So you’ve put some capital together and you’re ready to dive right into stock trading to earn your fortune, right? The only thing you need to do is open an account with a stock broker, right? Careful now – a wise stock investor would do more than that – a lot more actually.
They say that a year from now, over 90% of those who are trading stocks today will lose all their money and be out of the stock market altogether. This is not the greatest odds, is it? The good news is that it illustrates a huge common problem among would be stock investors – a serious lack of planning and discipline.
As you might imagine, the convenience of online stock trading is only made these numbers worse. Why? It is because stock brokerages nowadays allow people to go solo and call all the shots themselves as they see fit – and they are not knowledgeable enough to do so. At least back in the old days when you used an honest to God stock broker, they would provide some professional guidance and urge investors to acknowledge the danger signs – even though they were pretty expensive to use.
We simply don’t need stock brokers anymore unless we truly want them. There are two big reasons why we don’t need them anymore. The first – and most obvious reason – is cost. Back in the day, we might pay as much as fifty dollars per trade to buy or sell a stock. When we use our own stock trading account, it will cost as little as five dollars per trade. The second reason is that we have all the research information about stocks we would ever need available free on the internet. It used to be that only stock brokers had this information.
Unfortunately, even with this reduction in trading costs and availability of stock information, we still lose money. In fact, we lose even more money than we did before.
A Must For Stock Trading
The very first thing you must have to succeed in the stock market today is discipline. No, it’s not some new way to crunch financial data or a new price pattern on a stock chart, it only good old discipline.
You see, if want to learn how to buy stocks, then you must understand yourself and then apply principles that support who you are. Most people don’t get this, but investing in stocks in psychological. Don’t believe me? Then why is it that ten different stock investors can buy the exact same stock at the exact same time and then each one of them earn ten different profits from that stock? This has been proven over and over again.
There is one great way to force yourself to have discipline when you invest in stocks, and that is developing a trading plan before you invest any of your hard earned money. So what does a trading plan consist of?
A stock trading plan is where you establish all the rules that you will set for yourself when you invest your money. It defines the risks you are allowed to take and how you will manage your capital. It defines how you will take profits and manage stock positions in portfolio.
If you haven’t noticed by now, the key here is establishing rules BEFORE you begin trading. This means you are planning when you are away from the stock markets. This is a critical point because too many people make too many important decisions in the heat of the battle. The fact is that this is the absolute worst time to make investing decisions. Many professional traders will tell you that they make no decisions during trading hours; they make all decisions beforehand and merely execute the plan during market hours.
Mentally Rehearsing Your Stock Trades
If you want to put together a solid stock trading plan, then you should try to include contingencies for every conceivable scenario imaginable. The first two questions should pertain to taking losses and taking profits, but those are not only obvious, they’re also easy.
What will you do during a major sell off? How will you handle a prolonged bear market? Will you try to trade it or take scalps? Will you invest in treasury bills and stay on the sidelines? How about when one of your stocks “gaps down” at the open? How will you handle events like earnings reports or when the Federal Reserve has a quarterly meeting? These are all occasions that often introduce volatility into the markets.
The biggest key to how you handle these issues depends on who you are psychologically. You really have to understand the types of investments that you are best suited for, and more importantly, the types of investments that do not suit you well.
For instance, if you are laid back and do not prefer making lots of investing decisions in a short period of time, then you shouldn’t be a day trader. On the other hand, if you thrive on excitement and perform better in volatile environments, then the opposite may be true.
The good news here is that stock investors of types have gotten rich trading in the markets. There are day traders who are millionaires and there are long term traders who are millionaires. You just have to know which type you are and tailor your trading plan to suit your strengths.
Understand Your Stock Investing System
Investor’s lack of understanding their trading system when they invest in stocks is a huge reason for losing money in the stock market. It is quite amazing how many investors out there have no clue what the probability of finding a winning stock when using their trading system. Quite frankly, most of them don’t even have a trading system. And among those who do, I would venture to say that most of them are clueless as to what to expect from a series of trades.
Let me state this. If you don’t know the probabilities associated with your trading system, then you go ahead and flush your capital down the toilet now. Eventually, you will lose your money. You have to know what to expect from your system.
Let us illustrate with an example. Suppose your trading method produces 50% winners. And on average, your winning trades earn $50 per trade and your losing trades lose $75 per trade – is this a system you should keep using? Of course not.
What about if your trading method produces 65% winners? And you win $50 per winning trade and lose $75 per losing trade. Is this system profitable? Technically, it is profitable – by a little bit. Here’s the maths:
Expected Profit = (65% x $50) – (35% x $75) = $32.50 – $26.25 = $6.25 profit per trade
This trading system could become very profitable with a few tweaks – such as cutting loses quicker or holding winners a little longer or both.
Here’s another scenario – suppose you have a trading system that wins only 35% of the time. Yet on average it earns $250 per winning trade and loses only $55 per losing trade. This system is very profitable.
Expected Profit = (35% x $250) – (65% x $55) = $87.50 – $35.75 = $51.75 profit per trade
This has the characteristics of a long term trading system. They look for a big winner or two that makes most of the profits for their entire year. They keep cutting losses on many losing trades until they find the big winner. Patience is key when using this type of system.
Understanding your trading system is paramount. If you are not sure where you stand, then the best way to evaluate your method is the paper trade 30-50 trades exactly as you would in real life and record the statistics. This will give you a great starting point.
Money Management – The Forgotten Practice
Money management is another one of those important elements in stock investing that is overlooked too often. The fact of the matter is that when your money runs out, then the game is over – period. So your very first objective should be to protect your capital above all else. And yes, it’s even more important than earning a profit.
Money management should be a huge portion of your trading plan and it is so easy to accomplish when you’re engaged in stock trading. Online stock brokerages give you all the tools you could ever want to manage your trades. If you are not using these tools, then that’s on you.
The first element of money management is how much exposure you will submit to your overall stock account. A good rule of thumb is 8-10%. What this means is if the markets were to crash right now and all your stocks were automatically sold (because you used stop-losses, right?), then your exposure is how much you would lose theoretically. That number should be no more than 10%. Some traders like to use 5%, but if you don’t have much capital, 5% may restrict how much you can invest.
The next thing you must decide is how many positions you will hold at any given time. A rule of thumb here might be 3-5 positions. Here’s the thing – the fewer stocks you hold, the greater the potential reward and the greater the potential loss. Obviously, the more stocks you hold, then your risk and reward are both lower.
Now you must distribute that overall account exposure across all those stock positions. So if you hold three stocks, then each one might expose 3% of your capital. If you hold five stocks, then each one might expose 2% of your funds. This is all up to you, but you must address this and be smart about it. My advice is to never expose more than 10% of your capital at any one time.
Now let’s get down to the individual stocks. Each time you buy a stock, you should immediately place a stop-loss order to automatically sell it when it drops to a certain level. That level depends on your stock trading system. You may have to vary the number of shares you can buy to meet your overall exposure criteria. I recommend using a spreadsheet to track your exposures.
As your stock moves up in price, you should move your stop-loss up along with it. This is known trailing stop. Trailing stops are great for locking in paper profits and you can set them to move automatically. More importantly, trailing stops remove your exposure, so you should always use them.
Managing Your Stock Trades
We have already addressed cutting loses in the last section and of course, you do that by setting stop-losses immediately after purchasing every stock. When you cut losses, you stay in the game long enough to get those winners.
What we should discuss now is perhaps a harder decision and that is taking profits. I mentioned and urged you earlier to always use trailing stops. As you recall, these are stops that automatically move up as the stock price moves up to lock in paper profits. The question here is how tight do we set them?
If we set them too tight, we certainly protect our profits, but could also get “stopped out” of the position too soon and watch the stock soar 20 more points without us. If we set them too loose, then we might give back thousands of dollars and kick ourselves later.
The first thing you must embrace when trading stocks is that you will never pick the perfect bottom and get out at the perfect top of any market. Professional traders can’t do that, so why should you? They will tell you that the best way to make money in the stock market is by taking profits out of the middle of a big stock move. This is also the safest way to make money from stocks.
Let’s look at three different approaches:
1 – Set a reasonable trailing stop based on your trading system and let it run until the market stops you out.
2 – Set a loose trailing stop until your reach a predetermined profit level such as 20-30% and then take all profits.
3 – Set a reasonable trailing stop and sell off half of your position when achieving a predetermined profit level such as 10-20% and let the rest of the position run until the market stops you out.
A lot of money has been made in the markets using all three of these basic approaches. Of course, you can use any combination of these to suit your own needs. The important thing is you establish this before you begin trading.
Hopefully, after reading this, you understand the importance of having a stock trading system and more importantly, a trading plan. And we cannot stress enough how critical it is to put this plan together away from the market environment.
When you undertake stock trading and you learn how to buy stocks, it doesn’t have to be a painful experience. Just don’t rush things and use your common sense.