Trading Terminology

Common Terms You Might Need to Know

  • Day traders are traders who execute intraday strategies to profit off price changes for a given asset.
  • Day traders employ a wide variety of techniques in order to capitalize on market inefficiencies.
  • Day trading can be a lucrative undertaking, but it also comes with a high degree of risk and uncertainty.

A pattern day trader (PDT) is a regulatory designation for those traders or investors that execute four or more day trades during five business days’ time using a margin accountr. The number of day trades must constitute more than 6% of the margin account's total trade activity during that five-day window. If this occurs, the trader's account will be flagged as a PDT by their broker. The PDT designation places certain restrictions on further trading and is in place to discourage investors from trading excessively.

There are brokers that do not adhere to the PDT rule. 

Understanding Pattern Day Traders

A pattern day trader is a day trader who purchases and sells the same security on the same day in a margin account. Pattern day traders must also have more than six percent of those trades occur in the same margin account for the same period to be considered separate from a standard day trader. These securities can include stock options and short sales, as long as they occur on the same day. If there is a margin call, the pattern day trader will have five business days to answer it. Their trading will be restricted to that of two times the maintenance margin until the call has been met. Failing to address this issue after five business days will result in a 90-day cash restricted account status, or until such time that the issues have been resolved.

 

Note that long and short positions that have been held overnight but sold prior to new purchases of the same security the next day are exempt from the PDT designation.

 

Regulatory Guidelines for PDTs

The designation is determined by the Financial Industry Regulatory Authority (FINRA) and differs from that of a standard day trader by the amount of day trades completed in a time frame. Although both groups have mandatory minimum assets that must be held in their margin accounts, a pattern day trader must hold at least $25,000 in their account. That amount need not necessarily be cash; it can be a combination of cash and eligible securities. If the equity in the account drops below $25,000 they will be prohibited from making any further day trades until the balance is brought back up.

 

 

  • A margin account allows a trader to borrow funds from a broker, and not need to put up the entire value of a trade.
  • A margin account typically allows a trader to trade other financial products, such as futures and options (if approved and available with that broker), as well as stocks.
  • Margin increases the profit and loss potential of the trader's capital.
  • When trading stocks, a margin fee or interest is charged on borrowed funds.

What is Forex (FX)?

Forex (FX) is the marketplace where various national currencies are traded. The forex market is the largest, most liquid market in the world, with trillions of dollars changing hands every day. There is no centralized location, rather the forex market is an electronic network of banks, brokers, institutions, and individual traders (mostly trading through brokers or banks).

 

Many entities, from financial institutions to individual investors, have currency needs, and may also speculate on the direction of a particular pair of currencies movement. They post their orders to buy and sell currencies on the network so they can interact with other currency orders from other parties.

 

The forex market is open 24 hours a day, five days a week, except for holidays. Currencies may still trade on a holiday if at least the country/global market is open for business.

  • Trading platforms are software tools used to manage and execute market positions.
  • Platforms range from basic order entry screens for beginner investors to complex and sophisticated toolkits with live streaming quotes and charts for advanced traders.
  • What Is a Trading Platform?

    A trading platform is software used for trading: opening, closing, and managing market positions through a financial intermediary such as an online broker. Online trading platforms are frequently offered by brokers either for free or at a discount rate in exchange for maintaining a funded account and/or making a specified number of trades per month. The best trading platforms offer a mix of robust features and low fees.

     

    We recommend TDAmeritrade for those with accounts above $25k, or those that do not plan on trading more than 3 times per week. 

    If you plan on being an active day trader with less than $25k, we recommend F1Trade.com

What Is Paper Trading?

Paper trading is another term for simulated trading, whereby individuals can buy and sell securities without risking real money. While it’s possible to backtest trading strategies, traders may be tempted to use past information to make current trades—known as the look-ahead bias—while the wrong backtesting dataset could involve a survivorship bias. Survivorship bias is the tendency to view the performance of existing funds in the market as a representative sample.

Investors may be able to simulate trading with a simple spreadsheet or even pen-and-paper, but day traders would have quite a difficult time recording hundreds or thousands of transactions per day by hand and calculating their gains and losses. Fortunately, many online brokers and some financial publications offer paper trading accounts for individuals to practice with before committing real capital to the market. This allows them to test out strategies and practice using the software itself.

Setting Up a Day Trading Account

Day traders should ideally paper trade with the same day trading broker they plan to use for their live account since it will be as close to reality as possible.

What Is a Market Order?

A market order is a request by an investor – usually made through a broker or brokerage service – to buy or sell a security at the best available price in the current market. It is widely considered the fastest and most reliable way to enter or exit a trade and provides the most likely method of getting in or out of a trade quickly. For many large-cap liquid stocks, market orders fill nearly instantaneously.

The Basics of Market Orders

A market order is considered the most basic of all orders. It is meant to be executed as quickly as possible at the current asking price for a security. That is why certain brokerages include trading applications with a buy/sell button. Hitting this button generally executes a market order. In most cases, market orders incur the lowest commissions of any order type, as they require very little work from either a broker.

 

What is a Limit Order?

A limit order is a type of order to purchase or sell a security at a specified price or better. For buy limit orders, the order will be executed only at the limit price or a lower one, while for sell limit orders, the order will be executed only at the limit price or a higher one. This stipulation allows traders to better control the prices they trade. By using a buy limit order, the investor is guaranteed to pay that price or less. While the price is guaranteed, the filling of the order is not, and limit orders will not be executed unless the security price meets the order qualifications. If the asset does not reach the specified price, the order is not filled and the investor may miss out on the trading opportunity.

 

This can be contrasted with a market order, whereby a trade is executed at the prevailing market price without any price limit specified.

  • A limit order guarantees that an order is filled at or better than a specific price level.
  • A limit order is not guaranteed to be filled, however.
  • Limit orders control execution price but can result in missed opportunities in fast moving market conditions.
  • Limit orders can be used in conjunction with stop orders to prevent large downside losses.

What Is a Stop Order?

A stop order is an order to buy or sell a security when its price moves past a particular point, ensuring a higher probability of achieving a predetermined entry or exit price, limiting the investor's loss or locking in a profit. Once the price crosses the predefined entry/exit point, the stop order becomes a market order.

 

Also referred to as a "stop" a stop order to sell that is linked to a limit order is referred to as a "stop-loss order."

 

  • Stop orders are orders that are triggered when a stock moves past a specific price point. Beyond that price point, stop orders are converted into market orders that are executed at the best available price.
  • Stop orders are of various types: buy stop orders and sell stop orders; stop market and stop-limit.
  • Stop orders are used to limit losses with a stop-loss or lock in profits using a bullish stop.

What Is Short Selling?

Short selling is an investment or trading strategy that speculates on the decline in a stock or other securities price. It is an advanced strategy that should only be undertaken by experienced traders and investors.

Traders may use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one. Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to reduce risk exposure.

In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value by a set future date—the expiration date. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase them at a lower cost. The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.

  • Short selling occurs when an investor borrows a security and sells it on the open market, planning to buy it back later for less money.
  • Short sellers bet on, and profit from, a drop in a security's price.
  • Short selling has a high risk/reward ratio: It can offer big profits, but losses can mount quickly and infinitely.

What Is the Risk/Reward Ratio?

The risk/reward ratio marks the prospective reward an investor can earn, for every dollar he or she risks on an investment. Many investors use risk/reward ratios to compare the expected returns of an investment with the amount of risk they must undertake to earn these returns. Consider the following example: an investment with a risk-reward ratio of 1:7 suggests that an investor is willing to risk $1, for the prospect of earning $7. Alternatively, a risk/reward ratio of 1:3 signals that an investor should expect to invest $1, for the prospect of earning $3 on his investment.

 

Traders often use this approach to plan which trades to take, and the ratio is calculated by dividing the amount a trader stands to lose if the price of an asset moves in an unexpected direction (the risk) by the amount of profit the trader expects to have made when the position is closed (the
reward).

 

KEY TAKEAWAYS

  • The risk/reward ratio is used by traders to manage their capital and risk of loss during trading.
  • The ratio helps assess the expected return and risk of a given trade.
  • AWAYS

    • The risk/reward ratio is used by traders to manage their capital and risk of loss during trading.
    • The ratio helps assess the expected return and risk of a given trade.
    • A good risk reward ratio tends to be anything greater than 1 to 3. 

Indicators are statistics used to measure current conditions as well as to forecast financial or economic trends.

Technical Indicators

In the context of technical analysis, an indicator is a mathematical calculation based on a security's price and/or volume. The result is used to predict future prices.

 

Common technical analysis indicators are the moving average convergence-divergence (MACD) indicator and the relative strength index (RSI).

 

The MACD is based on the assumption that the tendency of the price of a traded asset is to revert to a trend line. In order to discover the trend line, traders look at the moving averages of asset prices over different time periods, often over 50 days, 100 days and 200 days. In addition, moving averages can be either simple or exponential.

 

The RSI compares the size of recent gains to recent losses to determine the asset's price momentum, either up or down. Using tools like the MACD and the RSI, technical traders will analyze assets' price charts looking for patterns that will indicate when to buy or sell the asset under consideration.

What Is Moving Average Convergence Divergence – MACD?

Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA.

 

The result of that calculation is the MACD line. A nine-day EMA of the MACD called the "signal line," is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals. Traders may buy the security when the MACD crosses above its signal line and sell - or short - the security when the MACD crosses below the signal line. Moving Average Convergence Divergence (MACD) indicators can be interpreted in several ways, but the more common methods are crossoversdivergences, and rapid rises/falls.

 

KEY TAKEAWAYS

  • Moving Average Convergence Divergence (MACD) is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA.
  • MACD triggers technical signals when it crosses above (to buy) or below (to sell) its signal line.
  • The speed of crossovers is also taken as a signal of a market is overbought or oversold.
  • MACD helps investors understand whether the bullish or bearish movement in the price is strengthening or weakening. 
 

What Is the Relative Strength Index (RSI)?

The relative strength index (RSI) is a momentum indicator used in technical analysis that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100. The indicator was originally developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, "New Concepts in Technical Trading Systems."

Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.

 

KEY TAKEAWAYS

  • The relative strength index (RSI) is a popular momentum oscillator developed in 1978.
  • The RSI provides technical traders signals about bullish and bearish price momentum, and it is often plotted beneath the graph of an asset's price.
  • An asset is usually considered overbought when the RSI is above 70% and oversold when it is below 30%.

What Is a Trendline?

Trendlines are easily recognizable lines that traders draw on charts to connect a series of prices together or show some data's best fit. The resulting line is then used to give the trader a good idea of the direction in which an investment's value might move.

 

A trendline is a line drawn over pivot highs or under pivot lows to show the prevailing direction of price. Trendlines are a visual representation of support and resistance in any time frame. They show direction and speed of price, and also describe patterns during periods of price contraction.

 

KEY TAKEAWAYS

  • Trendlines indicate the best fit of some data using a single line or curve.
  • A single trendline can be applied to a chart to give a clearer picture of the trend.
  • Trendlines can be applied to the highs and the lows to create a channel.
  • The time period being analyzed and the exact points used to create a trendline vary from trader to trader.

What is a Moving Average?

A moving average (MA) is a widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random short-term price fluctuations.

 

KEY TAKEAWAYS

  • A moving average (MA) is a widely used indicator in technical analysis that helps smooth out price action by filtering out the “noise” from random short-term price fluctuations.
  • Simple moving averages (SMA) take the arithmetic mean of a given set of prices over the past number of days, for example over the previous 15, 30, 100, or 200 days.
  • Exponential moving averages (EMA) use a weighted average that gives greater importance to more recent days to make it more responsive to new information.

What Is an Exponential Moving Average (EMA)?

An exponential moving average (EMA) is a type of moving average (MA) that places a greater weight and significance on the most recent data points. The exponential moving average is also referred to as the exponentially weighted moving average. An exponentially weighted moving average reacts more significantly to recent price changes than a simple moving average (SMA), which applies an equal weight to all observations in the period.

  • The EMA is a moving average that places a greater weight and significance on the most recent data points.
  • Like all moving averages, this technical indicator is used to produce buy and sell signals based on crossovers and divergences from the historical average.
  • Traders often use several different EMA lengths, such as 10-day, 50-day, and 200-day moving averages.
 
 

What Is Level 2

First introduced in 1983 as the Nasdaq Quotation Dissemination Service (NQDS), Level 2 is a subscription-based service that provides real-time access to the NASDAQ order book. It is intended to display market depth and momentum to traders and investors.

 

The service provides price quotes from market makers registered in every NASDAQ-listed and OTC Bulletin Board securities. The Level 2 window shows the bid prices and sizes on the left side and ask prices and sizes on the right side.

 

KEY TAKEAWAYS

  • Nasdaq's Level 2 subscription service provides market depth and momentum statistics to traders. It is intended to provide a bird's eye view of market action.
  • The additional information related to pricing action and market momentum gives traders and investors a leg up in implementing trading strategies.

Basics of Level 2

Level 2 provides users with depth of price information, including all the available prices that market makers and electronic communication networks (ECN) post.

 

Level 1 offers enough information to satisfy the needs of most investors, providing the inside or best bid and ask prices. However, active traders often prefer Level 2 because it displays the supply and demand of the price levels beyond or outside of the national best bid offer (NBBO) price. This gives the user a visual display of the price range and associated liquidity at each price level. With this information, a trader can determine entry and or exit points that assure the liquidity needed to complete the trade.

 

Price movement on Level 2 is not necessarily an actual reflection of the recorded trades; Level 2 is just a display of the available price and liquidity. This is an important distinction because high-frequency trading programs frequently adjust Level 2 bid and ask prices violently to shake the trees and panic onlookers despite the lack of actual executed trades. This practice is common in momentum stocks.

Level 2 and Reserve and Hidden Orders

Many ECNs, which are the automated systems that match buy and sell orders for securities, offer the ability for traders to post reserve orders and hidden orders. ECNs generally display the best available bid and ask quotes from multiple market participants, and they also automatically match and execute orders.

 

ECNs offer a reserve order option, which is composed of a price and display size along with the actual size. This order only shows the specific display size on Level 2 as it hides the true size of the entire order.

 

Hidden orders, which are an option where investors can hide large orders from the market on the ECN, function in a similar way but are invisible on Level 2. This allows for more discretion in determining prices. The best way for users to determine the status of reserve or hidden orders is to check the time and sales for trades at the indicated prices.

 

Benefits of Trading Using Level 2 Quotes

The main benefit of using Level 2 quotes is getting access to a wealth of information related to the market. This information can be used in various ways for profit-making. For example, you can ascertain liquidity volumes and order sizes for a stock traded on Nasdaq. You can also identify trends using information about bid and ask orders.

What Is Swing Trading?

Swing trading is a style of trading that attempts to capture gains in a stock (or any financial instrument) over a period of a few days to several weeks. Swing traders primarily use technical analysis to look for trading opportunities. These traders may utilize fundamental analysis in addition to analyzing price trends and patterns.

Understanding Swing Trading

Typically, swing trading involves holding a position either long or short for more than one trading session, but usually not longer than several weeks or a couple months. This is a general time frame, as some trades may last longer than a couple of months, yet the trader may still consider them swing trades. Swing trades can also occur during a trading session, though this is a fairy rare outcome that is brought about by extremely volatile conditions.

 

The goal of swing trading is to capture a chunk of a potential price move. While some traders seek out volatile stocks with lots of movement, others may prefer more sedate stocks. In either case, swing trading is the process of identifying where an asset's price is likely to move next, entering a position, and then capturing a chunk of the profit if that move materializes.

Successful swing traders are only looking to capture a chunk of the expected price move, and then move on to the next opportunity.

  • Swing trading involves taking trades that last a couple of days up to several months in order to profit from an anticipated price move.
  • Swing trading exposes a trader to overnight and weekend risk, where the price could gap and open the following the session at a substantially different price.
  • Swing traders can take profits utilizing an established risk/reward ratio based on a stop loss and profit target, or they can take profits or losses based on a technical indicator or price action movements

What Is a Gap?

A gap is an area of a chart where a security's price either rises or falls from the previous day’s close with no trading occurring in between. In the example below, Netflix’s stock gapped higher on January 15, 2019, after the company announced it was raising the cost of its monthly subscription.

KEY TAKEAWAYS

What Does A Gap Tell You?

Gaps typically occur when a piece of news or an event causes a flood of buyers or sellers into the security. It results in the price opening significantly higher or lower than the previous day’s closing price. Depending on the kind of gap, it could indicate either the start of a new trend or a reversal of a previous trend. In the example below, Amazon.com Inc. (AMZN) stock gaps higher on October 27, 2017, rising sharply from the previous days close after months of sideways consolidation. The stock's gain is accompanied by a massive increase in volume, confirming a breakaway gap. It is the start of a new trend higher in Amazon’s stock, which goes on to rally from $985 to $2,050 by September 2018.

The Difference Between Different Types of Gaps

There are some fundamental differences between the different types of gaps. For example, reversal or breakaway gaps are typically accompanied by a sharp rise in trading volume, while common and runaway gaps are not. Additionally, most gaps occur due to news, or an event such as earnings or an analyst's upgrade/downgrade. Common gaps happen more regularly and do not always need a reason to occur. Also, common gaps tend to get filled, whereas the other two gaps may signal a reversal or continuation of a trend.

Understanding Common Gaps

In general, there is no major event that precedes this type of gap. Common gaps generally get filled relatively quickly (usually within a couple of days) when compared to other types of gaps. Common gaps are also known as "area gaps" or "trading gaps" and tend to be accompanied by normal average trading volume.

 

Because common gaps are relatively small, normal and somewhat regular events in the price action of an asset, they tend to provide no real analytical insight. These gaps are observed frequently in assets that experience a break from one day's market close to the next day's open and may be exaggerated by events that occur between Friday and Monday trading over a weekend.

 

Common gaps are typically what market technicians refer to as filled gaps. This refers to when the price from a gap reverts back to where the gap initially began, where the empty space has thus been considered to be filled. For instance, if shares of XYZ stock closed at $35.00 on Tuesday, and then XYZ opens the next day at $35.10 on Tuesday morning, the Tuesday intra-day price will tend to include the $35 price level.

What Is an Exhaustion Gap?

An exhaustion gap is a technical signal marked by a break lower in prices (usually on a daily chart) that occurs after a rapid rise in a stock's price over several weeks prior. This signal reflects a significant shift from buying to selling activity that usually coincides with falling demand for a stock. The implication of the signal is that an upward trend may be about to end soon.

 

KEY TAKEAWAYS

  • This technical signal marks the potential change from upward trend to downward trend.
  • The signal has three main characteristics including increased volume and a downward price break.
  • Exhaustion gaps imply that buyers are used up or exhausted and don't have enough orders to overwhelm the significant number of new sellers that seem to have entered into the market.

Understanding the Breakaway Gap

A breakaway gap occurs when the price gaps above a support or resistance area, like those established during a trading range. When the price breaks out of a well-established trading range via a gap, that is a breakaway gap. A breakaway gap could also occur out of another type of chart pattern, such as a triangle, wedge, cup and handle, rounded bottom or top, or head and shoulders pattern.

 

Breakaway gaps are also typically associated with confirming a new trend. For example, the prior trend may have been down, the price then forms a large cup and handle pattern, and then has a breakaway gap to the upside above the handle. This would help confirm that the downtrend is over and the uptrend is underway. The breakaway gap, which shows strong conviction on the part of the buyers, in this case, is a piece of evidence that points to further upside in addition to the chart pattern breakout.

A breakaway gap with larger than average volume, or especially high volume, shows strong conviction in the gap direction. A volume increase on a breakout gap helps confirm that the price is likely to continue in the breakout direction. If the volume is low on a breakaway gap there is a greater chance of failure. A failed breakout occurs when the price gaps above resistance or below support but can't sustain the price and moves back into the prior trading range.

 

Gaps can occur at any time but are highly likely to occur following earnings announcements or other major corporate announcements.

 

Trend and Gap Cycles

While not every trend has a breakaway gap, some trends do have a breakaway gap and they are often seen early on in a trend when the price makes a significant move outside of a chart pattern. That said, anytime a significant chart pattern is followed by a gapping breakout, it could be called a breakaway gap.

 

As the trend accelerates it then tends to see another type of gap called the runaway gap. A runaway gap is when the price opens significantly higher than the prior close in an established uptrend. During a downtrend, a runaway gap is when the price opens significantly lower than the prior close. Typically the price continues moving in the runaway gap direction within a few weeks, and sometimes within days or even the next day. A runaway gap doesn't need to breach a major support or resistance level (like a breakaway gap) but it must occur in the current trend direction.

 

As a trend nears its end, it may experience an exhaustion gap. An exhaustion gap occurs near the end of a trend and is caused by a final group of buyers, who regret not having bought prior, surging in. In a downtrend, an exhaustion gap is a gap caused by sellers. An exhaustion gap is similar to a runaway gap, except that an exhaustion gap is usually associated with very high volume. Some runaway gaps are as well, yet traders can also watch for exhaustion gaps to fill quickly. Since an exhaustion gap usually occurs near the end of the trend, any progress the gap made is usually erased (gap filled) within a few weeks and often within several days.

 

There are also common gaps which occur when there is a small difference between the open and closing price. These occur frequently and most traders consider them to have less significance than breakaway, runaway, and exhaustion gaps.