If your attitude is that the market is a gamble and you are just rolling the dice, you begin at a major disadvantage to the multitude of market professionals who are in the market every day. It is true that the market is more speculative than, say, the fixed income market and certainly more so than money market instruments like U.S. Treasury bills. Market professionals do a better job of getting out of losing trades and investments or they won’t last long in the profession—they, by necessity, have to minimize the chance that their most precious commodity will be wiped out, which is their trading or investing capital. There is an old market saying that the small loss is the easy one. Here are seven trading rules related to how you manage your trading strategy, capital, and risk.
- Right entry—Buy early in a trend when a stock or index has initial technical signals suggesting a trend is beginning, and don’t wait. Or buy or sell short after a setback (reaction) to the trend that is underway, for example, when a stock comes back to natural technical support or resistance points. Waiting and patience are the greatest virtues in the market.
- Determine an objective when you are thinking of buying or shorting a stock. This is important because (and it may seem strange) it’s necessary to change your focus from how much you can make to how much you are willing to lose. Set profit objectives—how much we’re willing to risk or lose is defined in relation to how much we think the item could move in our favor, based on technical analysis criteria, of course!
- Do the math—If you set a stop (your risk point) equal to one-half or one-third of what you hope to make, here is the calculation: On a 2:1 reward to risk—we calculate entry only when we could make $2 for every $1 risked—you could be stopped out or exited on one half of your trades and still make a substantial gain, minus commissions, as long as the other transactions achieve your profit objectives on average. In 10 transactions on a 2:1 risk/reward basis and where a loss is taken 5 times and a gain 5 times, but the average profit is double the average loss, the net result is that total profits are double total losses. However, then also assume that 1 or 2 losses get away from us. We decide to watch and see what happens—it’s not apparent why the stock, for example, is not performing. We hope the setback is temporary—but the stock ends up losing more than several earlier winning transactions. This then upsets the profit equation and we quickly are at break even or down substantially from where we started.
- Physically place the stop—Many investors don’t actually enter stops, preferring to take a wait and see attitude. After all, they are in this for the long haul. But think of all the surprises that occur in companies and their competitive positions in the marketplace. Traders are afraid of stops being hit or activated, only to see the stock go back up. The underlying problem with both of these attitudes is related to stock trading tip number 1: Select an entry at an optimal point, where there is an effective place (either under support or above resistance) to place a liquidating stop order that is both not likely to get hit and is relatively small in relation to your entry price. With mutual funds, it’s suggested you set mental stops, however wide, and adhere to them by liquidation when the loss point is exceeded.
- Use trailing stops—Sell stops protect a long position or initial purchase and buy stop orders protect a short position. Canceling and re-establishing stop orders as needed so that they trail along with the ongoing price trend requires some work and diligence as you need to periodically raise or lower your stop orders. This insures that your stops can reflect what is a moving target—the point at which a trend reversal has begun. As things move in your favor, this process first gets your liquidating stop order to a break-even point, where you would have no loss if you exit. Assuming a further favorable trend, you can next begin to lock in some of that profit you had projected. For example, when you are in a stock that reaches your price target, the question arises whether to sell at your preset objective—a question without a set answer. If a price objective is based on the fulfillment of an objective implied by a chart pattern, then completion of the objective may remove the reason you had to take the trade. In other instances, I view initial projections as minimum hoped-for objectives within a trend. I also like to stay with, and in, a favorable trend. Once the price has passed a hoped-for objective, simply be vigilant to the trend reversing and protect as much profit, by use of a stop, as is warranted by technical considerations, as we are going to study in the chapters ahead.
- Be willing to get out or get back in—As soon as the reasons for being in a position or in a trade are no longer present, it is best to exit. You may have bought a stock because it was in a strong uptrend. You purchased it right, the stock went up, and now you have a probable break-even situation due to moving a stop up to your entry point. However, the stock then goes into a sideways trend and basically moves laterally for many weeks. If you got into the stock because of its having a strong uptrend or the expectation of one, now may be the time to exit. The reasons you bought the stock are no longer present, particularly if the overall market continues to trend higher. Let’s examine further the case of a stock that goes against you. The object is to never let a loss get out of control, not to forget about or get negative on the stock(s) in which you were and may still be, interested in. If you get stopped out of such a stock and the countertrend runs its course, with the stock then resuming its prior trend, a repurchase may be warranted. But again, use favorable risk-to-reward criteria: If you risk to a point where liquidation would result in losing 10 percent of the money invested, but upside potential is calculated for at least 20 percent or more, and enough of these transactions average out this way over time, the result is a substantial overall profit.
- Stick to your game plan or strategy and to sound money management rules—If you are successful in business or whatever profession you are in, you have probably had a particular plan or methodology you adhered to. You didn’t change the plan when it didn’t produce results right away or even for a prolonged period, assuming you were following time-tested practices. Setbacks are part of this and of stock market investing. Time and patience are required. You can’t force a business, or the market, to do what you want it to. You have to be sufficiently capitalized also. In investing or trading, just like in business, you need to have sufficient reserves to stay in business. In the same way, don’t commit all of your investment or trading money to the market. I suggest keeping one third to one-half in reserve, the larger figure when you’re in more speculative markets or stocks. If your losses are more than you anticipate as you gain experience, that experience you gain will be of no use to you if you are out of the market due to lack of money to invest. As well, some people will get very aggressive and not only be 100 percent invested but buy on margin or borrowed money. I have seen many people lose considerable amounts in the end, even after having substantial profits at one time, because they were on margin and didn’t having staying power because of it—this is the well-known forced margin selling situation. The market might come back in your favor, but you can no longer profit from it. I also suggest reducing the size of your position if the market turns difficult and gets into turmoil. It would be best to not be in only one or two sectors of the market. I love tech stocks myself, but also find a lot to like in health care and drug stocks, for example, as they reflect another dominant and earnings-favorable investment theme, that of an aging population. If you like a stock, you don’t have to buy all that you would hope to buy initially. See how it behaves. If it looks good, buy some more after the first setback, and see how it behaves after that. If the item resists going down further, an eventual rally may develop.
Jack Schwager, in the Wizard Lessons summary chapter from his book, Stock Market Wizards, found many common traits in his group of supersuccessful money mangers and speculators. I’ll mention some of these lessons that reinforce what my own experience has shown. A universal trait, regardless of the method used to select stocks, was that individuals in this group had effective trading strategies and stuck to a game plan that accounted for all possibilities. They would assume that everything that could go wrong would go wrong—it’s all downhill after that. Great traders and money managers are marked by their flexibility. They were willing to see their pet ideas and theories proven wrong and change accordingly. This includes never falling in love with a stock. Save that for your spouse. It also takes time to become successful. Don’t give up.
Something I’ve discussed and Jack puts very well about his supersuccessful market professionals, is the role of hard work. Ironically, many people are drawn to the markets because it seems like an easy way to make a lot of money. Wrong! This group is, as was my own market wizard mentor, Mark Weinstein, extremely hard working—he, like most other big market winners, has a major passion for the market. Have a little passion and carve out a few hours a week from your busy lives, if you want a moderate success potential!
Last, all the very successful market participants that I’ve known are constantly, and I do mean constantly, concerned with avoiding loss and with how they manage their trading capital. The professionals believe that one of the most common mistakes made by novices is to expend great energy on finding the big potential winning stocks and a good entry price.
They spend comparatively little time on preventing and controlling losses as time goes on. This point also goes back to the work ethic that is required, to frequently assess and reassess your strategy and assumptions you may have made that could be wrong. Think about when to get out and keep thinking about it until you are out.
I have congratulated myself many times on getting in at the right time on a stock, for example, only to go to sleep, so to speak, and miss seeing the point at which upward or downward momentum slowed and then stopped. By the time the reversal was well underway, I was still hanging on because of having suspended my ongoing evaluation. I then missed the profit potential that was to be had. I expended good effort to research and find the trade but then wanted the work part to be over. This is a common fallacy and situation. I can only suggest that you remember when this happens to you so that you can correct it once experience has shown you this lesson.
All the above lessons and points have the common ground of being led astray by the great dual enemies of fear and greed. Greed is what drives many of the initial mistakes. We don’t expect to get rich quickly in most businesses and professions. Yet somehow when we see a stock make a huge move, we start to imagine finding just that kind of stock next. This tends to lead to haste in selection, or bad timing because we don’t wait for those special situations, as well as overcommitment of capital to the big hopedfor winner. Fear comes mostly from letting losses get out of control and overtrading. There used to be a saying among traders to “sell down to a sleeping level.” If you are so worried about your losses, actual or imagined, then reduce the size of your holding. I have sold stocks that I was sitting with at a loss, thinking I had no choice but to hope for the stock price to rebound. But by taking the loss and then being careful to select and closely monitor some other stock or stocks that looked promising, I started increasing the value of my portfolio again. And perhaps as important, I found a renewed interest in the market. And renewed commitment to not make the same mistake or mistakes I made before.
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