Bonds can be an excellent investment vehicle. Sadly, they are often misunderstood and thus many investors don’t take advantage of the potential that bonds offer. Even if you aren’t interested in actually trading bonds, it can be of great use to understand the bond market and its relation to other markets such as equities.
In this article you will receive an answer to all of the following questions:
What is a bond?
How does a bond work?
What types of bonds exist?
What are the differences between bonds and stocks?
What is a Bond
When a company needs capital, they have multiple options. For instance, they could get a loan from a bank or issue more shares. A popular alternative to these two methods is to issue a bond. Bonds allow companies to borrow money from the public. One advantage of issuing bonds over issuing more shares is that they don’t have to give up any equity. Furthermore, bonds often have lower interest rates and can be cheaper than bank loans (for companies).
Just like with a normal loan, the company will pay interest to the buyers of their bonds. Furthermore, they promise to pay the borrowed money back after a certain time-frame.
Bonds can be issued by companies or even by government entities.
How Does a Bond Work
Bonds work very similarly to normal bank loans. The following list summarizes some of the key features of bonds:
Face Value: The face value is also referred to as par value. This is the value of the bond when it is first issued. The most commonly used face value is $1000.
Coupon Rate: The coupon rate is the yearly interest rate paid by the bond. Just like with normal loans, these interest payments are usually paid at regular intervals (e.g. once or twice per year). Typically, the coupon rate does not change.
Maturity: Just like all loans, bonds also have an expiration after which the bond issuer has to pay back the borrowed funds. This time-frame is also known as maturity. The maturity of a bond can vary widely. It can be shorter than a year or as long as 30 years.
Price: The price is not the same as the face value. Just like stocks, bonds can also be bought and sold after they are issued. The face value refers to the value of the bond at issue, whereas the price refers to the money that you could currently buy or sell the bond for.
Yield: The yield of a bond takes into account the current price of a bond and its coupon rate. The yield is typically calculated by dividing the coupon rate by the bond’s current price.
Hopefully, this gives you an overview about how a bond works. Next up, I will discuss some of the risks associated with bonds.
The Risks of Bonds
Just like stock prices, bond prices also change. One of the main factors influencing the price of a bond is how its yield compares to that of similar bonds. For instance, if the yield of one bond is much lower than that of other bonds, fewer people will want to buy this bond which will likely lead to a drop in its price.
However, if you are planning on holding a bond until its maturity, these price fluctuations won’t affect you. You will still receive the same sized interest payments as you normally would. Furthermore, no matter what the price is, you will be paid back the face value of the bond at maturity.
Longer maturity bonds usually have higher yields because they are more exposed to changes in interest rates. But more on shorter vs longer term bonds later.
As bonds don’t give you any equity, a bond gives you no direct exposure to a company’s stock price.
The main risk of bonds is that the issuer will default. If this happens, the bond issuer won’t be able to meet their obligation to pay back the borrowed money. Depending on the bond, this risk can be very low to moderately high. Riskier bonds usually also have higher coupon rates. The bonds with the lowest default risk are those issued by stable governments.
For instance, US Treasury bonds (issued by the US government) are considered some of the lowest risk financial instruments because it is very unlikely that the US government will default. With that being said, very low-risk bonds such as US Treasury bonds also have low yields. For example, at the time of writing this, US Treasury bonds have a yield of under 3%.
How Does a Bond Work – Example
To make how a bond works as clear as possible, let me outline the entire process from issuing the bond to its expiration with an example:
Company XYZ needs $1’000’000 to finance one of its newest projects. They don’t want to give up any of their equity which is why they don’t issue more shares. Instead, they have decided to issue 1000 5-year bonds with a face value of $1000. The coupon rate is 7% and the interest payments occur semi-annually.
You decide to buy two of these bonds for $1000 each. If you hold these bond until maturity, you will receive $70 twice a year for the next five years. As long as company XYZ does not default, you will be paid back the entire $2000 that you paid for the two bonds after 5 years. This means that you will have made a total profit of 5 * $140 = $700 on a $2000 investment after 5 years.
Alternatively, you could also sell the bond sometime before maturity. If you do this, you won’t receive any further interest payments. The price at which you will be able to sell the bond depends on a variety of factors. The biggest factor is the coupon rate of comparable bonds. If the yield of XYZ’s bond is relatively low, you might not be able to sell the bonds for $1000 each. However, if XYZ’s bond yield is relatively high compared to similar bonds, you might even be able to sell the bonds for more than $1000 each.
How to Trade Bonds
Just like stocks, there are multiple different ways to trade bonds. Probably, the most common way to trade bonds is just to buy and hold them for their interest payments. If you buy and hold a bond until its maturity, you won’t be exposed to the changes in the bond’s price. You will only be exposed to the risk that the borrower will default and changes in interest rates.
To clarify this let me give you an example. Let’s say you buy a $1000 10-year bond with a coupon rate of 3%. This would mean that you will receive 3% of $1000 ($30) every year for the next 10 years. Over the next few years, interest rates go up and other similar bonds have coupon rates up to 6%. Now your bond doesn’t look that attractive anymore. Now you have two options:
Just hold on to the bond until maturity.
Sell the bond. However, as your bond has a much lower coupon rate than other comparable bonds, you likely will only be able to sell it for less than $1000.
Hopefully, this example clarifies how bonds’ prices can be affected by changes in interest rates. This exposure to interest rates is higher for longer term bonds because interest rates are much more likely to change in a long time period than in a short one. To compensate for this, longer term bonds often have higher coupon rates. But more on this later.
An alternative trading style to buying and holding a bond is to bet on the price fluctuation of the bond. If you are doing this, you are mainly betting on the changes in interest rates.
Generally speaking, bonds are a great investment vehicle for diversification. Depending on the bond, they are relatively low-risk vehicles with predictable behavior.
The Yield Curve
I just described an example of how changing interest rates can affect the price of a bond. Furthermore, I mentioned that longer term bonds are more exposed to changing interest rates. Therefore, longer term bonds normally offer higher yields than short term bonds. But sometimes this isn’t the case.
The yield curve is a chart that plots the yields of short term vs medium term vs long term bonds.
Here is a great video that explains what the yield curve is and how to use it:
What is the Yield Curve, and Why is it Flattening? - YouTube
Different Types of Bonds
Now that you know what bonds are and how bonds work, let me present some of the different types of bonds that exist:
US Treasury Securities
Treasury securities are considered one of the safest investment in existence. The reason for this is that they are backed by the US government as the issuer of these bonds is the US Treasury. Furthermore, they are very liquid.
But as these bonds are very safe, they have some of the lowest yields out of all bonds.
There are three main types of US Treasury securities:
Treasury Bills (T-Bills): These are short term zero-coupon bonds. They have life spans from only a few days until one year. Zero-coupon means that they don’t pay any interest. Instead of receiving interest payments, you will be able to buy T-Bills for a discount.
Treasury Notes (T-Notes): These are medium term bonds with maturities from two to ten years. The interest payments for Treasury notes occur semiannually (twice a year).
Treasury Bonds: These are very long term bonds with a maturity of 30 years. Treasury bonds also pay interest twice a year.
Different than many other bonds, the minimum investment for US Treasuries is only $100 (instead of the more common $1000).
Corporate bonds are the bonds issued by companies that need money and don’t want to get a loan from a bank or issue new shares. Different than buying stock, buying corporate bonds does not give you any ownership rights in the company. You are simply lending the company money.
The specifics of a corporate bond vary from company to company. The maturity generally is as short as a year or as long as 30 years. The coupon rates can also vary widely depending on the type of company, industry and much more.
Most of the time, the minimum investment for corporate bonds is $1000.
Municipal Bonds (Munis)
Municipal bonds are issued by governmental entities such as states and cities. They are used to raise money for public projects (e.g. for schools, roads, general infrastructure…). These bonds can vary greatly in quality, liquidity, risk, coupon and maturity.
Some municipal bonds have maturities up to 30 years, whereas others have maturities of only a few years. Furthermore, some municipal bonds are zero-coupon bonds (issued at a discount) and others have regular interest payments.
The minimum investment for municipal bonds usually is $5000.
In addition to the bonds mentioned so far, there also exist non-US bonds. Most countries have their own set of bonds that can be issued by a country’s government, by companies in the country and more. Buying foreign bonds can be a great way to further diversify your portfolio as they allow you to gain exposure to other countries/economies.
Depending on the state of the different country/company, the risk and yield can vary widely. Generally, all the specifics for the different foreign bonds can differ a lot. However, the overall structure of these bonds should be very similar to that of US bonds.
As most foreign bonds pay interest in the country’s local currency, foreign bonds also expose you to currency risk. This is the risk that the local currency can increase or decrease in value compared to the US Dollar.
Besides the types of bond just presented, there also are some other (less popular) types of bonds that I won’t cover in this article.
The tax laws for bonds highly depend on the type of bond that you are trading. For instance, the interest payments that come from US Treasuries are only subject to federal income tax, whereas interest payments from corporate bonds are subject to both federal and state income tax.
Usually profits and losses that come from selling a bond are taxed in the same way as profits and losses from stock trades.
What are Investment Grade Bonds
Corporate and municipal bonds are subject to so-called credit ratings. These credit ratings are performed by credit rating agencies. The three biggest and most well-known credit rating agencies are:
Standard and Poor’s
These are also known as the “Big Three” credit rating agencies.
These rating agencies rate the credit risk of different bonds and rank the bonds into different categories. The categories vary from rating agency to rating agency. To explain the different categories, I will use the Standard and Poor’s rating scale.
This is how S&P’s rating scale looks like:
Bonds that are rated AAA are usually very high-quality bonds that have a very low risk of default. These bonds are also referred to as prime. The further down the scale you go, the higher the rated risk of default becomes.
There are two overall categories when it comes to bond ratings:
Investment Grade: Investment grade bonds are those with a rating better than BB+ (and better than Ba1 on Moody’s scale). These are usually considered relatively safe, high-quality investments with a low risk of default. The yield of investment grade bonds is normally relatively low.
Non-Investment Grade (Junk Bonds): These are the bonds that have worse ratings and thus don’t make it into the investment grade category. To compensate for the added risk, junk bonds have higher yields which is why they are also known as high-yield bonds.
After bonds have been issued, their rating can still change. The price of a bond can be severely impacted by a change in its rating.
Government bonds such as US Treasuries aren’t subject to these ratings. But they are considered to be of the highest quality (AAA).
Note that there have been multiple scandals with credit rating agencies in the past. For instance, in the aftermath of the 2008 financial crisis, rating agencies have faced severe criticism as a lot of their ratings have not been objective which, today, is considered one of the causes of the 2008 crisis.
Stocks vs Bonds
Stocks and bonds are two entirely different investment vehicles. Stocks give you ownership rights in a company (equity), bonds don’t. Bonds are debt obligations that are used by companies and governments as an alternative to issuing stock and loaning from banks.
Generally speaking, bonds are much less volatile and also less risky than stocks. But this highly depends on the bond. For example, US Treasuries are considered the safest investment in existence as they are backed by the US government. This means that the risk of a US Treasury bond is that the US government will default which is very unlikely.
On the flip side, the returns of bonds are usually also lower than those of stocks.
As bonds offer exposure to very different factors than stocks, bonds and stocks are quite uncorrelated. Therefore, a combination of bonds and stocks can be a great way to diversify your portfolio.
Bonds are a great investment vehicle with relatively low risk and low volatility. They can be a great way to further diversify your portfolio.
However, just like with all investments, it is very important to do your research before investing any money into bonds. The exposure and risk that different bonds offer can vary widely. So make sure to be aware of the risks before risking any hard earned money.
I really hope that this article helped you understand how bonds work. I would love to hear if you are planning on adding bonds to your future investment arsenal, in the comment section below.
Some people consider news essential information for successful trading. However, other people claim that news is nothing but useless noise. So should you ever trade the news and if so, how should you do it? After reading this article, you should have a pretty good idea about the actual role of news in trading.
How Important is News Really?
There is no question about that news can be a good way to stay updated about what is going on in the world. But is it also a good way to stay updated about the financial markets? Should you ever trade the news?
My answer to these questions is: it depends. To clarify this, let me present you some of the problems that I see in financial news media:
1. Lack of objectivity
This is the case for almost all news outlets. All of them have some sort of bias and, therefore, they aren’t 100% objective. But this lack of objectivity is far worse in financial news than in normal news because often the topics presented in financial news are subjective, speculative theories. For instance, the exact reason behind a certain price move isn’t always known. Nevertheless, financial news often present their explanations as facts even though they aren’t anything than speculation.
2. There can’t be no news
Furthermore, it is important to understand that most news stations make their money from their news. This means that they always have to push out new news stories even if there isn’t anything going on. This often leads to irrelevant or even worse, made up news stories. That’s also why news stations have new news stories for even the tiniest of market moves. Most of the time, normal daily price fluctuations have nothing to do with these news stories.
There have even been cases in which the same news stations have contradicted themselves by stating that a specific news event was the cause for rising prices in the morning and the exact same news event was the reason for falling prices in the afternoon. Obviously, this doesn’t make any sense. It is very likely that there was no specific reason for these minor price swings. However, as the entire business model of news stations relies on outputting news, they can’t afford to report no news. (Even if there isn’t any real news.)
3. Backfit explanations
The vast majority of the time, news is about something that has already taken place. Therefore, news stations often add backfit explanations to past events. These backfit explanations might make a lot of sense in hindsight, but most of the time they have nothing to do with the actual event or price move.
Does this mean that news is completely useless?
No, but it means that the majority of financial news is nothing else than irrelevant noise. So my recommendation for looking at news it to focus on objective stories with actual consequences. Examples of this could be earnings announcements, Fed announcements, and similar stories. I recommend using an economic calendar and paying attention to only the most important upcoming events.
So to what extent can you really profit from news?
Once again, the answer is: it depends. The main problem with most market-impacting news is that everyone has access to it. This means that millions of people will gain access to the same information at once. Often, institutions and big investors even have access to this information beforehand. Therefore, it can be really hard to gain an edge from the news.
When Should You Trade the News?
Here are some of the few cases that I could come up with in which you might be able to successfully trade the news:
1. Long Term Impact
If major news comes out that likely will have a severe longer-term impact on an assets price, you might be able to open a position before the entire move has occurred. However, obviously, this often is a quite speculative bet.
2. Trading Through The News
One way to profit from certain financial news is to already have a position open before the news is released. By doing this, you won’t have to compete for a position right after the news comes out as you already have a position open beforehand.
However, this also comes with some disadvantages. First of all, often you might not be able to predict when news will come out and even if you know when the news will be released, it can be close to impossible to predict if the news will be positive or negative. Even for binary news events such as earnings announcements, it can be extremely difficult to predict the outcome. Not even ‘professional’ analysist and economists manage to consistently predict the earnings results of companies and the consequential stock price reactions.
Due to this, I don’t recommend trying to predict major news. The only scenario in which it can be beneficial to trade through major news is if the following is the case:
The news has two possible outcomes: positive/negative. An example of a binary news event would be an earnings announcement in which the earnings figures either beat or miss earnings targets.
The Risk/Reward ratio is tilted severely in your favor or you have a very favorable probability of profit.
Trying to predict news is usually a gamble, so if the odds aren’t stacked in your favor, it’s normally best to avoid news speculation.
3. Be There Before Most Others
The last tactic that can be used to profit from news is to be early. This only really works for major news that hasn’t spread yet. For instance, when a company wins a huge contract. This news might take up to a few days to completely spread. So if you are able to take a position within hours of the news release, you might be able to take advantage of all the latecomers that will push the price into a certain direction.
The problem with this is that for most well-known companies, it is almost impossible to be early. Most well-known stocks have millions of viewers all the time. Therefore, this only really works for less well-known stocks.
When a less well-known stock has new major news, it often leads to a significant price move. If you are able to catch the news early, before this major move, you can certainly make profitable trades. When doing this, make sure to pay special attention to the news. It has to have some kind of medium to longer-term impact on the company. Otherwise, it likely won’t have a big enough effect on the stock’s price.
If you want to learn more about all the intricacies of this strategy, I recommend checking out Tim Sykes. Tim Sykes is a very successful trader that specializes in lower-priced stocks. One of his strategies is the one that I just described. He offers extensive courses and material for anyone interested in learning his way of trading.
I hope this article shed some light on the role of news in trading. It is much harder to gain an edge from news than you might think. Nevertheless, it is important to have some general market awareness. In other words, you should have a general idea about what is going on. You can easily get a good understanding of the overall market conditions by scanning major news headlines, using an economic calendar or simply by following major market indices such as the S&P500.
The vast majority of financial news is irrelevant noise and should, therefore, not be treated as valuable trading-relevant information. Only big economic events, earnings announcements and similar news really deserve your attention.
I personally don’t recommend directly trading on the news. Instead, I recommend using it to get a broad idea about what is going on. Rarely, do I put on a trade as a direct consequence of any kind of news.
With that being said, there are some strategies that can be used to trade based on news events. But all of them have their disadvantages and risks as well. Therefore, I only recommend using the news-trading strategies presented in this article if you really know what you are doing and have a clear trading plan with implement risk management strategies for each and every trade.
If you aren’t completely sure how to put the strategies of this article into practice, you could check out Tim Sykes education for concrete guidance.
When trading, things sometimes don’t turn out to go entirely according to your plan. But what do you do if this happens? Do you sit tight and wait, close the trade or do something else? In this article, you will learn about a few options adjustment strategies that will help you deal with struggling options trades. These adjustment techniques will help you minimize your risk without eliminating the potential for profit.
General Adjustment Guidelines
Before we get into any specific options adjustment strategies, I want to start by presenting a few general principles to always follow when adjusting your positions.
1. The entry trumps any adjustments
This first point isn’t really an adjustment principle. Instead, it is a general trading guideline. In my opinion, the most important part of a trade is the entry. No adjustment methods will allow you to turn an otherwise terrible trade into a good one. This means you should spend the majority of your time on the opening process of your positions and not on the adjustment process. In other words, a good trade setup and entry is far more important than any trade adjustments.
2. Have a clear plan
The next adjustment guideline to follow is to always have a plan for when to adjust your position before putting on a trade. Your plan should answer all of the following questions:
Will I adjust this position if it goes against me? For some options strategies, it might not necessarily make sense to adjust the trade at all. Sometimes, taking a small loss can be superior to any adjustments. But it is important to decide this before putting on the trade.
At what point will I adjust it? If you decide that you want to adjust your trade if it goes against you, you need to set a clear adjustment point. This adjustment point could be a price level of the underlying asset, a certain delta value, an implied volatility level or something else.
How will I adjust it? Last but not least, you should also plan how you potentially will adjust the trade. Here you don’t have to know every single detail, but you should definitely have an idea about how you will adjust the position if it reaches your adjustment point.
3. Don’t jump the gun
This guideline is about where to set your adjustment point. You should not adjust your position extremely aggressively. You should not adjust your position as soon as it goes slightly against you. Give your trades some room to breathe.
One reason why you shouldn’t adjust your positions too quickly is that the probability of touch is about twice as large as the probability that an option will expire ITM. This means that most positions will be tested at some point before their expiration. I recommend checking out my article on options trading probabilities to learn more about the probability of touch and the probability of ITM.
4. Decrease risk
A common adjustment mistake is taking on additional risk. But this does not really make sense as the entire point of adjusting a position would be to limit your downside potential while still leaving some room for the upside. If your trade is riskier after an adjustment than before an adjustment, I would not consider the adjustment successful.
An example of a good adjustment would be one in which you do not increase the risk, but you give yourself more time to be right. Another good adjustment of a losing trade could be one in which you move the breakeven point further out without increasing the risk.
To prevent increasing the risk, I usually recommend only adjusting if the entire adjustment can be done for a net credit. But more on this later.
5. Efficient capital management
Before adjusting a position, always ask yourself if this adjustment is the most efficient way to allocate your capital. Usually, an alternative to an adjustment would be to simply close the position and open an entirely new position.
So before adjusting a struggling trade, ask yourself where your money will do more for you: in a new trade or in an adjustment of this trade. It only makes sense to adjust a position if the capital allocated to it will be at least as efficient as a new trade.
Options Adjustment Strategies
Now that we covered some general adjustment guidelines, let us move on to some specific options adjustment strategies.
How to adjust an Iron Condor
Let me start by presenting an options adjustment strategy for the defined risk and defined profit strategy, short iron condor. A short iron condor is a neutral, range bound option strategy that achieves max profit if the underlying asset’s price is between the two short strikes at expiration.
The following image is an example of how you could set up an iron condor:
First, it is important to understand when you even should consider adjusting an iron condor. In my opinion, it would only make sense to adjust an iron condor, if the underlying’s price breaches either the upper or lower leg of an iron condor. I would not recommend adjusting an iron condor if the price stays in between the two short legs.
The following image shows the payoff diagram of the iron condor that we just set up. The two arrows indicate potential adjustment points.
The most intuitive way to adjust an iron condor would be to move the tested side further away from the underlying asset’s price so that the breakeven point is further out.
Let’s say that the underlying price for the just-shown iron condor moves up and beyond the upper short strike price. Therefore, we close the short 105 and long 110 call options and sell a new call at the 110 strike price and buy one at the 115 strike price.
If you make this adjustment the new payoff profile of our iron condor will look as follows:
is the original payoff profile.
is the new payoff profile.
As you can see, the new upper breakeven point is much higher than the original one. HOWEVER, the profit potential dropped and even worse, the total risk increased! This is a direct violation of the 4. adjustment principle that we defined earlier in this article.
Even though it is definitely possible to adjust an iron condor like this, I would not recommend it as it increases the overall risk which isn’t something I would want to do with an adjustment.
So what should you do instead?
A better way to adjust an iron condor is to move the untested side closer to the underlying asset’s price. If the underlying’s price breaches one side of an iron condor, you usually aren’t worried about the other side. Furthermore, the other side normally won’t be worth a lot anymore as it will be quite far OTM.
This iron condor adjustment technique takes advantage of exactly this. It allows you to take profits in the untested side and collect additional premium by selling a new side closer to the underlying’s price. This won’t only decrease the overall risk and increase the profit potential, but it will also move the breakeven point further out.
In other words, it’s a win-win-win situation.
This is how the original payoff profile (1.) looks compared to the adjusted payoff profile (2.).
The only real disadvantage of this adjustment technique is that the profitable range becomes smaller. So if the underlying’s price comes all the way back, it might not be ideal. However, otherwise, it certainly outperforms an unadjusted iron condor.
The great thing about this adjustment technique is that you could theoretically repeat it over and over again as long as you still are able to collect enough premium. If that’s the case, you could decrease your risk, increase the profit potential and move out the breakeven point again and again…
You sell the following iron condor on ABC which is trading at $50 at the time of entry:
1 long 40 put
1 short 45 put
1 short 55 call
1 long 60 call
Now ABC’s price drops down to $42 which is your adjustment point. The adjustment would be to move the call options lower. This can be done by closing both call options and then selling the 50 call option and buying the 55 call option. The new iron condor would look like this:
1 long 40 put
1 short 45 put
1 short 50 call
1 long 55 call
Let’s say you could make this adjustment for a net credit of $0.5. This would mean that the max loss decreased by $50 and the max profit increased by $50. Furthermore, the lower breakeven point was moved lower as well.
What about straddles and strangles?
This iron condor adjustment technique can also be used for other options strategies such as short straddles or short strangles. All you have to do is close the untested side and sell a new option closer to the underlying asset’s price.
Generally, just make sure to leave some room for the underlying price to move in. Don’t adjust too quickly and don’t adjust too aggressively!
What is going inverted?
If you repeat the just-presented adjustment technique over and over again, your put strikes will move closer and closer to your call strikes. At one point, the short put strike might even become the same as the short call strike. If this is the case, you won’t be able to repeat the adjustment again for iron condors as you won’t be able to make the adjustment for a net credit.
But if you are trading strangles (or straddles), you will still be able to continue moving up the put side (or moving down the call side). This would lead to your put strike being higher than your call strike. This is also known as ‘going inverted’.
Let me explain this with a brief example. Let’s say you sold a strangle on XYZ which is trading at $100 with the following strikes:
Now XYZ’s price moves up and beyond $105. Therefore, you buy back the 95 put option and sell a new one at the 100 strike price. Your new strangle looks like this:
XYZ’s price rises even more. So you decide to roll up the put option once again. The new strangle has the following strikes:
XYZ’s price continues to rise even further. Thus, you do the same adjustment one more time. Now your position looks as follows:
Now you just went inverted because the put option’s strike price is higher than the call option’s strike price. There usually isn’t something wrong with going inverted. Just make sure to collect enough premium to make the move worth it. You can’t go inverted for iron condors or other defined risk strategies as you won’t be able to do this for a net credit.
How to Adjust Credit Spreads
We can use the same approach as we used to adjust iron condors for credit spread adjustments. One great way to adjust credit spreads is actually to turn them into iron condors. From there on you will be able to use the above adjustment method for any further adjustments.
Once again, we do not touch the tested side of the strategy. Just like last time, I will present this options adjustment strategy with an example. The following image shows which short call vertical spread we will use for this example:
Similarly to before, a good adjustment point for credit spreads is when the underlying’s price breaches the short (or long) option. In our example, we assume that the underlying asset’s price moves up to about $108 (which is right between the short and long strike price).
Now we sell a second put vertical spread to turn the original position into a short iron condor. The following graphic shows how the payoff is affected.
is the original short call spread
is the new short iron condor
As you can see, our adjustment, once again, significantly decreased the overall risk, increased the profit potential and moved out the breakeven point of the call side. The new position looks like this:
long 90 put option
short 95 call option
short 105 call option
long 110 call option
After this initial adjustment, you could theoretically, move up the untested side, if the underlying’s price continues to rise (and you are able to collect enough premium).
Like I said before, don’t be too aggressive with these options adjustment strategies. Give the underlying’s price some room to move in. You don’t want to sell the put spread too close to the underlying’s price. Otherwise, a big price reversal could hurt you.
Adjusting for Time
So far, we have only discussed options adjustment strategies that decrease your risk and increase your profit potential. In addition to these adjustment strategies, you can also adjust your positions for more time. The advantage of adjusting for time is that you give the underlying’s price time to come back into the profitable range.
Keep in mind that when adjusting for time, we still want to consider the general adjustment principles defined at the beginning of this article. So we still don’t want to increase the overall risk of a position. In practical terms, this means that the adjustment has to be done for a net credit.
How to adjust for time?
The specific strategies to adjust a position for more time are relatively simple. All you do is close your current position and reopen the same position in a later expiration cycle. The only problem with this is that you often won’t be able to make this adjustment for a net credit. Therefore, you often have to change the strike prices in the new expiration cycle.
Let me give you a concrete example:
You sell the following strangle on ABC which is trading at $200:
short 190 put option
short 210 call option
30 days until expiration
Over the next 20 days, ABC’s price drops down to $185. This means that your strangle only has 10 days left until its expiration date and things aren’t looking great. Now, you could use the adjustment technique presented earlier in this article (where you move down the short call option). The problem with this is that, you likely won’t collect a lot of premium as there isn’t a lot of time premium left in the options.
So what you could do instead is close the entire position and look at the options in the next expiration cycle with about 40 days left until expiration. One way of doing things would be to sell the exact same strangle in this expiration cycle. However, often, you won’t be able to do this because you couldn’t do it for a net credit. If this is the case, you could either move the upper strike closer to ABC’s price or move both strikes.
For the sake of this example, we will say that we have to move down the call strike to close the previous strangle and sell the new one in the new expiration cycle for a net credit. So the new position looks as follows:
short 190 put option
short 205 call option
40 days until expiration
With this adjustment, you just gave your position 30 more days to work out without increasing the risk. Furthermore, this adjustment moved the lower breakeven point closer to the underlying’s price.
For which strategies can you extend time?
Once again, rolling should only be done for a net credit. Sadly, this limits the strategies which you can roll to undefined risk strategies. You usually won’t be able to roll defined risk strategies such as iron condors for a net credit. So this adjustment strategy is mainly for strangles and straddles.
When should you roll?
You should not roll too early or too late. If there still is a lot of time left until expiration, you could either just wait or use the previously presented adjustment method in which you just move the untested side closer to the underlying’s price.
In my opinion, a good time to roll your positions to the next expiration cycle is about one week before the expiration date. So in the week before expiration week.
Even though adjusting your struggling positions can improve your overall profit and loss, it is important to not overestimate the importance of adjustments. Adjustments can be great, but you should still focus most of your attention on the trade entry!
There are obviously many ways to adjust options strategies. But in my opinion, the options adjustment strategies presented in this article are some of the best. But feel free to incorporate other adjustment techniques into your trading as well. My advice for this would be to still follow the general adjustment principles that I outlined at the beginning of this article.
Furthermore, make sure to not adjust too aggressively. Always remember that it is quite likely that a trade will be a loser sometime before expiration. So just because a position goes slightly against you, does not mean that you should immediately make an adjustment to it.
Define a rational adjustment point and adjustment strategy as a part of a clear trading plan before opening a trade and then stick to this plan.
Generally speaking, undefined risk strategies are easier to manage than defined risk strategies. The tradeoff here is that undefined risk strategies are per definition riskier than defined risk strategies. So depending on your risk appetite, capital and other preferences, you might prefer one over the other. But I would not say that one is clearly better than the other.
All the strategy images and adjustments were taken from The Strategy Lab. The Strategy Lab is a tool that TradeOptionsWithMe recently developed to help traders deepen their understanding of the options markets.
If you want to improve your understanding of options, make sure to check out The Strategy Lab:
I have a question for you. Please try to answer it as honestly as you can:
How Well Do You Understand Options Pricing And Options Strategies?
To help you answer this question, I have prepared three statements. Make sure to read them and then consider to what extent you agree with them:
I know more than 8 different options strategies and their basic payoff behavior. (Agree/Disagree)
I know what the Greeks are and how to use all of them in my trading. (Agree/Disagree)
I completely understand the relationship between implied volatility, time and price of a wide variety of multi-leg options strategies. (Agree/Disagree)
If you fully agree with all of the just-mentioned statements, you clearly have a very good understanding of options pricing and options strategies.
But don’t worry if you didn’t fully agree with all of these statements. I have created a tool that will help you develop a much better understanding of options pricing, options strategies and much more. I call it The Strategy Lab.
Everything in the Strategy Lab is based on the Black Scholes Model – a mathematical model that won a Nobel Prize in Economics. The model was developed by Fischer Black, Robert Merton, and Myron Scholes and is still one of the most commonly used derivative pricing models.
What Is The Strategy Lab
The Strategy Lab allows you to visually learn all the intricacies of the rather complicated Black Scholes options pricing model. Furthermore, it allows you to directly see how changes in market conditions can and will impact your trades. Summed up, The Strategy Lab is the research tool for option strategists.
In my opinion, the best way to present The Strategy Lab is with a short video presentation:
Interactive Charts of All The Greeks For Every Strategy
Over 2 Dozen Preset Strategies
Fully Customizable Strategy Creator (Supports Up To 6 Legs of Options and/or Stocks)
3-Dimensional Interactive Graph That Visualizes The Relationship Between, Implied Volatility, Time and Price For Every Strategy
Works On All Devices
Very Easy To Use
Ability To Save All Charts
Lifetime Access + Access To All Future Updates
Excellent Customer Support
Access To The Strategy Lab From Anywhere, Anytime
In-Depth Guide To The Strategy Lab
The following image will give you an overview of how The Strategy Lab looks like:
How much does The Strategy Lab cost?
The final price of The Strategy Lab will be a one-time payment of $50. However, if you are reading this, you still have the chance to gain lifetime access to The Strategy Lab (including future updates) for a one-time payment of $29.
Let me present you an example of how The Strategy Lab could be used to analyze the commonly used option strategy: short iron condor.
The exact iron condor that I used was set up in the following way (default short iron condor):
The following animation shows how changes in time affect a neutral short iron condor. With the help of The Strategy Lab, this can be done by sliding a slider to the left. You can see the days until expiration of this iron condor on the right-hand side of the animation. (The dotted line represents the underlying’s price at entry.)
For the sake of this example I chose to display four plots:
At Expiration (blue): This shows the payoff of this iron condor at its expiration date.
X Days Out (orange): This plot shows the payoff of this iron condor X days before expiration.
Delta * 10 (green): This plot shows the Delta of this short iron condor multiplied by 10.
Theta * 10 (red): This plot shows the Theta of this iron condor multiplied by 10.
Theoretically, it would also be possible to display the plots of all the other Greeks at once. However, then it would be hard to recognize what is going on.
The blue ‘At Expiration’ plot looks just like you would imagine the payoff diagram of a short iron condor. It achieves max profit if the price of the underlying stays between the two short strikes (95 and 105). The max profit of this iron condor is $351.4.
Max loss, on the other hand, will occur when the underlying’s price is either below the 90 long strike or above the 110 short strike at expiration. The max loss is $149.
When changing the time until expiration, the blue ‘At Expiration’ plot is not affected because there always are 0 days left for this plot.
Next up, let’s discuss the orange ‘X Days Out’ plot. As seen with this plot, time clearly has an impact on the payoff behavior of the iron condor! The impact that the passing of time has depends on where the underlying asset’s price is. If the underlying asset’s price is in between or near the two short strikes, the impact of passing time is positive. Otherwise, the opposite is the case.
This means, as long as there still is sufficient time left until expiration, an iron condor can still be profitable even if the underlying’s price moves slightly above the upper or below the lower short strike price.
Now let me present, what the Delta plot shows you. Delta is the option Greek that measures the effect that a $1 increase in the underlying’s price has on the option’s price.
While the price of the underlying asset is 100, the Delta of this iron condor is 0. This makes sense as this iron condor is a neutral strategy and wants the underlying’s price to stay inside of a certain range. That’s also why the Delta becomes positive if the underlying’s price drops and negative if the underlying’s price rises. If the underlying asset’s price drops, the iron condor becomes more and more bullish and the opposite is the case for increases in the underlying’s price.
With less and less time until expiration, the Delta of this iron condor right around the long strikes becomes more and more extreme. This means with less and less time, this iron condor becomes more sensitive to changes in the underlying’s price. So a small move in the price of the underlying can have a much larger impact on this iron condor when it has little time left than if it would have many days until expiration.
That is one of the multiple reasons why it is a good idea to take profits early on iron condor trades. The longer you wait, the more volatile the profit and loss of the iron condor becomes.
Last but not least, let us talk about the Theta of this iron condor. Theta is the option Greek that measures changes in an option’s price for changes in time. In other words, Theta is the amount that an option’s price will change for the passing of one day.
As you can see on the animation, the Theta of this iron condor seems to be pretty flat while there still is a lot of time left until expiration. However, as time passes, Theta seems to awaken. This means that for every day that goes by, this iron condor will change more in price than it did the day before. The increasing sensitivity to changes in time is not linear. The closer the iron condor gets to its expiration date, the more its payoff will be impacted by changes in time.
Furthermore, it is evident that the Theta is positive while the stock price is in between the two short strikes. This indicates that time will have a positive effect on this iron condor’s payoff while the stock price is between the two short strikes and negative if is elsewhere. The closer the iron condor gets to its expiration date, the narrower the range in which time has a positive effect becomes.
Now we covered all the plots shown on the animation above. Hopefully, my relatively basic analysis of this iron condor could give you some insights into how to potentially use The Strategy Lab. Obviously, this only just scratched the surface of The Strategy Lab’s analysis capabilities.
I only analyzed the effect of time on four plots on one chart of one variation of one option strategy. In addition to this, you could also analyze all the other Greeks, the effect of changes in implied volatility, the effect of changes in the risk free rate, the ‘IV, time and price relationship chart’ and much more for hundreds, thousands or even more different strategies and their variations.
The Strategy Lab allows every trader, regardless of skill level, to significantly improve their understanding of options strategies, options pricing and the dynamics of options in the markets. These are things you need to know to become a successful (options) trader!
I hope that you can see how The Strategy Lab can further develop your understanding of options and thereby improve your profitability as a trader. You can gain lifetime access to The Strategy Lab with less than the profits of a single good trade: $50 $29
Dealing with emotions and having the right mindset whilst trading can be one of the hardest parts of becoming a successful trader. Humans simply aren’t completely rational beings, especially not when hard-earned money is at risk. That’s why the main differentiator between winning and losing traders is not their strategies. It is their mindset!
To acquire the mindset of a winning trader, you can read books to learn from the industry’s best. This article will cover the best trading psychology books that I have personally read and enjoyed. Some of the books have been written by well-known and highly respected psychologists such as the Nobel Prize winner Daniel Kahneman. Some of the other books that I will present give you direct insights into how some of the most successful traders deal with their psychology.
The amount of knowledge and value you get for the price of one book is incomparable with any trading course, seminar or conference that you will ever participate in.
1. Trading In The Zone by Mark Douglas
‘Trading In The Zone’ is a book written by Mark Douglas who is also the author of the ‘The Disciplined Trader’ – another book on trading psychology. It is the first and best trading psychology books that I have read so far. The 216-page long book has 11 chapters covering various trading psychology topics.
In ‘Trading In The Zone‘, Mark Douglas states that he thinks the main factor separating winning from losing traders is their mindset. Therefore, his goal with this book is to help you acquire the mindset of a winning trader. The book teaches you to think in probabilities and focus on the big picture instead of focussing on the results of single trades. Furthermore, Mark Douglas provides you with a concrete list of rules to follow to make sure you are making good trades. Ever since I read this book, I have printed out a copy of this list and some additional notes from the book and taped it next to my trading screen.
One major part of ‘Trading In The Zone’ is Mark Douglas’ so-called ‘Five Fundamental Truths’:
Anything can happen.
You don’t need to know what is going to happen next in order to make money.
There is a random distribution between wins and losses for any given set of variables that define an edge.
An edge is nothing more than an indication of a higher probability of one thing happening over another.
Every moment in the market is unique.
Without reading the book, some of these truths might seem obscure. However, after reading the book, you should understand why each of these truths is indeed the truth. Understanding these truths allows you to trade like a casino without getting emotional because of a losing trade.
If you are struggling with emotions while trading or have problems handling losing trades, this trading psychology book will definitely help you deal with this.
2. The Daily Trading Coach – 101 Lessons For Becoming Your Own Trading Psychologist by Brett N. Steenbarger
‘The Daily Trading Coach’ was written by Brett N. Steenbarger, PhD – a clinical associate professor of psychiatry and behavioral sciences at State University of New York Upstate, trader and author of multiple trading psychology books.
Professional traders that work in trading firms often have access to psychologist trading coaches such as Brett N. Steenbarger. These trading coaches help the traders solve various of their trading problems so that they can become better and more profitable traders. Retail traders such as you and me, however, usually don’t have access to this kind of service.
To solve this problem, Brett N. Steenbarger wrote ‘The Daily Trading Coach’. The goal of the book is to help you become your own daily trading coach. The 349-page long book has 11 chapters that cover 101 different trading lessons.
‘The Daily Trading Coach’ is not written in the same way as most other books. It isn’t designed to be read once from the start to the end. Instead, it is divided into chapters that each cover a different psychological trading problem. These chapters are then further divided into different trading lessons with coaching cues (clear exercises to help you deal with certain problems), resources and much more.
This means you can always go to any section of the book to clearly find out how to deal with a specific psychological trading problem. There you will find concrete coaching cues that you can add to your trading process to help you improve that aspect of your trading. While reading this book, I recommend focusing on a few aspects of your trading at once. I don’t recommend trying to improve all the mentioned aspects of your trading by doing all the exercises at once. This would be way too overwhelming and likely lead to no or very small improvements only.
If you want to learn how to become your own trading coach with concrete trading exercises from a clinical psychologist that often helps professional traders with their trading problems, I highly recommend checking out ‘The Daily Trading Coach’ by Brett N. Steenbarger.
The International bestseller ‘Thinking, Fast and Slow’ was written by the psychologist Daniel Kahneman who was awarded the Nobel Prize in Economics in 2002.
Even though the book covers trading concepts such as decision making under uncertainty, risk and more, it is not written specifically for traders. Instead, it tries to explain how humans think. It presents different kinds of thinking systems (a fast and a slower one) and the issues with each.
The 499-page long book is divided into 5 parts (Two Systems, Heuristics and Biases, Overconfidence, Choices, Two Selves) with a total of 39 chapters. The book sheds some light on the actual rationality of humans. It shows that often humans act much less rational than you might think. Furthermore, it shows how people (even very well educated people) constantly fall prey to cognitive biases that can impair their decision making. (Cognitive biases are flaws in cognitive processes such as remembering, evaluating or reasoning.)
One of the things presented in the book is ‘Prospect Theory‘ that tries to explain how people make decisions under uncertainty and risk. One very interesting finding of Kahneman is the effect of wins and losses of the same size on humans. He found that a loss will negatively affect someone significantly more than a same-sized profit will impact the same person positively.
The following graph illustrates the asymmetry of the emotional impact of a same-sized profit or loss on most people. All the intricacies of this model are thoroughly presented in the book.
In my opinion, this trading psychology book is written very well. Daniel Kahneman presents the different biases, heuristics, and theories with a lot of examples and very small exercises so that you can see if you too make irrational decisions. This book might very well severely impact the way you think, not only while trading. Therefore, I definitely recommend reading Thinking, Fast and Slow.
4. Reminiscences of a Stock Operator by Edwin Lefèvre
‘Reminiscences of a Stock Operator’ by Edwin Lefèvre is a classic trading book that belongs into every trader’s bookshelf. Even though this book was originally published almost a century ago (1923), it still covers some very relevant and important topics.
The book is about the life and trading of one of the best traders of all time, Jesse Lauriston Livermore (July 26, 1877 – November 28, 1940). During the 1929 crash before the Great Depression, Livermore made about 100 million US Dollars in total. Note that this was in ‘1929 USD’, which would be multiple billion USD in ‘today’s Dollars’.
During his career as a trader, Livermore made and lost fortunes multiple times. He ended his life in 1940 after losing everything yet another time. So it is safe to say that Livermore had A LOT of trading experience and important lessons to share.
‘Reminiscences of a Stock Operator’ was ranked 15th on ‘Fortune’s 75: The Smartest Books We Know’ and labeled a classic by The Wall Street Journal. The book has 24 chapters and a length of about 247 pages.
This book is not a trading psychology specific book. Nevertheless, it covers some important psychological and other trading lessons that Livermore has learned during his career. It is not often that you get the opportunity to learn from one of the best traders in history. So like I said before, this is a book that every trader should read.
Jack D. Schwager is a trader and the author of an entire series of trading books: The ‘Market Wizards’. Up to this point, I have read two out of the ‘Market Wizards’ books and I already own the third book out of the series.
The idea behind the ‘Market Wizards’ series is that there already exist extremely successful traders, so why not just learn from them? Jack D. Schwager meets up with some of the top traders alive and interviews them about their trading approach, trading advice, the markets, their mindset and similar topics. Even though the books aren’t solely about trading psychology, they do show how some of the best traders deal with their psychology while trading.
The ‘Market Wizards’ will teach you tons of important technical and psychological trading lessons. They allow you to see what kind of mindset you need to have to become a truly great trader.
The ‘Market Wizards’ series consists of the following three books:
Market Wizards – Interviews with Top Traders
The New Market Wizards – Conversations with America’s Top Traders
Hedge Fund Market Wizards – How Winning Traders Win
In my opinion, these books are written and structured in a very good manner. Nevertheless, some things might be hard to understand if you are a complete beginner to trading and the stock market. So if you are totally new to the markets, you might not understand everything in all of the books. Otherwise, I really think every trader should read and learn from the ‘Market Wizards’! It isn’t often that you get the opportunity to learn from dozens of the world’s most successful traders!C
6. Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb
Nassim Nicholas Taleb, PhD, the author of ‘Fooled by Randomness’ is a former quantitative options trader who has dedicated his life to studying randomness, uncertainty and probability. Furthermore, he is the author of The Black Swan and has been a professor at multiple universities.
The 368-page long trading psychology book ‘Fooled by Randomness’ is about the role of randomness in the markets, science, evolution, past performance and our life in general. Furthermore, Nassim Nicholas Taleb writes about the completely overrated role of the media in the markets. He also presents how very rare events (black swans) impact our life in and outside the markets. In addition to that, he talks about the right and wrong way to manage risk. Certain cognitive biases and how to avoid them are another topic that Nassim Nicholas Taleb goes over.
One very interesting thing that is mentioned in ‘Fooled by Randomness’ is that in almost every moment the currently best performing traders are actually some of the worst traders. Without context, this might seem very counterintuitive or even paradoxical. Nassim Nicholas Taleb’s explanation of this statement is that the currently best performing traders are simply those that are best fitted to the current market environment. However, as soon as the market behavior deviates from its current behavior, these traders often blow up because they fail to adapt.
Let me give you an example:
During the incredible bull-run of Bitcoin, some traders made unbelievable amounts of money. The traders that were long the most amount of Bitcoin, made the most amount of money. So someone who had a highly leveraged long position in Bitcoin was likely one of the best performing traders of that time. But as soon as Bitcoin’s price stopped shooting up, these traders stopped making money. Many of these Bitcoin traders even lost most of their money on the sharp decline that followed after Bitcoin’s peek in December of 2017.
This means that the best performing traders during the Bitcoin mania often weren’t good traders at all. They simply were best fitted to the market at that exact time in history. You could say they just got lucky… Perhaps a result of randomness?
The Bitcoin craze is just one of countless examples. I hope it could give you some insight into why often the best performing traders frequently are the worst traders.
‘Fooled by Randomness’ is written in a quite amusing, slightly arrogant, but very understandable style. I definitely recommend reading it as it certainly has the potential to change the way you think about many things, including the significance of randomness in your trading and in your life.
Nassim Nicholas Taleb has released a second edition of his book ‘Fooled by Randomness’. As the newest version is longer and more detailed in some aspects, I recommend getting the newest and best version.
Having the right mindset and keeping your emotions in check while trading is an essential part of becoming a successful trader. One of the best ways to acquire the right mindset is by learning from the lifeworks of industry experts such as psychologists and highly successful traders. Books allow you to do exactly that.
I hope you enjoyed reading this list of the best trading psychology books. I have read all of the trading psychology books mentioned in this list and I do certainly recommend all of them!
Have you read any other trading psychology books that you think deserve a place on this list?
If so, make sure to let me know in the comment section below!
There are basically two major categories when it comes to investment styles. The first is investing for capital appreciation. An example of this is buying stocks or other assets hoping to profit from an increase in the asset’s price.
The second investing style is investing for cash flow. One of the most popular ways to invest for cash flow is investing in dividend stocks. Dividend stocks allow you to receive payments from your stocks in regular intervals. This can be compared to receiving rent from a real estate property that you are renting out. The main difference being that you don’t have to worry about all the work related to keeping your property in good condition.
In this article, you will learn everything you need to know about how dividend stocks work and how to properly invest in dividend stocks.
What are Dividends and why do they exist:
Before we get into how dividend stocks work, it is important to understand what dividends even are and why they exist. When a company goes public, it receives money from investors in exchange for ownership in the company. These investors are also referred to as stakeholders.
At the end of every year, there are two possible outcomes for a company’s profitability: Either it has generated a profit for the year or it hasn’t. If a company has managed to generate a surplus in revenue, it has to decide what to do with its profit. The two most common options are:
Re-invest the profit back into the company/keep it in form of retained earnings.
Pay the surplus out to its stakeholders.
The second option is also known as paying dividends. This means dividends are basically nothing else than a distribution of a company’s profit to its shareholders.
As a company can make the choice to pay or not to pay dividends, not all companies pay out dividends. In fact, out of the about 500 large-cap companies in the S&P 500 index, ca. 93 did not pay out any dividends in 2018.
How Dividend Stocks Work:
Now that you know what dividends are and why they exist, let me present what you need to know to take advantage of dividend payments. The dividend payment process can be broken down to four days:
The Announcement/Declaration Date: This is the date on which the company announces that it will pay out dividends. During the time leading up to the ex-dividend date, the stock price tends to increase by about the amount of the dividend as investors are willing to pay a premium to receive the dividends.
The Ex-Dividend Date: If you want to receive dividends, you have to own shares of the stock before the ex-dividend date. You will not receive any dividends if you buy the stock on or after the ex-dividend date. Furthermore, the stock price will drop by about the amount of the dividend on this date.
The Record Date: If you sell your shares of the stock before the record date, you will not receive any dividends. This means you have to own shares of the stock during the time between the ex-dividend and record date to receive dividends.
The Payment Date: This is the date on which the company actually pays out its dividends. As long as you owned shares of the stock before the ex-dividend date and until the record date, you will receive dividends even if you don’t own any shares on the payment date.
I created the following infographic to hopefully, help you understand how dividend stocks work:
If you want to download this infographic, you can do so by clicking here.
As you can see, it is not possible to buy a stock just before the dividends are paid out and then sell it right after it. You have to be a shareholder for a certain amount of time to be eligible for dividends. The length of this time frame usually is a few days.
After a company pays out dividends, it is theoretically worth less than before because it hands over cash (for cash dividends) to its shareholders. This is also one reason why the stock’s price drops on the ex-dividend date.
Furthermore, if the stock’s price would not be adjusted downward on the ex-dividend date, it would allow for arbitrage opportunities. This is the case because an investor could buy the stock right before the ex-dividend date, sell it right after the record date and receive the dividend. Simultaneously, the investor could hedge his long position so that he is (more or less) immune to price fluctuation. This would lead to a profit of the size of the dividend received.
If, however, the stock price drops by the amount of the dividend on the ex-dividend date, the investor would have a loss in the stock position of the size of the dividend which would offset the profit from the dividend received.
If you frequently short sell stocks, it is important to understand that if you are short a stock on the record date, you will have to pay the dividend! Therefore, make sure to check any upcoming dividends before shorting a stock.
Different Types of Dividends:
I will now present the different types of dividends that a company could choose to pay out:
Cash dividends are by far the most common type of dividend. Furthermore, they are the most straightforward. When a company pays cash dividends it simply distributes its profits to its shareholders in form of cash. The amount is usually expressed on a per share basis.
For instance, a company could declare a dividend of the size $0.5/share. This would mean that for each share that you own in this company, you will receive $0.5.
Stock dividends are nearly as common as cash dividends. Nevertheless, they aren’t as rare as other dividend types. When a company declares stock dividends, it issues new shares of stock and distributes these to the current shareholders. For example, if a company declares a 1% stock dividend, you will receive one additional share for every 100 shares that you already own.
The problem with stock dividends is that they lead to dilution which means that even though you receive additional shares of the stock, your total position value won’t increase as the stock price should drop. In this sense, stock dividends are essentially miniature stock splits.
Stock dividends are usually used when a company either doesn’t have cash available or doesn’t want to distribute its current cash to its investors (likely due to liquidity reasons).
Besides cash and stock dividends, other dividend types do exist as wel. I won’t cover them though because it is very rare that a company declares any other type of dividend than one of the just-mentioned ones.
How often are Dividends paid out?
The frequency of dividend payments depends on the company and its profitability. In theory, a company could pay out dividends monthly, quarterly, semiannually, annually or even less frequently.
The most common frequency is quarterly as companies tend to pay out dividends shortly after their earnings announcements. Typically, companies don’t vary their dividend payment frequency a lot.
Common vs Preferred Dividends
Many companies have more than one type of share class. The ‘normal’, most actively traded shares are referred to as common stock. But some companies also have ‘special’ (usually less liquid) shares that are also known as preference shares.
When it comes to dividends, preference shareholders often have some advantages over normal shareholders. Some of these advantages can be:
Fixed dividend payment frequency
Note that not all companies offer preferred stock and out of those that do, not all preference shares are traded as openly and actively as common stock.
Cash Dividends in case the Company does not generate a Profit
Even though it might not be the best thing for a company to do, a company can still pay cash dividends even if it has not managed to generate a profit. In this case, the cash paid out does obviously, not come from the company’s current quarters profits. Instead, the company can pay its dividends through its retained earnings.
‘Retained earnings’ is an equity account in which a company puts the profits that have not been paid out as dividends. So even if a company is not profitable for the current quarter, it likely has profit reserves from the past quarters. These can be used to pay out cash dividends for the current quarter.
If, however, a company does not have sufficient profit reserves available, it will not pay out any cash dividends.
Dividend’s impact on Options
As the stock price is adjusted as a part of the dividend process, options prices are also affected. Due to the downward adjustment on the ex-dividend date, call options tend to become cheaper and put options more expensive on the days leading up to the ex-dividend date.
Furthermore, the assignment risk for short option positions right before an ex-dividend date increases dramatically (especially for short calls). This is the case because many options traders exercise their options right before the ex-dividend date so that they will receive the dividend.
Due to the just-mentioned reasons, it is important to pay special attention to dividends when trading options.
Note that, if you own options on a stock that pays out dividends, you will not receive the dividends unless you have a long stock position.
An Example of How Dividends Work – AAPL November 2018
In my opinion, examples are one of the best ways to learn how dividend stocks work. That’s why I will now present the entire process from the declaration of dividends to the payout of the dividends based on Apple Inc’s (AAPL) last dividends of 2018.
Here is a table displaying all the relevant information:
As visible all the way to the left, the dividend type is a cash dividend which means that Apple Inc will distribute its profits to its stakeholders in form of cash. The amount of cash is $0.73/share.
Apple Inc declared this dividend on 11/1/2018. The ex-dividend date was 11/8/2018. On this date, Apple Inc’s stock price was adjusted downward by $0.73, the size of the dividend. Furthermore, you had to buy shares of AAPL before this date to receive the $0.73/share in dividends. In addition to that, you had to hold your long AAPL position at least until the record date which was 11/12/2018, four days after the ex-dividend date. Finally, the $0.73/share dividends were paid out on 11/15/2018.
As clearly visible on the following AAPL price chart, dividends did not seem to have any significant impact on AAPL’s price. Just like most of the other large-cap stocks, AAPL’s price declined drastically in November of 2018.
Apple Inc’s November 2018 Dividends
To recap, for every 100 shares of AAPL that you owned before 11/8/2018 (Ex-Date) and held until at least 11/12/2018 (Record Date), you will receive $73 on 11/15/2018 (Pay Date).
Which Stocks to Buy for Dividends:
Which stocks to buy for dividends highly depends on your appetite for risk, available capital and investment philosophy. Therefore, I can’t give you any personal recommendations of stocks to buy for dividends. With that being said, I can still give you some general guidelines to follow when buying stocks for dividends.
First of all, it is important to understand the correlation between dividends and a company’s profitability. If a company struggles to be profitable, it is not a good investment (for dividends). When looking for stocks to buy for dividends, it is, therefore, best to look for consistently profitable companies that have more than enough cash reserves to pay out cash dividends.
Highly speculative and volatile stocks usually aren’t the best choice for a dividend investor.
Generally, when looking for stocks to buy for dividends, you should remember that you are investing for cash flow and not for growth. This means, your main focus should not lie on a rapidly increasing stock price, but rather on consistent (and ideally, increasing) dividend payments.
Often stocks with slow and stable dividend yield growth rates can be better than stocks with the highest dividend yield in one year. Always remember that cash dividends are paid by a company’s profit. So if a company pays very high dividends, this might severely negatively impact the company’s future.
Also, make sure to take your overall market assumption into account. For instance, if you are very bearish on the overall market, you should not be buying dividend stocks because they will very likely also be negatively affected if the overall market falls.
Finally, make sure to enter at the right moment. With that I mean, before the ex-dividend date. Otherwise, you won’t receive the next dividends.
Investing in stocks that pay dividends is a great way to invest for cash flow instead of investing for growth. This is a great standalone strategy, but can be even better if combined with growth investing as diversification.
Receiving dividends allows you to profit from stocks even if the stock price does not rise. Nevertheless, you can still profit even more if the stock price increases. Therefore, dividend-paying stocks are often preferred as long-term investments over non-dividend paying stocks.
There are four dates to pay attention to when it comes to dividend stocks:
The Declaration Date
The Ex-dividend Date
The Record Date
The Payment Date
To be able to take advantage of dividend-paying stocks, it is very important to understand how dividend stocks work. I really hope this article helped you understand exactly this and much more.
If you enjoyed this article and learned something new, make sure to share it with a like-minded friend or relative.
If you have trouble understanding anything in this article or have something else to say, make sure to let me know in the comment section below. Thanks for reading!
Scaling in and out of trades can be a real game changer when it comes to consistently profitable trading. No matter if you trade stocks, options, futures, forex or whatever, if you are currently entering and exiting your trades in one step, you are making trading much harder for yourself. In this article, you won’t only learn what scaling in and out of trades is. You will also learn why and how you should scale in to a trade instead of opening it in one go.
What is scaling in and out of trades
First of all, let me present what scaling in and out of trades is. Scaling in and out of trades is also often referred to as averaging in and out trades. The main difference between a ‘normal’ trade entry and a scaling entry is that when scaling, you build your position in multiple steps.
Let me give you an example:
Let’s say, you want to open a 1000 share long position in stock XYZ. The most straightforward way to do this is to send a 1000 share buy order. However, what you could do instead is split up the opening process into multiple parts. For instance, buy 500 shares twice or 200 shares 5 times, 100 shares 10 times etc… If you would do this, you would scale in to a trade.
The same can be done when exiting your trades. Instead of selling the entire position at once, you can split up the process into more than one step. The following chart shows how you could scale in and out of a trade:
You’re probably asking yourself why this is better than just opening the entire position in one step. So let me present you the advantages of scaling in and out of trades next.
Pros and cons of scaling in and out of trades
1. Smaller losses
Generally speaking, scaling in and out of trades leads to
fewer and smaller losses. One main reason for this is that your initial entry
is with a much smaller size than if you would go in with full size right away.
Let me give you a concrete example:
Once again, you want to buy 1000 shares of XYZ which is trading at $25. If you scale into the position, you could split it up into 3 steps (400, 400 and 200 shares). Your first order is a buy order for 400 shares. Now let’s say XYZ’s price immediately goes against you and drops down to $24 which is your max risk level. Therefore, you exit the position and cut the loss. Your total loss is $400 (400 * $1).
If you would have opened that position with the full 1000
shares right away, that loss would have been $1000 instead of $400 (1000 * $1).
2. Bigger gains
In addition to smaller losses, scaling in and out of trades, often also leads to bigger profits. One reason for this is that when scaling out of positions, you give your trades the opportunity to make (more) money.
Once again, I will give you an example:
You bought 100 shares of stock ABC at $150 and ABC’s current
price is $155. If you would close the entire position at once right away, your
total profit (without commissions) would be $500 (100 * $5). However, let’s say
you only sell half of the position at $155 and hold on to the remanding 50
shares a little longer. Now ABC’s price continues to rise to $158 at which you
sell the last 50 shares. Now the total profit would be $700 (50 * $5 + 50 * $9)
which is $200 more than before.
All of the advantages that I am going to present next are related to the two just-mentioned ones as they lead to bigger profits and smaller losses. In other words, they lead to better, more consistently profitable trading results.
3. Room for error
One more major advantage of scaling in and out of trades is that it allows for imperfection. If you always open and close all your trades in one go, you have to be correct right away. If the position goes against you, you will likely take the entire position off to cut losses. This leaves little room for error.
However, if you scale in to a trade, your first order will only be a fraction of the full position. So if that position goes against you, you have a much smaller position with much less risk than before.
The same goes for when closing your positions. If you take
off your entire position at once, you immediately eliminate the entire profit
potential. But if you scale out of your position, you give your positions more
time to work as you only lock in the loss or profit of a small part of your
4. Improved trading psychology
Another advantage of scaling is that it helps to cope with emotional trading. A few examples of aspects that are improved by scaling in and out of trades are patience, confidence/conviction, stubbornness…
Patience is probably the most straightforward. A common
problem amongst traders is that as soon as they see a profit, they begin
wanting to lock in the profits so that they can’t turn into losses. The problem
with this is that this often leads to people leaving a lot of money on the
table which leads to overall smaller profits. This can often be a reason for
the lack of profitability.
The way that scaling out of trades helps against this is that it allows you to lock in profits without eliminating the entire remaining profit potential. When taking partial profits, you still give your positions the chance to make more money.
Furthermore, scaling helps with your confidence in your own
trades because you slowly build your position instead of putting on the entire
thing at once. This means that you should only be in a position with the full
intended size if it already has proven itself. Otherwise, you should only be in
the trade with a small position.
Generally, the aspect of trading that has the biggest effect on your emotions is the size of your positions. To make this point clear, answer this question honestly:
Would your emotions impact your decision making when you trade a $20 stock with 1 share?
Probably not, because 1 share is a tiny position. The smaller your position, the less emotional you usually are. Scaling in and out of trades leads to you, on average, being in your trades with full size less and for shorter periods than if you wouldn’t scale in to a trade. This alone, leads to more rational and mechanical trading.
5. Better entry and exit prices
Another advantage of scaling in and out of trades that I could think of is that it often helps you get better average entry and exit prices. This is the case because not all your buy orders or sell orders will be at the same prices. Let me give you an example:
ABC is trading at $10.5 and you want to buy 1000 shares. If you just buy the 1000 shares in one go, your average entry price will be $10.5. However, if you begin by buying 500 shares at $10.5 and then ABC’s price drops to $10.0 which is where you buy 500 shares more, your new average entry price will be $10.25 ((500 * $10.5 + 500 * $10.0) / 1000). This is a significantly better breakeven-point than before.
Summed up, scaling in and out of trades allows you to be less perfect and more flexible with your trading.
The following graphic compares scaling in/out of trades and opening/closing your trades at once:
The main disadvantage of scaling in and out of trades is commission costs. Depending on your broker and on your commission structure, scaling in and out of trades can be more expensive than opening and closing everything in one go. If you, for instance, have a flat-fee that you have to pay to open a trade, scaling into trades will cost more than not scaling into trades.
Due to commissions, scaling in and out of trades is especially useful in larger accounts where commissions don’t play a big role. With that being said, I still think that scaling in and out of trades can be beneficial for small accounts.
As you can see, tastyworks’ commissions are very competitive. Due to tastyworks’ commission structure, it is very possible to, at least, scale out of your trades even if you only have a very small account. Tastyworks does not charge any commissions when you close your positions. Therefore, it does not affect your trading cost whether you close your positions in one, two, three or even more orders.
Tips for scaling in and out of trades
Scaling in and out of trades has many advantages. Nevertheless, it is still important to have rules in place when scaling in or out of trades. Furthermore, there are some things that should be avoided when you scale in to a trade. So here is a list of things to look out for when scaling in and/or out of trades:
Proper risk management: Just because you are scaling in and out of trades, does not mean that you shouldn’t actively manage your risk. Regardless of your entry and exit style, you should always have a plan and define your max risk before you open a trade.
Don’t just add and add to losing positions: Adding to your position after it has already gone against you allows you to move your average entry price closer to the current price. But this does not mean that you should just continue to add and add to a position that has clearly already gone too far against you. Always remember that for each time you increase your position size, you are increasing your risk as well!
Remember to take profits: Scaling out of trades allows you to be more patient with your positions. With that being said, it is still important to not be overpatient.
Let your position prove itself: Before adding to a position, let it prove itself. Everything should be going according to your anticipated plan. If things aren’t going as expected, do not increase your position size and risk!
Scaling in and/or out of trades can be very beneficial to your trading. Nevertheless, it is important to understand that scaling in and out of trades won’t always lead to better results. There will be some trades where you might have had a better outcome if you wouldn’t have scaled. But this does not mean that you should never scale in to a trade. In my opinion, more often than not, scaling helps.
Scaling in and/or out of trades just allows you to be less perfect and more flexible. However, if a certain trade would have been perfect (e.g. you bought at the low and sold at the high), scaling does not help. But let’s be honest, it is rare to execute a trade completely flawless.
In other words, scaling is not for you if you are a perfect trader that always hits the tops and bottoms perfectly.
For everyone else, I at least recommend trying to scale in and/or out of trades. A good beginning is to start by closing your positions in more than one step. This is especially useful if your broker is tastyworks because there are no commissions on closing orders at tastyworks.
Short selling has a reputation for being extremely dangerous which is the reason why many retail traders avoid it. The risks of shorting stocks, however, aren’t really much greater than those of buying stocks, if you know what you are doing.
Understanding what short selling is and how it works is very important for a trader, even if he/she doesn’t plan on short selling himself/herself. The reason for this is that understanding what short sellers are doing can, for instance, increase your understanding of a stock’s behavior.
In this short selling guide, you won’t only learn what short selling is. You will also learn how shorting works, reasons to short sell, the risks of shorting and how to avoid them, and even more.
What is Short Selling?
First of all, let me start this short selling guide by presenting what exactly short selling or shorting is:
When you short sell a stock, you are basically betting against it. So shorting a stock is the opposite of buying it. When you are about to open a stock position, you have two possibilities:
You buy it to open your stock position. This is also commonly referred to as going long. If you do this, you most likely hope for an increase in the stock’s price so that you can sell the stock position later for a higher price.
The second option would be to sell to open the stock position. This is the same as shorting or short selling it. If you do this, you hope for a decrease in the stock’s price so that you can buy back the sold shares for a lower price. The buying back of the shares is also referred to as covering a short position.
This means, when short selling, you are basically selling shares of a stock that you don’t even own. Right now, this might seem pretty weird to you. To clarify your confusion, I will now present how short selling works.
How does Short Selling Work?
I created the following infographic to explain how short selling works:
As you can see, short selling consists of four steps:
Before being able to sell shares, you need to acquire shares. That’s why you borrow shares from your broker.
Next up, you sell these shares to open your short position.
As soon as you are ready to close your position, you buy back the shares. Ideally, you buy back the shares for less than you sold them earlier. If that’s the case, you would achieve a profit.
The final step is giving back the borrowed shares to your broker.
You might think that short selling seems quite complicated. But this isn’t really true because you won’t have to worry about step 1 and 4. Step 1 is automatically performed when you open a short position and step 4 is automatically done when you close your short position. Therefore, the process of opening a short position isn’t really difference for you than the process of opening a long position.
It is important to note that the broker does not carry any major risk when you are shorting. It is the short seller that carries the risk. If the stock’s price rises, you will have a loss of the size of the difference between the stock price and the entry price (per share). The opposite is the case if the stock’s price drops. Note, however, that in addition to commission costs, brokers often charge borrowing fees when you short sell as you are essentially selling their shares.
To make it completely clear how short selling works, I will now present you with an example of a short stock trade:
Let’s say you are watching XYZ which is a stock that is currently trading for $100. You believe that XYZ’s price will decrease in the near future and that’s why you decide to open a 100-share short position in XYZ. You send a ‘sell to open’ order with a limit price of $100 to open the position. To do this, your broker lends you 100 shares of XYZ.
The following table indicates different profit and losses for different price moves in XYZ (without accounting for commissions):
Your Position’s P&L:
+ $1000 (100 shares * $10)
+ $500 (100 shares * $5)
– $500 (100 shares * – $5)
– $1000 (100 shares * – $10)
Here is the payoff diagram of the just-described short stock position (profit and loss on a per share basis):
After closing your XYZ short position, you automatically return the borrowed shares to your broker.
Why Short Sell?
By now, you hopefully understand what short selling is and how it works. But you might not be fully aware of the different motivations that someone could have for short selling. So let me now present you with different reasons to short sell.
As you know, short selling is the opposite of buying. It is very commonly used by traders of all kinds. There are many scenarios imaginable in which one would want to bet against a stock (or other assets). For instance, if you believe a certain company will go under, short selling is a way to express this belief in form of a trade.
Some people argue that short selling is unethical and unamerican as short sellers are profiting from other people’s failure and problems. But I have to disagree with this. In my opinion, short selling is a totally legitimate addition to your trading arsenal. It gives you added flexibility and allows you to express your trading beliefs in more ways.
Furthermore, short selling allows you to bet against sketchy businesses or even straight-up scams. In my opinion, betting against bad or sketchy businesses is definitely not unethical.
An Example of a Short Squeeze
You might also have heard people blaming short sellers for big price drops in certain stocks. This, however, is often just a bad excuse of the management of certain companies. It is quite unlikely for a stock to drop significantly solely due to short sellers. People that are selling their long positions usually have a more significant negative impact on prices than short sellers.
Sometimes, short sellers can actually drive up prices to irrational levels! This is referred to as a short squeeze. Short squeezes work because short sellers have to buy back the shares to close their position. If a stock has a sharp up-move, many short sellers might want to cut their losses by exiting their short positions. This can lead to a lot of buying pressure that can drive up the price even more which in turn can lead to even more short sellers closing their positions which leads to even higher prices and so on… This is especially common amongst less liquid small-cap stocks.
Besides betting against stocks or other assets, short selling is also commonly used for hedging purposes.
How to Short Sell?
To be able to short sell, you will, first of all, need a broker that allows you to short. This should not be a problem though as most major brokers offer shorting capabilities.
All of the following brokers allow you to short sell:
The next requirement for short selling is that you need to have a margin account. If you have a cash account, you will not be able to short sell. I recommend checking out my article on cash vs margin accounts to learn more about these different brokerage account types.
The final requirement is that there have to be shares available to short. If your broker can’t lend you any shares, you won’t be able to short sell that stock. As long as you are trading liquid and well-known stocks, this shouldn’t be a problem at all. If, however, you want to short sell lesser known penny stocks with limited liquidity, your broker might not always have shares to short. Some brokers are better in locating shares to short for such stocks than others. So if you are planning on shorting a lot of penny stocks, you might want to look for specialized brokers.
Some brokers also allow you to reserve shares to short so that you will have the option to open a short position at a later time. This usually isn’t free of charge though.
Here is a brief recap of what you need to be able to short sell:
Broker that allows short selling (most brokers do)
Shares available to short (rarely an issue for well-known stocks)
Short sell button in tastyworks
Risks and Costs of Shorting
It is very important to understand the risks of shorting before short selling any assets. Short selling has some additional risks than normal buying has. That is also why many people label shorting as extremely dangerous. After presenting the risks of shorting to you, I will explain how you can manage these risks.
The first and most talked about risk is the theoretical infinite risk of short selling. When buying stocks, your loss is normally limited to the size of your initial investment. This is not the case for short selling.
When buying your loss is limited because a stock’s price can’t fall below $0. But there is no upside limit that a stock’s price can’t surpass. That is also the reason why you can lose more than 100% on a short stock position.
Let me give you an example of this:
If you decide to short ABC at $10 and ABC’s price rises up and beyond $20, your loss will be over 100%. The further ABC’s price rises, the larger that loss becomes. If ABC’s price rises so much that the paper loss comes close to exceeding the capital in your account, you will receive a margin call which requests you to deposit more money to your account. If you fail to answer the margin call, your broker will close your short position for you.
As a stock’s price can always go higher, there is, in theory, an infinite risk when short selling. In reality, however, this isn’t actually the case. Or have you ever seen a stock price rise to infinity?
Nevertheless, it is very important that you keep your risk and position sizing in check when short selling. To avoid big losses, you should always define a max loss point before opening a short position. Furthermore, it is important to keep position sizing small when short selling.
Risk of Buy-Ins
As you are trading with borrowed shares, there is a risk that the lender of the shares will want their shares back. If that’s the case, your short position will be closed so that the lender (your broker) can get back the shares. In certain cases, this can be very annoying.
The longer the time you plan to hold your short position, the higher the odds that you will get bought-in become. To mitigate the risk of buy-ins, you should focus on highly liquid and well known stocks.
Costs of Shorting
Like I mentioned earlier in this short selling guide, there usually are some additional costs besides just commissions when short selling. Normally, you will have to pay interest on the borrowed shares. The interest rate can vary widely depending on the stock and the availability of shares to short. However, if you aren’t planning on holding your short position for more than a few days, the interest costs are negligible.
Hard to borrow disclaimer in tastyworks
Some brokers also offer the option to reserve shares to short for a later time. These brokers normally also charge commissions for this service.
Short selling can be a great addition to your trading arsenal. Almost any professional trader will both use long and short strategies in his trading. Often, traders short sell just as much as they buy in their trading.
Besides expressing a bearish belief in an asset, shorting can also be used to hedge other positions.
Shorting is most commonly used for shorter term trading strategies such as day trading or swing trading. Rarely do traders short sell and hold stock positions just like they would buy and hold other stocks. On the one hand, this is because larger cap stocks have a natural tendency to rise in price over time. On the other hand, the risks of short selling scare many investors off.
Due to these reasons, I personally don’t recommend initiating a long term short position in any well-known large-cap stocks unless you have a very convincing reason for such a bearish position.
Nevertheless, I have nothing against using short selling as a part of your trading system. Just make sure to define your risk before entering a trade and always keep your position sizing check. (I recommend the same for buying!)
Alternatives to shorting (if you are bearish) would be to buy put options, sell call options or use other options strategies. One of multiple advantages of long puts over a short stock position is that long puts allow you to profit from bearish price action but with limited risk.
If you want to learn more about using long puts and other options strategies instead of normal long and short stock positions, I recommend checking out my free options trading education.
Otherwise, I truly hope you enjoyed this short selling guide and learned a lot. If you have any questions or comments, make sure to let me know in the comment section below!
In 2010, it was estimated that over 80% of the volume in the public equity markets was traded algorithmically. Furthermore, out of the best performing hedge funds, a very large percentage rely on algorithm-driven trading. This list includes the worlds largest hedge fund Bridgewater Associates that manages about 150 billion US Dollars, AQR Capital Management, the second largest fund with $70 billion under management, Renaissance Technologies, the third largest hedge fund, Two Sigma Investments, the fifth largest hedge fund and many more.
Moreover, the deployment of algorithmic trading is expanding at a rising rate. This rapid growth is not expected to stop in the foreseeable future.
And now you want to join the party as well? If that’s the case, you have come to the right place! There has never been a better time to learn algorithmic trading than right now.
In this article, I will present you with a step by step guide for how you as a retail trader can get involved in the exciting world of algorithmic trading. You will learn how to acquire the skills necessary to develop your own trading algorithms and much more.
Algorithmic Trading vs Discretionary Trading
Before we dive into the nitty-gritty of learning algorithmic trading, I just want to draw a comparison between algorithmic and discretionary (manual) trading.
One major advantage of algorithmic trading over discretionary trading is the lack of emotions. The computer program that makes the trades follows the rules outlined in your code perfectly. There is no second-guessing or hesitation. If a buy or sell signal is found, it is followed by a reaction of the algorithm.
This can not be said about manual human traders. In fact, dealing with your psychology while trading can be one of the toughest things. Often, the quality of your decision making is impaired by emotions such as fear and greed.
With that being said, the complete mechanical nature of trading algorithms can also act as a disadvantage. Trading algorithms don’t think about their trades like humans do. They simply check pre-programmed conditions and take action if certain criteria are met.
This means if the creator of the algorithm made a mistake or forgot to think about certain things, this can lead to bad trades that no human in their right mind would ever take.
A different aspect in which algorithmic trading definitely comes out on top is the aspect of time. Not everyone, certainly not retail traders, can afford to watch the markets all day. This, however, is no problem for a computer program.
A further advantage would be the ability to backtest and optimize your trading strategies. This can’t really be done in the same way for manual trading strategies. This means algorithmic traders can take advantage of the insane amounts of data that are accessible in our world today.
Emotional Decision Making
Watches Market All The Time
Ability To Backtest Your Strategies
Can’t Backtest To The Same Extent
Inconsistent Approach Due To Human Nature
The Trading Is As Good As Your Code
The Trading Is As Good As You
Furthermore, algorithmic trading takes a much more consistent approach to the markets than discretionary traders do. If a trading algorithm would be confronted with the exact same situation twice, it will make the exact same decision every time. This can not be said about human traders because their decision making is heavily affected by human factors such as their mood, past experiences, prior trades, emotions etc.
In conclusion, both discretionary and algorithmic trading have their pros and cons. I wouldn’t necessarily say that either one is 100% better than the other. In my opinion, this really depends on the code and the trader that are being compared. At the end of the day, an algorithmic trader is only as good as his algorithm and a discretionary trader is only as good as himself. A good trader can beat a bad algo every day and vice versa.
If algorithmic trading is for you depends on who you are and what your personal preferences are.
Now without further delay, let me present to you how to learn algorithmic trading.
Step 1: What is Algorithmic Trading?
The first step is understanding what algorithmic trading even is or at least, understanding what kind of algorithmic trading is relevant for you. For instance, in recent years, high frequency trading has become a popular topic. However, this is not a trading style that is usable by a retail trader such as you or me. High frequency trading is all about speed and being the fastest. Retail traders have no chance at all competing against multi-billion dollar companies when it comes to accessing technology to gain a minuscule speed advantage.
You can check out the following video if you are interested in learning more about high frequency trading.
High Frequency Trading - YouTube
So when I am talking about learning algorithmic trading in this article, I am not talking about high frequency trading (because retail traders can’t use it). Instead, I am talking about developing trading strategies that can be translated to an algorithm that can be used by you. The goal with this algorithm is to let it trade profitably for you. You won’t make any trades manually. All the trading is automated and performed by your algorithm.
To drive this point home, here is an example of a very simple trading algorithm:
If SPY's price crosses above its 30-day moving average: -Buy 100 shares of SPY If SPY's price crosses below its 30-day moving average: -Sell 100 shares of SPY
Like I just said, this is a very simple trading algorithm and I would not recommend trading real money with this algo. Nevertheless, this example can give you an idea of how a trading algorithm might look like. It usually consists of different conditions that have to be fulfilled. As soon as a certain condition is met, a pre-programmed action is performed (e.g. a buy order is sent).
Step 2: Understand the Basics of Trading
This step applies to any kind of trader. It really doesn’t matter if you want to learn algorithmic trading or become a discretionary trader. You need to understand the basics first. Understand how the markets work and learn some basic finance topics.
Here are just a few examples of things that you have to understand:
As a trader, you need to know this stuff! Generally, I recommend building a solid knowledge foundation before risking any significant amounts of real money. Otherwise, I can tell you with a relatively high level of confidence that things won’t go too well.
Step 3: Learn to Program
There is simply no way around it. If you want to become an algorithmic trader, you will have to learn to code, unless you already have sufficient programming experience. But don’t worry. Learning to program can be fun and it is a very good skill to acquire anyway. Besides that, learning to program really isn’t that hard either.
Which programming language to learn for algorithmic trading?
The language that you should learn for algorithmic trading purposes depends on what exactly you are planning to do with it. However, in my opinion, a very good and versatile language to start with is Python. It is easy to learn and you can do a lot with it. Furthermore, one of my favorite algorithmic trading platforms also solely supports Python for its algorithms. But more on that further down.
Alternatives to Python would be Java, C++, C# or even R. In an ideal world, you would learn more than one programming language. However, this isn’t necessary if you don’t want to do so. But believe me, after you learned one programming language such as Python, you will have a much better time learning a second or later even third coding language.
A great place to start learning how to program is Udemy. Udemy is an online learning platform with thousands of courses on different topics including programming. Usually, you can get a course for as cheap as $10.
Before finally being able to start developing your own trading algorithms, you should learn how to deal with data. This can be just as essential as learning how to program. To develop your strategies, you will want to take advantage of the available data that exists in our day and age. However, to do so effectively, you should ideally, acquire some data science skills.
Once again, no matter what you do, this is a useful skill to learn regardless. If you don’t learn how to handle large amounts of data, you could fall into some common pitfalls that could severely hinder your trading algorithms from performing as intended. So acquiring some basic data science knowledge is part of learning algorithmic trading.
Once again, a great place to learn about data science is Udemy. I know that having to learn all these different things might seem overwhelming. But don’t worry. At the end of this article, I will provide you with a link to a course that covers almost all the topics mentioned in this article. I have personally taken this course and can only recommend it.
Step 4: Develop Your Own Strategies/Algorithms
After learning how to program and about basic trading concepts, it is finally time to develop your own trading strategies in form of algorithms. But to do so, you will first need an algorithmic trading platform. So let me introduce you to some:
Algorithmic Trading Platforms
To develop, backtest and optimize trading algorithms, you will need access to large amounts of data and access to a platform with a solid infrastructure that supports this. Luckily, you won’t have to acquire any of this yourself.
In fact, you can gain access to the just-mentioned things without having to spend a dime. Here are a few different platforms for algorithmic trading:
Quantopian is a web-based platform that allows you to backtest and create your own trading algorithms. Quantopian is probably the most popular and most used platforms when it comes to algorithmic trading for retail traders. They also offer the opportunity for your algorithms to participate in trading contests in which the creators of the best algos can win prize money.
The very best algorithms are even offered a chance to get funded with investors’ money. If you achieve this, you will obviously receive a certain percentage of the profits achieved with your algorithms (typically 10%).
Furthermore, every trading algorithm that you create on Quantopian is your intellectual property.
I have personally tried out Quantopian and can definitely recommend it.
Cost: Free (except for some premium data)
Assets: Equities and Futures
Quantiacs is an alternative to Quantopian. I personally don’t have any experience with them and thus, I can’t say too much about Quantiacs. However, I have heard a few good things about them.
They also offer contests with prize money and you can get funded with investors’ money if you develop a really good algorithm.
A few examples of brokers that support algorithmic trading are:
With that being said, you really shouldn’t be concerned about signing up to a broker that has algo trading capabilities yet. Go through all the other steps first. Real life implementation is one of the very last steps.
Develop your own trading algorithms… finally!
Now it is finally time to develop your own trading strategies/algorithms. This is much more than just coming up with one good idea for a strategy. You also have to translate that idea to code, backtest it, optimize it…
Here are the steps necessary to create a winning trading algorithm:
Come up with an idea: This will be the foundation of your trading strategy. Ideally, you find some kind of edge/inefficiency to exploit.
Code it: The next step is to translate your idea into code.
Backtest it: Next, it is time to test your algorithm on historical data.
Optimize: You should continuously try to improve and optimize your algo.
Add safeguards: It is essential to add risk management to your trading algorithm. Add safeguards so that you can’t lose more than a certain amount of money on a single trade. Examples here would be stop-losses, dynamic position sizing, trailing stop losses, exposure and leverage limits etc.
Test and optimize, optimize, optimize…: Don’t forget to backtest and to not stop optimizing! You should really stress-test your algorithm with a wide variety of different events to make sure it can handle the real world.
Paper trade: Before letting your algorithm trade with any real money, let it trade with some no-risk, imaginary money. This will also allow you to find out if you overoptimized your algo to the backtest data.
Start small: Assuming everything else so far went good, it is finally time to start feeding your algorithm some real money. With that being said, make sure to start small.
Increase size: If you are satisfied with the algorithm’s performance, you can slowly begin to allocate more capital to it.
Optimize and monitor: Especially, in the beginning, it is very important to monitor your algorithm(s) so that you can see if it does what it should do. Ideally, all bugs should have been fixed in the previous steps. Nevertheless, you should oversee it and even consider intervening if there are problems.
Here is how Quantopian’s integrated development environment looks like. This is where you can create and backtest your trading algorithms:
The world of quantitative trading is a very exciting and rapidly expanding one. I can only commend you if you want to get into it. I really hope this article gave you a good introduction to the ins and outs of algorithmic trading. Furthermore, I hope you now know how to continue your journey to learn algorithmic trading.
Here is a brief recap of the 4 steps you need to take to become an algorithmic trader:
Understand what algorithmic trading is. ()
Understand the world of trading. ()
Learn to program and data science. ()
Develop your own trading strategies/algorithms. ()
It is important to understand that all these steps go hand in hand with each other. Your ability to create robust and profitable trading algorithms highly depends on your understanding of the markets and coding/data science skills. The more you learn about programming and trading, the more tools you will have in your trading algo arsenal. For instance, if you learn a new programming topic such as machine learning, you will be able to implement it into your trading algorithms. So if you keep at this for long enough, you might once be able to do some truly phenomenal stuff. But first, you have to learn the basics.
Earlier in the article, I promised that I will provide you with a link to a course that I took that covers all of the above steps. So that’s exactly what I am going to do now:
The course is called Python for Financial Analysis and Algorithmic Trading. Just like the name implies, it covers everything from a crash course to python to some data science and how to use Quantopian to develop your own trading algorithms. Note, however, that if you are completely new to programming, you might want to take another course that is more tailored to learning how to program before taking this course.
The course has almost 20 hours of video material, 121 lectures, exercises, downloadable resources and more. Usually, you can gain access to the course for $10-$20.
If you prefer to take a different course, you can browse thousands of other courses on Udemy by clicking HERE.
Some of the links within this guide are affiliate links of which I receive a small compensation from sales of certain items. There are no added costs for you and these affiliate links do not influence the objectivity of my content. I do only recommend products that I have personally tested and used.
In this article, you will learn how to specifically analyze your trading performance so that you can become a better, (more) profitable trader. I will teach you everything from the data collection, how to perform an in-depth analysis of your trading to the importance of having regular performance reviews. If you take action and implement the advice that you will learn from this guide, you will see an improvement in your trading results!
Before I get down to the nitty-gritty, let me tell you why you should even bother analyzing your trades:
Tracking your trades and analyzing them is one of the only real, proven methods that will improve your trading performance. Collecting real hard data will give you an edge in the markets. Data on your personal trading style is very valuable. You may have a certain perception of what you are good at and where you aren’t as good. But there often is a huge difference between the perceived and actual reality.
Having data and making use of it will open your eyes and eliminate the negative impact of that perception error on your trading.
Just imagine what it would be like if you had something that tells you exactly where you are losing money and where you are making money. With that information, you will be able to either change or just cut out the areas in which you are losing money and work on the winning areas. This shouldn’t be a one-time thing. This should be a continuously ongoing process of refining your trading style.
In the remainder of this article, I will tell you how to do exactly that.
How to Track Trades
First of all, if you haven’t done so already, you need to acquire the data on your trading. Once again, this should also be a never-ending process.
When collecting data on your trades, it is important to not only track the simplest data such as entry and exit price. Doing this is pointless as this wouldn’t allow you to gain a lot of insights into your trading which would mean that you can’t really improve anything.
Generally, the more data you have on your trading, the better. However, it is obviously not very feasible to track everything. Therefore, it is important to find a balance between the amount of useful data and the burden of actually collecting it. For instance, if it takes you two hours every day to track your trading data, you are probably doing something wrong (i.e. tracking too much data).
Some examples of useful aspects that I recommend tracking are:
Entry Price, Exit Price
Size (e.g. number of shares)
Entry Day and Time, Exit Day and Time
P&L $ and %
Notes and Lessons learned from each trade
Now that you have an understanding of what to track, let us get into how you should track your trades. There are obviously multiple different ways to collect data on your trading and you have to decide which you think is best suited for you. The three most common/best ways that I can think of are:
Do it Yourself
Dedicated Trading Journal Software
The first and probably most straightforward method to track data is using trading journal software. This allows you to either enter your trades manually or depending on the software and your broker automatically import your trading data from your broker platform.
The main pro of this method is that it is very easy.
Some of the cons are that gaining access to this software can be pricey and you usually can’t customize what you want to track in a big way.
Do it Yourself
Another possible way to track your trades is by doing it yourself. If you want to do this, I recommend using spreadsheet programs such as Microsoft Excel, Google Sheets or something similar. I don’t recommend using pen and paper as this would severely limit the analysis opportunities.
The pros of this method are that this is the cheapest way to track data and you can customize everything.
The main con, on the other hand, is that it is quite time-consuming. If you want to do everything yourself, I recommend creating some sort of template for you to use when entering and analyzing trades.
That is exactly what I did:
I created an Excel Trading Journal Template in which you simply can fill out ca. 10 fields (with information such as entry/exit price/time…) and everything else is done automatically. The template is highly customizable and automatically analyzes a multitude of different aspects of your trading without you having to do anything. But more on the different analysis features further down.
Before I move on to how to analyze your trading data, let me present you a few common data collection pitfalls that you should try to avoid! When analyzing your trades, you want to use the collected data to become a better trader, not a worse one. To make sure that you don’t become a worse trader, you have to make sure that your data is reliable. To make sure your data is reliable, avoid the following:
1. Not Having Enough Data
A common mistake is to base fundamental changes in your trading style on a too small sample size. If you analyze data, make sure you have enough of it. DO NOT change or adapt your entire trading style based on a handful of trades. If you only have tracked a few trades, they might be outliers which would mean that they wouldn’t be a good representation of your actual trading performance. So always make sure to base changes in your approach on a big enough number of trades that indicate the same.
2. Tracking Useless Data
Even though it is usually true that more data is better, you should still focus on relevant data. Don’t track something just for the sake of tracking it. Only track it if you think it might help you understand your winning and losing trades better.
3. Tracking Unusable Data
Besides avoiding tracking irrelevant aspects of your trading, also try to make your data usable. That is also why I recommend using a spreadsheet program such as Excel. This will allow you to present the collected data in a useful visual manner. Furthermore, it allows you to perform arithmetic functions on it (e.g. calculating averages, totals…).
An example of almost unusable data would be something like this:
If that’s how you track your data, you might as well let it be.
4. Jumping to Conclusions
When analyzing data, use common sense and don’t jump to conclusions. In other words, try to work like a scientist. You might uncover weird correlations (especially if you have inaccurate/useless data). If something doesn’t make sense, investigate it further. Generally, make sure to be thorough before you change how you trade.
5. Being Selective
From personal experience, I can say that sometimes it can be tough to sit down and track bad losing trades. Human psychology wants us to forget bad experiences. But reflecting on and tracking bad trades is often one of the most important things because it is often these trades that give you the most opportunity for improvements.
This is also related to the reliability of your data. If you are selective in your data collection process and only track the good winning trades, your stats will be close to useless and they will not be a real representation of your trading. So make sure to track all your trades!
6. Not Segmenting the Data
Not differentiating between your data is another common mistake. Most traders have more than one trading strategy. If that’s the case for you, make sure to track different strategies differently. If you treat all your strategies as if they were one, you will have a very unclear picture of your trading. Instead track everything individually and analyze different strategies separately. That is also why I divided my Excel Template into different sections with multiple subsections.
Trading Data Analysis
Now let us finally get into how you should/could analyze your trading data to become a better trader. I will present this with the help of my Excel Trading Journal Template. Obviously, I recommend that you use my spreadsheet as well. However, if you have another preferred way, that is totally okay as well. You will still be able to get good insights or at least some inspiration for how to analyze your own data.
If you use my template, you won’t really need any Excel experience. In addition to that, you also won’t really need any statistics experience or anything of that kind either. I created it in a way so that it is extremely easy to get a clear picture of your own trading performance even without a lot of analysis. I made use of different color sets, a multitude of different charts, graphs, and tables to accomplish this. If you want to create your own spreadsheet, make sure to do the same!
I will not present all the different analysis features of the template. Let’s start at the top.
Top of the Template
The top of the template is mainly designed for you to enter your trades. However, it is also possible to get a good impression of the development of your trading by looking at this section of the spreadsheet. You can mainly do this by looking at the different colors of the P&L column. The more green they are, the more (consistently) profitable you seem to be. A lot of red means that you still have to work on your consistency. The opacity of the colors indicates the size of the loss or gain (darker means bigger).
Furthermore, you could look at the notes and lessons learned of some of the outstanding trades (e.g. biggest gains/losses).
At the bottom of the trade entry section of the template, you will have a summary bar that summarizes some of the major stats for each strategy (P&L, Average Time in a Trade, Win %, Average % Gain/Loss, Average $ Gain/Loss). This is a great place to get a good overview of the performance of each strategy.
Big Summary Bar
The next section of the Excel Trading Journal Template is a big summary bar in which you can learn about some of the stats of your overall trading performance. Some of the things listed here are:
Average % Gain/Loss
Average $ Gain/Loss
Total Commissions Paid
Number of Trades
Average Time in a Trade
This can give you a very good overview of your entire trading performance. This is especially good for regular performance reviews such as daily/weekly/monthly/yearly reviews. However, I recommend focusing more on the stats of the individual strategies as they tell the whole story. The big summary bar just sums everything up to give you a broad overview of your trading. For deeper analysis, you should look at each strategy separately.
Individual Strategy P&L Line Charts
In this section, you will be able to view P&L line charts for each strategy. This allows you to see the entire development of your trading with that strategy in one place. It shows the periods in which you were trading better and the periods in which things weren’t going as splendid. A good idea here would be to go to the top section and look at the notes (and lessons learned) on your trades in the best and worst periods. Hopefully, this will shed light on the reason for the worse (or improved) performance which could give you an idea of how to adapt your trading style in the future.
Individual Strategy P&L Distribution Bar Charts
This section allows you to easily compare the size of the different gains and losses of each strategy. Ideally, your wins are generally bigger than your losses. Otherwise, you would need a lot more wins than losses to achieve profitability. Looking at these charts is a good way to learn about the risk to reward potential of your current trading styles. If the losses for a strategy are much greater than the wins for the same strategy, you could, for instance, consider cutting losses faster or taking profits later.
Another way to use this section is to look at some of the notes of some of your notable wins or losses to get a better understanding of what went right/wrong on those trades. Doing this might help you avoid similar big losses and repeat big gains in the future.
Next up are the strategy rankings. This is a table in which all your strategies are ranked by Total P&L, Win %, Average % Gain/Loss and Average $ Gain/Loss. This allows you to quickly see which strategies are working best for you in the just-mentioned aspects. If you have enough data and there is a clear differentiation between your best and worst strategies, you might want to consider focusing more on your best strategies. You could even consider dropping your worst strategy from your arsenal if you don’t see a way to improve its performance.
Besides the just-mentioned table, there also are two more tables in which you can view your Biggest % Profit, Biggest % Loss, Biggest $ Profit, Biggest $ Loss, Average % Profit, Average % Loss, Average $ Profit and Average $ Loss. These tables exist to let you know how your best, worst and average trades look like. One way you could use this information is to look at the notes of your best and worst trades and learn from them.
Furthermore, the averages give you a good general understanding of your trading performance. The next time you trade, you could, for example, compare the stats of your open positions to the stats of your average trades. Doing this could potentially help you in deciding when to take off the trade.
Total P&L Waterfall Chart
This chart shows the development of your entire total P&L on a trade by trade basis. Once again, this can be used to get a quick and good overview of your overall trading performance. In my opinion, it is especially useful for longer-term performance analysis such as monthly or yearly reviews.
P&L vs Holding Time (Days and Intraday) Scatter Diagrams
These are two scatter diagrams that compare the P&L of each trade of each strategy to the holding time of it (once for day trades and once for longer-term trades). This allows you to identify the most and least profitable time frames for each strategy. Try to use this information to adapt the holding time of your future trades.
For instance, if all your most profitable trades for a certain strategy occur when you hold your positions for only a few minutes and most of your biggest losses come from the trades that are held for multiple hours, you might want to take off your trades faster in the future.
P&L vs Stock Price Scatter Diagram
This diagram compares the performance of the trades of each strategy to the stock price. You could use this diagram to find out which price range is best suited for a certain trading strategy. An example here could be that you notice that most of your losing trades for a certain strategy come from lower-priced stocks. A follow-up action to this might be to focus more on higher priced stocks when trading that strategy in the future.
P&L vs Time of Entry/Weekday of Entry Scatter Diagrams
These are two more scatter diagrams that compare the P&L of each trade of each strategy to the time of entry with respect to time of day and day of the week. One thing you could potentially notice from these diagrams is that your trading performance for a certain strategy is significantly lower (or higher) during certain times of the day (or on specific days of the week). If this is the case, you should try to investigate why this is the case. If you can’t find a way to improve your performance, you could just stop trading that strategy during the periods with decreased performance.
I hope these examples of what I added to my Excel Trading Journal Template could give you a good idea of how analyzing different aspects of your trading could help you discover areas of potential improvements. Ideally, you should not look at each section in isolation like I did here. Instead, take more than one aspect into account when analyzing your trading strategies.
You might have noticed that almost everything on my template is divided into different strategies. That is the case because I find it very important to treat different strategies differently. Showing everything for each strategy separately instead of showing everything together paints a much clearer picture of your trading performance. In other words, dividing everything into different strategies is a way to dissect your overall P&L. It shows you exactly where the most money is being made and where the most money is being lost.
The Importance of Regular Performance Reviews
Now that you know how to track trades and how to analyze the tracked data, let me tell you about the importance of actually analyzing your data on a regular basis. I recommend reviewing your trading performance as frequently as possible. This will make it much more useful.
Here are some routines that I recommend implementing into your trading life:
End of Day Analysis: In my opinion, it is important to review your own performance after every trading day. This can be combined with collecting the data. For example, my Excel Spreadsheet doesn’t allow the automatic collection of data from your broker platform. But in my opinion, that is a good thing because it forces you to manually enter and think about your trades again. So even if you aren’t in the mood, you have to reflect on your trades again. Furthermore, this helps with avoiding making bad trades.
In addition to entering your daily trading data, you should also just take a few minutes and think about how you feel your trading was on that day. Was it good? If not, why not? Were you disciplined? Did you stick to all your rules? …
Weekly Performance Reviews: Weekly review sessions are a very good thing as well. Just take a few minutes and look at how your trading performance in that week was and compare it to previous weeks. To get a fast impression of your weekly performance, you could look at the Weekly P&L stat in the template. During weekly review sessions, you could also set achievable short-term goals for the next week.
Monthly Performance Reviews: Make sure to look back at your trading after every month. Ask yourself what you did good and what you didn’t do so well? What do you want to do better next month? When answering such questions, I don’t recommend thinking about P&L. Instead, think of how you could make better trades. For example, don’t set yourself the goal to make X Dollars next month. Instead set goals like avoiding certain mistakes, being more patient with certain trades, cutting losses faster etc. If you do this, your trading performance will automatically improve.
To get a fast impression of how your monthly..