The Trading Equation:
The biggest question in the minds of the traders is that which stock to buy or which stock to short sell? Whether to be with the trend of the market or play against it? What to do at the market opening? Trading equation will serve appropriate answers to these questions. First, we will discuss generally what a trader does in a particular market situation or a particular market opening?
- Situation Number 1 (Strong Market Opening): For example, if the market is opened 1% up, a trader would do any of the following trades:
- Find the weakest stocks in the market & buy those stocks.
- Find the strongest stocks in the market & short sell the same.
- Situation Number 2 (Weak Market Opening): For example, if the market is opened 1% down, a trader would do any of the following trades:
- Find the strongest stocks in the market & short sell the same stocks.
- Find the weakest of the stocks in the market & buy those stocks.
- Situation Number 3 (Flat Market Opening): For example, if the market is opened few points up or down, a trader would do any of the following trades:
- Find the stocks which are weakest stocks for the day & buy the same.
- Find the stocks which are strongest stocks for the day & short sell the same stocks.
Whereas, ideally a trader should do exactly opposite of what he normally does. I mean to say here that ‘Trend is your friend’; so be with the trend. Trading equation would help you to follow this principle & earn good rewards. Let’s understand the concept of trading equation.
| Trading Equation | ||||
| Position | Market Trend | Stock Trend | Possible Outcome | Colours |
| Buy | Positive | Positive | Positive | Green |
| Buy | Negative | Positive | Neutral to Positive | Blue |
| Buy | Positive | Negative | Neutral to Negative | Yellow |
| Buy | Negative | Negative | Negative | Red |
| Short Sell | Positive | Positive | Negative | Red |
| Short Sell | Negative | Positive | Neutral to Negative | Yellow |
| Short Sell | Positive | Negative | Neutral to Positive | Blue |
| Short Sell | Negative | Negative | Positive | Green |
Explanation: Have a close look at the table given above. Try to understand what it is trying to say. Trading equation would help you to identify momentum stocks & trade with the trend. The trading equation is based on the following trading principle:
“Trend is your friend.”
It’s always confusion for the traders; whether to follow overall market trend or stock specific trend. The common mistake a trader makes is that he generally follow market trend & ignore the stock trend. Let me explain you this concept from market fundamentals.
- If market is up 2% or more, there are stocks which may be up 20% & there would be stocks which are down 10% or more. What I am trying to say here that in a rising market you can find stocks which are weak. For example, if there are 1000 stocks listed on a stock exchange, the equation in a strong market would be Advances: 700, Declines: 280, Same: 20.
- If market is down 2% or more, there would be stocks which are up 10% or more. What I want to say here is that you can find strong stocks in a falling market. For example, if there are 1000 stocks listed on a stock exchange, the equation in a weak market would be Advances: 325, Declines: 660, Same: 15.
It means whatever is the situation, there would be advances as well as declines, but the ratio of advances & declines may change as per market situations. In trading, stock trend is more important than the market trend. Precisely, a trader should follow stock trend as well as the market trend; but if the stock trend & the market trend are contradictory, the weightage should be given to the stock trend.
There are four major sections in this table which are descripted in different colours. The meaning of these colours would be explained further. On the other side, first column is showing position of a trader, i.e. buy or short-sell. Second column is showing the market trend, third column is showing the stock trend & the last column is showing the possible outcome considering the different situations & combinations. It’s not necessary that the outcome would be same what we have mentioned here, but if this is regular practice the outcome would be more or less same as mentioned as per the positions in different market conditions. This table is designed to make you a more disciplined & effective trader, but we don’t guarantee outcome of a position. The results mentioned here are on the basis probabilities & average results in different conditions.
It’s always said that ‘trend is your friend’. But what to do, when stock trend & market trend are contradictory? Consider an example, if we have to give importance to human beings; who is the most important person to me? Obviously it’s myself first, then my friends & relatives, and then comes other persons in the society. In the similar passion, if you have to give importance to the trend, first it should be a stock trend, then an industry trend & then the market trend. Let’s understand here, what can be the outcome in different market conditions:
- Green Section: This section is shown at the top & the bottom of the table given above. This would give you the best results. In this section you are following the stock trend along with the market trend. The trader would create the following positions in different market conditions:
- Buy: if stock trend is bullish & the market trend is also bullish.
- Short-sell: if stock trend is bearish & the market trend is also bearish.
It means clearly you are in win-win situation. Most of the times in this kind of position trader would book good amount of profit. I would like to warn here that a market may take various swings during the trading hours; a trader has to be smart enough to change his strategy as per market conditions. Charts would help you to understand the trend in a better manner.
- Blue Section: This section is also shown at the top & the bottom of the table but inside the green section. This would lead to positive results. This strategy is helpful when there is no clear trend in the overall market. Market may be range-bound trading with slightly positive or slightly negative bias. The trader can take the following positions in different market conditions:
- Buy: if stock trend is bullish, but the market trend is bearish.
- Short-sell: if stock trend is bearish, but the market trend is bullish.
This strategy is a limited risk strategy. This would lead to positive inflows, but the profit figures may be smaller in comparison to the green section. Sometimes, blue section may work better than green section. Especially in case of range bound market or when there is no clear direction but market is taking big swings.
- Yellow Section: This is the section to avoid in a trending market.The traders try to follow the overall market trend rather than stock trend. They try to buy weak stocks in a strong market and short strong stocks in a weak market. The trader carries following positions in the yellow section of trading equation:
-
- Buy: if market trend is bullish & the stock trend is bearish.
- Short-sell: if market trend is bearish & the stock trend is bullish.
Generally a normal trader would follow yellow section strategies in different market situations. This would lead to very small profits or big losses as stock trend is more important than the market trend. This is not suggestive to follow this kind of strategy. This strategy may be followed only in one situation i.e. when expecting trend reversal on the basis of technical analysis either in stock or in the market.
- Red Section: Red is the colour of loss (negative) in the stock markets. Never ever apply this strategy. No one want to take losses, therefore, no one should ever try to do the red section of the trading equation. Following are the positions carried by a trader in this section:
- Buy: if market trend is bearish & the stock trend is also bearish.
- Short-sell: if market trend is bullish & the stock trend is also bullish.
Some mistakes should never be committed by a trader under any circumstance. Red section is especially mentioned here to warn traders that some mistakes may become causes for disasters. I would mention only one thing for the red section, i.e. ‘avoid…avoid…& avoid.’
Trading equation can’t guarantee profits as mentioned here. This concept is based on probabilities. Most of the times markets move in trends. But sometimes it may not follow the trend & may move sideways. It depends on trader to trader that how effectively, he can make use of the trading equation.
How to use Trading Equation?
Strategy Number 1: If market opens strong in the morning, wait for 10-15 minutes; let the market settle down to find out its real trend. If still the market is trading strong, you need to find out stocks which are trading 2% to 4% up with good volumes & buy the same. Hold the position with a strict stop loss & reasonable target. Don’t buy the stocks which are up less than 2% (trend is not strong enough) or more than 10% (may give a strong pullback). You can expect the stock to go up 5% to 7%, which will give you a decent profit of 2% to 5%. This strategy works most of the times in strong markets. I would like to caution you here that uncertainty is the only certain thing in the markets, therefore, always trade with stop loss.
Strategy Number 2: If market opens weak in the morning, wait for 10-15 minutes; let the market settle down to find out its real trend. If market is still trading weak, you need to find out stocks which are trading 2% to 4% down with good volumes & short-sell the same. Hold the position with strict stop loss & a reasonable target. Don’t short-sell the stocks which are down less than 2% (trend may not be weak enough) or more than 10% down (may bounce back strongly). You can expect a decent profit of 2% to 5% in this trade. This strategy works most of the times in weak markets. A note of caution, ‘never ever trade without stop loss.’
Strategy Number 3: If market opens on a flat note in the morning; i.e. few points up or down. A mix of strategy number 1 & 2 can be applied here. If you want to be on the buyer side find the stocks which are strong and if you want to be on the seller side find the weak stocks. During strategy number 3, a trader may book smaller profits in comparison to trending markets. Keep the volumes low & trade less in this kind of market situation.
As discussed earlier, discipline is more important for a trader than knowledge. Consistency can be achieved through discipline only. Trading equation is another instrument to follow the discipline in stock markets. You should be flexible enough to change your strategy according to the market swings. Trading equation will help you to improve decision making under different market conditions.