An investor Rakesh expects the price of Airtel with current market price at Rs 400 to go down. Since he has no stocks, he borrows 100 Airtel stocks from the market and sells it immediately earning Rs 40,000.

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After sometime, as he expected, the Airtel price went down to 350. He buys 100 stocks back at 35,000 and gives it back. He earns Rs 5000 from this transaction. We are ignoring transaction costs and other charges for the sake of simplicity.

Risk mitigation

Short-selling is speculative in nature and investors may lose if the prices go up. There is no guarantee that stocks will go down as expected.

There are other ways to mitigate the risk by using derivatives but those are out of scope of this article. If you are keen on doing it, use a very small amount (less than 10 per cent of your investment) for short-selling.

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In conclusion

Short term is tempting to investors. Short term trading offers excitement, action, and instant gratification. Compared to this, long term is boring, tedious, and requires extreme patience. However, there is no way to build wealth but by using long term strategies.

This is true for most of the investors. There are short term investors who have done tremendously well but they are few and far between.

Hence investors should put their major portion of investment corpus for long term wealth building assets and segregate a minor portion for short term speculation.