trading-fundamentals

# Trading Fundamentals > **Skill:** Trading Fundamentals | **Domain:** trading | **Category:** fundamentals | **Level:** beginner > **Tags:** `trading`, `fundamentals`, `psychology`, `development`, `dual-tf`, `risk` ## 1. Market Structure ### Market Types | Market Type | Description | Examples | |-------------|-------------|---------| | **Exchange-Traded** | Centralized, regulated, standardized | NYSE, NASDAQ, CME, CBOE | | **OTC (Over-the-Counter)** | Decentralized, bilateral, flexible | Forex spot, bonds, derivatives | | **Dark Pools** | Private exchanges, minimal pre-trade transparency | Liquidnet, IEX | | **ECN/ATS** | Electronic, direct order matching | ARCA, BATS, IEX | ### Market Participants | Participant | Role | Typical Behavior | | ----------- | ---- | --------------- | | **Market Makers** | Provide liquidity, quote bid/ask | Mean-reverting, earn spread | | **Institutional Investors** | Large funds, pension funds | Slow accumulation, trend-following | | **Hedge Funds** | Diverse strategies, leverage | Short-term tactical, event-driven | | **Retail Traders** | Individual accounts | Often contrarian signal (sentiment) | | **High-Frequency Traders** | Algorithms, co-location | Latency arbitrage, market making | | **Central Banks** | Currency intervention | Large directional moves | | **Arbitrageurs** | Exploit price discrepancies | Keep markets efficient | ### Market Microstructure - **Bid-Ask Spread**: Cost of immediacy; tighter = more liquid - **Order Book Depth**: Volume at each price level; thin books = slippage - **Price Discovery**: Process of finding fair value through supply/demand - **Market Impact**: Price moves against your order as size increases - **Slippage**: Difference between expected and executed price - **Tick Size**: Minimum price increment (e.g., $0.01 stocks, 0.25 pts ES futures) - **Lot Size**: Standard trading unit (100 shares stocks, 100,000 units forex standard lot) --- ## 2. Order Types ### Basic Orders | Order Type | Description | When to Use | Risk | |------------|-------------|-------------|------| | **Market Order** | Execute immediately at best price | Need instant fill | Slippage in thin markets | | **Limit Order** | Execute only at specified price or better | Price-sensitive entry/exit | May not fill | | **Stop Order** | Becomes market when price reached | Stop-loss, breakout entry | Slippage at trigger | | **Stop-Limit** | Becomes limit when stop triggered | Breakout with price control | May not fill past gap | | **Trailing Stop** | Stop adjusts with price movement | Lock in profits on trends | Whipsaws in volatile markets | | **MIT (Market if Touched)** | Market order when price touched | Reversal entries | Slippage | | **GTC (Good Till Cancelled)** | Order stays until filled or cancelled | Swing trade entries | Forgotten orders | | **FOK (Fill or Kill)** | Fill entire order or cancel | Large block trades | Frequent cancellations | | **IOC (Immediate or Cancel)** | Fill what's available, cancel rest | Partial fills acceptable | Partial execution | ### Advanced/Algorithmic Orders | Order Type | Description | Formula/Logic | |------------|-------------|--------------| | **TWAP** | Time-Weighted Average Price | Executes equal portions each time interval | | **VWAP** | Volume-Weighted Average Price | Executes proportional to volume distribution | | **Iceberg** | Shows only portion of total size | Total size hidden; refreshes displayed qty | | **POV (% of Volume)** | Participate at set % of market volume | Slices = Volume × Target% | | **Implementation Shortfall** | Minimize cost vs. arrival price | Optimizes between urgency and market impact | | **Pegged Orders** | Price pegs to bid/ask/midpoint | Dynamic pricing with spread | ### Iceberg Order Example Total Order: 100,000 shares Display Quantity: 1,000 shares → Market sees only 1,000 at a time → After each fill, 1,000 more displayed → Used to hide large institutional interest ``` --- ## 3. Asset Classes | Asset Class | Sub-Types | Key Characteristics | Typical Instruments | |-------------|-----------|--------------------|--------------------| | **Equities** | Stocks, ETFs, ADRs | Ownership stake, dividends, earnings driven | AAPL, SPY, QQQ | | **Fixed Income** | Gov bonds, Corp bonds, Munis | Interest payments, duration risk | TLT, AGG, UST | | **Commodities** | Energy, Metals, Agri | Inflation hedge, cyclical | Gold, Oil, Corn | | **Forex** | Major, Minor, Exotic pairs | 24/5 market, leverage, macro driven | EUR/USD, USD/JPY | | **Derivatives** | Options, Futures, Swaps | Leverage, hedging, expiration | SPX options, ES futures | | **Cryptocurrencies** | Layer-1, DeFi, Stablecoins | 24/7, high volatility, on-chain data | BTC, ETH, SOL | | **Real Assets** | REITs, Infrastructure | Tangible, inflation protection | VNQ, MLP | | **Alternative** | Hedge funds, PE, Commodities | Low correlation, illiquid | SPACs, art, wine | ### Asset Class Correlations (Typical) - **Stocks ↔ Bonds**: Negative correlation in risk-off; breaks down in stagflation - **USD ↑ → Gold ↓**: Usually negative (priced in USD) - **Oil ↑ → CAD ↑**: Canada major oil exporter - **Risk-off**: Buy USD, JPY, Gold, Treasuries; Sell EM, commodities - **Risk-on**: Buy stocks, commodities, EM; Sell USD, bonds --- ## 4. Trading Timeframes | Style | Holding Period | Chart TF | Trades/Day | Typical R:R | Capital Required | |-------|---------------|----------|-----------|-------------|-----------------| | **Scalping** | Seconds–minutes | 1s–5m | 20–100+ | 1:1–1.5:1 | High (commissions) | | **Day Trading** | Minutes–hours | 5m–1h | 2–10 | 2:1–3:1 | $25k+ (PDT rule) | | **Swing Trading** | Days–weeks | 4h–Daily | 3–15/month | 3:1–5:1 | $5k–$25k | | **Position Trading** | Weeks–months | Daily–Weekly | 1–5/month | 5:1–10:1 | $10k+ | | **Investing** | Months–years | Weekly–Monthly | Annual | N/A | Any amount | ### Multi-Timeframe Hierarchy ``` Higher TF → Determines Trend Direction (Primary Bias) Middle TF → Confirms Setup / Pattern Lower TF → Precise Entry/Exit Timing Example (Day Trader): HTF: Daily chart → Uptrend (above 200 EMA) MTF: 1h chart → Pullback to key support LTF: 15m chart → Bullish reversal candle for entry ``` --- ## 5. Core Principles: Risk Management (10 Rules) ### Rule 1: Never Risk More Than 1-2% Per Trade ``` Account: $50,000 Max Risk/Trade: 1% = $500 If stop = 50 points at $10/point → Max 1 contract ``` ### Rule 2: Define Risk BEFORE Entry - Place stop loss before entering - Know exact dollar risk before sizing position - Never move stops to avoid a loss (move only to lock in profit) ### Rule 3: Use Position Sizing, Not Gut Feel - Size = Risk Amount ÷ (Entry Price − Stop Price) - Always calculate; never guess ### Rule 4: Maintain Positive Expected Value ``` EV = (Win Rate × Avg Win) − (Loss Rate × Avg Loss) EV must be > 0 for long-term profitability Example: 40% WR, $300 avg win, 60% LR, $150 avg loss EV = (0.40 × $300) − (0.60 × $150) = $120 − $90 = +$30 per trade ✓ ``` ### Rule 5: Risk-Reward Minimum 2:1 - Never take a trade with R:R < 1.5:1 - Optimal: 2:1 to 3:1 for most strategies - Allows profitability at 40% win rate: (0.40 × 2) − (0.60 × 1) = +0.20R ### Rule 6: Correlation Risk Management - Don't hold multiple correlated positions at full size - If 3 long tech stocks: effective risk = 3× single position risk - Limit correlated sector exposure to 5–6% of capital ### Rule 7: Drawdown Limits - Daily loss limit: 3% of account → Stop trading for the day - Weekly loss limit: 6% → Reduce size by 50% next week - Monthly loss limit: 10% → Full review before continuing - Account drawdown: >20% → Stop, assess, fix before continuing ### Rule 8: Scale In, Scale Out - Enter in 2–3 tranches to average better price - Exit in 2–3 tranches to lock profits while running winners - Never add to a losing position ("averaging down" = dangerous) ### Rule 9: Keep a Trading Journal - Record every trade with: entry/exit, rationale, emotion, result - Review weekly for patterns and improvement areas ### Rule 10: Protect Capital First, Make Profits Second - Goal #1: Survive to trade another day - Goal #2: Consistent small gains compound to large gains --- ## 6. Position Sizing Formulas ### Method 1: Fixed Percentage Risk (Most Common) ``` Position Size = (Account × Risk%) ÷ |Entry − Stop| Example: Account = $100,000 Risk% = 1% → $1,000 risk Entry = $50.00, Stop = $48.00 → $2.00 risk/share Position Size = $1,000 ÷ $2.00 = 500 shares Position Value = 500 × $50 = $25,000 (25% of account) ``` ### Method 2: Kelly Criterion ``` f* = (bp − q) ÷ b Where: b = average win / average loss ratio p = probability of win (win rate) q = 1 − p (probability of loss) Example: Win Rate = 55%, Avg Win = $300, Avg Loss = $150 b = 300/150 = 2.0 f* = (2.0 × 0.55 − 0.45) ÷ 2.0 = (1.10 − 0.45) ÷ 2.0 = 0.325 = 32.5% ⚠️ Full Kelly is too aggressive! Use Half-Kelly (16.25%) or Quarter-Kelly (8.1%) ``` ### Method 3: ATR-Based Position Sizing ``` Position Size = (Account × Risk%) ÷ (ATR × Multiplier) Example: Account = $100,000, Risk% = 1% ATR(14) = $3.50 on a $75 stock Multiplier = 2× ATR for stop distance Stop Distance = 2 × $3.50 = $7.00 Position Size = $1,000 ÷ $7.00 = 142 shares ``` ### Method 4: Volatility-Adjusted (Equal Volatility) ``` Position Size = Target Volatility / (Price × Daily Vol %) Target each position to contribute equal volatility to portfolio Used in risk parity and institutional portfolios ``` ### Risk-Reward Analysis Table | Win Rate | Min R:R Required for Breakeven | |----------|-------------------------------| | 30% | 2.33:1 | | 40% | 1.50:1 | | 50% | 1.00:1 | | 60% | 0.67:1 | | 70% | 0.43:1 | --- ## 7. Drawdown Management ### Drawdown Calculations ``` Max Drawdown = (Peak Value − Trough Value) ÷ Peak Value × 100 Recovery Required from Drawdown: 10% loss → Need 11.1% gain to recover 20% loss → Need 25.0% gain to recover 30% loss → Need 42.9% gain to recover 40% loss → Need 66.7% gain to recover 50% loss → Need 100.0% gain to recover ``` ### Drawdown Response Protocol | Drawdown Level | Action | |---------------|--------| | 5% | Review recent trades, check for pattern errors | | 10% | Reduce position size by 25%, increase selectivity | | 15% | Reduce size by 50%, review strategy validity | | 20% | Stop trading, full strategy audit, paper trade | | 25%+ | Complete reset: new strategy or long break | --- ## 8. Trading Psychology: 12 Cognitive Biases ### Bias 1: Confirmation Bias - **What**: Seek information that confirms existing view - **Example**: Only reading bullish articles on a stock you own - **Counter**: Actively seek bearish arguments; read the bear thesis ### Bias 2: Recency Bias - **What**: Overweight recent events, underweight long-term data - **Example**: After 3 winning trades, expect #4 to win too - **Counter**: Review at least 100+ trade sample; use statistics ### Bias 3: Loss Aversion - **What**: Pain of losing 2× stronger than joy of equal gain - **Example**: Hold losers too long, cut winners too early