Many new traders want to learn from the experiences of professional traders to start their trading journey. However, they get confused by basic terms which professional traders use frequently, making it difficult to start learning about trading. Here are 11 basic trading terms which every trader should know.
1. Stop-loss
Stop-loss is a price where a trader accepts that the trade has gone wrong. It is a price at which the trader squares off (more on this later) his/her trading position and takes a small loss. It is the amount of loss which a trader is willing to take in order to avoid further losses. Let’s suppose you bought a stock at Rs. 100 with the target of Rs. 110, it is prudent to put a stop-loss at around Rs. 95 at which the trade will be considered a failed trade & you will exit with a small calculated loss. NOTE : The numbers mentioned here are just an example. Professional traders always use stock charts for their entry, target & stop-losses.
Stop-loss is considered to be an extremely essential part of a trader’s vocabulary since it is an essential part of a trader’s successful trading plan. It is a small price to pay for a trader when he/she has been proven wrong by the market. To learn more about the importance of stop-loss in trading, visit this article – Why Stop-loss is very important in Stock Trading?
2. Target / Take Profit
Target (also known as take profit) is the price where a trade accepts that the trade has been successful. At this price, the trader closes the trading position & exits with the profits. Whether the stock further increases or decreases in value is of no concern to the trader since he/she has already exited & made money in the stock. Similar to the stop-loss, the target is also typically derived from the stock chart. Every trade which a trader takes has a pre-determined stop-loss and target levels which are defined even before the trade is executed. Trading is simply a game of finding out which price level gets hit first!
3. Square Off
Square off is a fancy way of saying that the trading position has been closed. There are other terms used similar to square off such as “Long unwinding” or “Short covering”. However, there are subtle differences between these terms.
Let’s suppose you bought a stock at Rs. 100 hoping that the price of the stock will rise to Rs. 110. If you decide to close your trading position (i.e. sell the stock), then it is referred to as squaring off your position regardless of whether you made a profit or a loss. On the other hand, “Long unwinding” is typically used for big players (such as FIIs, DIIs, fund houses, etc.) & is considered a part of profit booking. Even though the big players are also simply squaring off their trading positions, it is called Long unwinding.
Similarly, if you sold a stock at Rs. 100 hoping that the price of the stock will fall to Rs. 90. If you decide to close your trading position (i.e. buy the stock), then it is still referred to as squaring off your position regardless of whether you made a profit or a loss. On the other hand, “Short covering” is typically used for big players (such as FIIs, DIIs, fund houses, etc.) & it is considered a part of profit booking.
To summarize – any type of trading position being closed is called a “Square off”, big players profit booking on long position is called “Long unwinding” & big players profit booking on short position is called “Short covering”.
4. Long/Short Position
Long position means that you are bullish on a stock or an index. If you have a long position in Reliance Industries, it means that you are expecting that the price of the stock will increase and you plan on capitalizing on this price rise by either buying the stock directly or trading in futures/options for Reliance Industries.
On the other hand, a short position means that you are bearish on a stock or an index. If you have a short position in Reliance Industries, it means that you are expecting that the price of the stock will decrease and you plan on capitalizing on this price fall by either selling the stock directly or trading in futures/options for Reliance Industries.
To learn more about long & short positions in the stock market, visit this article – What are Long and Short positions in the stock market?
5. Win Rate
Win rate is a measure of a trader’s accuracy in stock trading. It is referred to as the percentage of winning trades compared to the total number of trades which a trader has taken. Let’s suppose a trader has taken 10 trades out of which 5 are winning & 5 are losing trades, then a trader has a win rate of 50%. Similarly, if a trader has taken 10 trades out of which only 3 have hit the target, then this trader has a win rate of 30%.
It might seem obvious that a high win rate is good for a trader. While this is true in some cases, the win rate is not the only factor in a trader’s success. This brings us to our next point. To learn more about win rate in stock trading, visit this article – What is a good win rate for profitable traders?
6. Reward to risk ratio
Reward to risk ratio is the heart of the trading strategy which can make the difference between a profitable & an unprofitable trader. Reward to risk ratio is a number which tells us about the potential reward which a trader is hoping for every unit of risk taken. If you are taking a trade with a reward to risk ratio of 2:1, then you are looking at a reward of Rs. 200 for every Rs. 100 risk taken.
Professional traders almost always trade in the market with a high reward to risk ratio. It is not wise to take a risk of Rs. 100 for a potential reward of Rs. 75! Most professional traders are willing to reduce their win rate in order to get a high reward to risk ratio.
7. Drawdown
Drawdown refers to the loss of a trader’s equity when the trades are not going in favour of a trader. Every trader suffers from drawdown from time to time because every trading strategy has a weakness & can fail from time to time. There are times in a trader’s life when most of his trades are failing leading to a losing streak. Let’s suppose that there are two traders who have a win rate of 50% each. They take 10 trades each in a week and here are the results.
It can be seen that even though both Ram & Shyam made the exact same amount of money, there was a time when Ram’s trading capital was down from Rs. 10,000 to Rs. 7,500 because he was on a losing streak of 5 losses in a row. This means that Ram suffered a drawdown of 25% on his trading capital i.e. his trading capital was down 25% from his maximum capital. On the other hand, Shyam did not suffer any drawdown during these 10 trades because his wins & losses were distributed fairly uniformly. So, what caused Ram to undergo a drawdown? LUCK! Every trader suffers from a losing streak & can end up taking big drawdowns on his/her trading capital. This is where risk management comes in & this brings us to our next point.
8. Risk management
Risk management refers to the capability of a trader to take up a limited amount of risk (generally recommended risk is ~0.5-1% of the trading capital) per trade. This allows a trader to survive a losing streak without any worries because no single trade is causing a massive erosion of capital. Imagine being a trader who takes up a risk of 10% per trade. That trader would blow up his/her account if a losing streak of 6-7 consecutive losses are encountered.
Risk management (also referred to as money management) is an essential part of a trader’s business plan. Every successful professional trader is a great risk manager. A good risk manager always prepares for the potential worst case scenario & protects himself/herself from blowing up the trading account. To learn more about a new trader’s guide to a profitable trading system, visit this article – New trader’s guide to a profitable trading system!
9. Trading Setup (also known as just Setup)
Trading setup is a tried & tested strategy which a trader likes to use in the stock market. It generally refers to a pattern which repeats in the market or a scenario which leads to predictable outcomes. A professional trader sticks to his/her proven setup & follows it with discipline. If the market doesn’t provide any trades as per the setup, then no trades should be taken. The only goal of a professional trader is to watch the market & wait for the setup!
10. Position Sizing
Position sizing is the size of a trade (i.e. the quantities bought or sold) which a trader should take. It is often derived from risk management. Let’s suppose that you want to go long on a stock, then how do you decide how many stocks you should buy? The position size depends entirely upon your risk! If you are willing to take a risk of Rs. 1000 in a stock & the stop-loss is Rs. 10 below your entry price, then you should buy exactly 100 stocks. If you buy exactly 100 stocks, then you would risk Rs. 1000 which is a calculated risk that you are willing to take.
It is always recommended for a new trader to keep a small position sizing when starting their trading journey since this will allow the trader to bounce back from adversities & avoid blowing up your account!
11. Getting filled
Getting filled simply means getting what you want! Let’s suppose that as per your trading system, you want to buy a stock exactly at Rs. 105.5 and the stock is currently trading at Rs. 106. Now imagine that the stock didn’t come down to your price & didn’t “fill” you into the trading position. This means that even though you were right about a trade, you didn’t make any money because the stock never came to your buy price! This happens often in trading where a trader is right about a stock but doesn’t get entry in the stock at his/her desired price. What can a trader do when he/she doesn’t get filled? Just forget about that trade & move onto the next trade. Being right in trading is not important, making money is! To learn more about this, visit the article – The biggest psychological mistake which retailers make in the market!
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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Nice work to familiarise the terms
Thanks 😀