Use Technical Analysis
You need particular analytical techniques and tools to determine when a trend starts and when it will likely come to an end. Technical analysis specializes in interpreting price trends, identifying the best time to buy and sell a security with the use of charts. Unlike fundamental analysis, technical analysis sees price as an all-important factor that tells the direction a security will take in the short term.
Here are three principles of technical analysis:
For the most part, the current price of a stock already reflects the forces influencing it—such as political, economic and social changes—as well as people's perception of these events.
Prices tend to move in trends.
History repeats itself.
From these three principles emerges a complicated discipline that designs special indicators to help the trader determine what will happen in the future. Indicators are ways in which price data is processed (usually by means of a calculation) in order to clarify price patterns, which become apparent when the results of the indicator's calculation are plotted on a chart. Displayed together with plotted historical prices, these indicators can help the trader discern trend lines and analyze them, reading signals emitted by the indicator in order to choose entry into or exit from the trade. Some examples of the many different types of indicators are moving averages, relative strength and oscillators.
Fundamental analysis can be used to trade, but most traders are well trained and experienced in the techniques of charting and technical analysis. It is a blend of science and art that requires patience and dedication. Because timing is of the utmost importance in active trading, efficiency in technical analysis is a great determiner of success.
Leveraged Trading
The short term approach of investing offers opportunities to realize capital gains not only by means of trend analysis, but also through short-term investing devices that amplify potential gains given the amount invested. One of these techniques is leveraging, which is often implemented by something called margin.
Margin is simply the use of borrowed money to make a trade. Say you had $5,000 to invest: you could, instead of simply investing this amount, open a margin account and receive an additional, say, $5,000 to invest. This would give you a total of $10,000 with which to make a trade. So, if you invested in a stock that returned 25 percent, your $10,000 investment turns into $12,500. Now, when you pay back the original $5,000, you'd be left with $7,500 (we'll assume interest charges are zero), giving you a $2,500 profit or a return of 50 percent. Had you invested only $5,000, your profit would've been only $1,250. In other words, margin doubled your return.
However, as the upside potential is exacerbated, so is the downside risk. If the above investment instead experienced a 25 percent decline, you would have suffered a loss of 50 percent, and if the investment experienced a 50 percent decline, you would've lost 100 percent.
You may have already guessed that, with leverage, a trader can lose more than the initial investment! As such, it is a trading tool that should be used only by experienced traders who are skilled at the art of timing entry into and exit from investments. Also, since margin is borrowed money, the less time you take to pay it back, the less interest you pay on it. If you take a long time to try to reap profits from a trade, the cost of margin can eat into your overall return.
The Risks of Active Trading
Active trading offers the enticing potential of above-average returns, but like almost anything else that's enticing, it cannot be achieved successfully without costs and risks.
The shorter time frame to which traders devote themselves offers a vast potential, but since the market can move fast, the trader must know how to read it and then react. Without skill in discerning signals and timing entries and exits, the trader may not only miss opportunities but also suffer the blow of rapid losses—especially if, as we explained above, the trader is riding on high leverage. Thus, learning to trade is both time consuming and expensive. Any person thinking of becoming an active trader should take this into account.
Also, the higher frequency of transactions of active trading doesn't come for free: brokerage commissions are placed on every trade. Since these commissions are an expense, they eat into the trader's return. Because every trade costs money, a trader must be confident in making decisions: to achieve profits, the return of a trade must be well above the commission. If a trader is not sure of what to do and ends up trading more frequently because of blunders, the brokerage costs will add up on top of any losses.
Finally, because securities are being entered and exited so often, the active trader will have to pay taxes on any capital gains realized every year.
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