Trading
101- How to Approach Stock Market Trading
Trading with a business like approach
Chapter Outline:
- TRADING CAPITAL
- TRADING OBJECTIVE
- PLANNING FOR HOW TO REACH TRADING OBJECTIVE
- TRADING STRATEGY- WHAT TO TRADE AND WHEN
- DAY-TO-DAY MONITORING OF TRADING ACTIVITIES
- MISCELLANEOUS TRADING RULES
- A SAMPLE TRADING PLAN
What should one
do before he starts trading? How should he create his trading plan?
There is no straight answer or a standard plan. What works best for
one person may not work well for others! So I am not going to give advice
on how one should trade but I would strongly recommend that one should
approach trading as if he were starting a business.
How do most people
get into trading world? Most people start trading without putting
any serious thought into it. It is interesting to know what brings people
into trading. Many times, one hears a friend or a stranger talking about
his impressive profit in a stock trade and this tempts him to trade
stocks for seemingly easy money. He starts by watching a few stocks,
say around 6-8, and as time passes, his list gets narrow as stocks that
are not doing good will drop from his watch list! So after some time,
he forgets about the stocks that were on his watch list but did not
do well, and he keeps focusing only at those 2/3 stocks that are doing
well. This fills up one with false confidence that he has exceptional
stock picking skills and he genuinely starts believing that he is born
with necessary skills for success in trading! Now he will not want to
waste any time so he makes first trade. It may be just a coincidence
or may be a lot of research behind it, but a person's first trade is
more likely to be in profit than in a loss! Maybe that is the law of
the nature to drag more people into trading! After first trade, there
is no looking back! Before one even realizes, he is hooked up. He is
addicted to stock trading!
As mentioned earlier,
people enter trading without any plan or any idea about how they want
to approach trading. To me, trading is like a business and like in any
business one needs to do some thinking and planning before he gets in.
One has to decide how much money he wants to start with, what his strategy
is and what the goal is. I strongly believe one should write down these
things on paper before he makes any trade. This is like having a business
plan.
Let
me give you some ideas about what should be part of a good trading plan.
How
much money do you need to start trading with?
There
is no standard number. It all depends on one's financial situation,
circumstances, experience, investment objectives and risk tolerance.
For a novice trader, I think he should start with an amount from 5 to
20 thousand dollars. This starting amount has to be the amount that
if one loses it all, it will not create financial hardship for him or
for his dependents. If it were all lost, it wouldn't create a stress
on one's bank account, retirement plans or on lifestyle. This is like
a risk capital. Let me highlight the importance of this starting amount.
There is a big difference between trading and any other business. In
any other business, it is not difficult to determine when to call the
quit. However in trading, I have seen people continue trading for a
long time despite the fact that they know that they are not making any
money! May be it is hard for one to accept the fact that trading is
not for him or maybe it is the hope of winning in the end that is not
letting people quit the game. Nevertheless it is very important for
a person to accept his limits and understand that there are a lot of
things for which one does not have necessary skills, emotions and/or
aptitudes. Every one of us can't be a successful auto mechanic, plumber
or a heart surgeon! In the same way, the stock trading may not be appropriate
for every one of us! This is why it is important for a person to start
with a pre-defined risk capital to test himself for trading, and then
if successful, he can keep doing it. If he loses his risk capital, he
will need to stay away from trading for a considerable time if not forever.
Write
down here: My risk capital is: ___________________
What
is our objective with regard to trading?
When
a person starts a business, he has some goals, objectives or expectations
about how much business he wants to do or money he will make/lose over
a specific period. As I keep saying, trading is also a business but
you would be surprised to know that there are a lot of people who have
no goals or objectives when they are trading. (I am not talking about
dreams of making millions! They are there in every trader!!) Unless
a person knows where he wants to go, how can he plan? Unless he plans,
how can he reach there? If a person has a goal, he can create a road
map or a plan to reach there. To have some profit objectives is absolutely
required if one wants to be a successful trader.
If you are starting with 20,000 dollars, an objective could be to make
500/1,000/1,500/2,000 dollars every month. Or it could be like 10, 25,
50 or even 100% return per annum. Start with a number that makes sense
to you and then later in the Chapter you will see if this goal is achievable
or not. If not, you will need to fine-tune it.
Write
down here: My goal is profit of _______ per month or ____% return per
annum.
What
is your plan to achieve your goal?
This
is a tough question and there is no straight answer that fits all traders.
However here are some guidelines and ideas. See if they make sense.
If they don't, try to find your own version of it.
For
one to reach his monthly profit target or annual return objective, he
needs to look at following factors:
- Trading Odds
(ODDS).
- Desired Profit
in a successful trade (PPT).
- Planned Maximum
Loss in an unsuccessful trade (LPT).
- Trades per month
(TPM).
Let us take an example
of a trader who wants to make 1,000$ per month. If his stock selection
is average, his trading odds will be 50%. Half of the trades result
in profits and half result in losses. Now if he takes say 300$ of profit
in a profitable trade and 300 dollars of loss in a losing trade, you
can see that with 50% success rate, he will not reach any where. He
will in fact lose money because of the commission on both sides of each
trade. So to reach to his goals, we will need either boost his Trading
Odds (ODDS) and/or increase Profit Per Trade (PPT) in comparison to
Loss Per Trade (LPT). Based on these three variables and your monthly
profit target, you will get an idea about how many trades you will need
to make per month.
- Increase
the odds. What is the success rate or odds for a trade to be
in profit? It can be any number between 0 to 100%. However for an
average trader, it can be expected to be around 50%. If a trader
makes ten trades, on average five may turn profit for him and five
may result in losses. So to come out as a winner in this game of
trading, one will benefit by increasing his trading odds. Question
is: is it possible to increase odds of success? If so, how far one
can expect to go? This is the area most addressed in investment
and trading books. One will find several books on the topic and
this one- Profit From Prices- also deals with it. Based on my experience,
it is possible to push the ratio to around 70% with the signals
discussed in this book. However at this stage when we are developing
our trading plan, I will advise one to be cautious than being too
optimistic. I think you should take 50% ratio in your planning calculations
with a goal to push it higher to around 70% as you gain more experience
in trading.
Write down: I
want to achieve a success rate of ___.
- Have more
profit in a winning trade than a loss in a losing trade. This
is crucial to keep in mind if one wants to succeed in trading: Small
Losses Big Profits. This is easy for anyone to say or advise but
it is very hard to practice in real life. Most of the individuals
have their emotions and psychology trained in quite an opposite
fashion, and most of the time it acts against them. When a trader
is in profit, he doesn't want to take any risk on that profit so
at the first justification or sign of risk, a profitable position
is likely to get closed. On the other hand, when a trade is in a
losing position, he will neglect all negative developments and signals.
Instead of acknowledging that he might have made a mistake, he will
hold on to the position hoping/praying for one powerful positive
news/development in the stock. A losing position is often time held
too long in the hope that some day the stock price will reverse
its course and there will be profit (or no loss)!!! So in short,
normally an individual is practicing in the trading world what most
of the religions have been teaching for thousands of years: Pass
on the joy (profitable positions, I mean) to others and keep the
bad part, bad incidences/happenings and bad luck to oneself (losing
positions). Pass on nice smelling flowers or perfume to others but
keep holding onto rotten bad smelling corpses for yourself! Believe
it or not, the truth for most investors is: Small Profits and Big
Losses!
So how much money should one risk per trade? How much profit should
one go for in a trade? There are no straight answers but one can
risk anywhere from 1% to 10% of his risk capital per trade depending
on his situation, circumstances and objectives. For most novice
traders, I would say they should not risk more than 5% of their
risk capital on an individual trade. Profit target should be around
2 to 3 times the amount risked on that trade. I have made this a
guideline for myself: Before I enter into any position, I like to
see if the position offers me two to three times more gain opportunity
than the risk or loss exposure it has.
My Goal is to
make ____$ profit per successful trade and want to stop my loss
at _____$ at most in every unsuccessful trade.
- 3. How
many trades will be required per month? Let us do little math
here. Let us take ODDS as a ratio. For 50% odds, it is .50 and for
70% success ODDS, it is .70
Expected Profit per Trade= ODDS * PPT
Expected Loss per Trade = (1-ODDS) * LPT
Expected Net Profit/Loss per Trade = Expected Loss per Trade - Expected
Profit per Trade.
Hence, # of Expected Trades per Month = (Expected
Monthly Profit)/Expected Net Profit or Loss per Trade.
As an example, with an expected ODDS of 60% (.60), PPT of 500$,
LPT of 250$ and Monthly Profit Target of 1000$
Expected Profit per Trade = .60 * 500 = 300$.
Expected Loss per Trade = (1 - .60)*250 =100$
Expected Net Profit or Loss per Trade = 300$ - 100$ = 200$.
Hence, # of Trades required per month= 1000$/ 200$ = 5 Trades.
Now, put your numbers in the formulae above and find out how many
trades you will need to make per month to reach to your target profit
per month.
My Target Trades per Month are =_________ trades.
What
is my trading (entry and exit) strategy?
This is the major
component that will determine any one's success or failure and it
forms the central part of any trading system. How to select which
stock to buy or short? Does it have the required PPT potential at
the risk of LPT? When to take this position? What is going to be an
exit strategy? It is not easy to answer these questions.
Some trading strategies
look at fundamentals of the stock or market to answer above questions.
Some others use the news, announcements or earnings. Some strategies
even look at interest rate movements, money supply, Inflation, consumer
sentiment or other economic/psychological indicators. However majority
of trading systems base their trading decisions on technical indicators
like MACD, ROC, Volatility, Bollinger Bands, or on contrary indicators.
Or one can invent and use his own ratios. In short, a trader has thousand
of choices. However, when you are choosing a strategy, you need to
make sure it is capable of taking you where you want to go. Try to
find answers to following questions:
Has it the success
rate you are looking for?
Has it the
potential to give you your target Profit Per Trade at the cost of
target Loss Per Trade?
Will it give you enough trading opportunities that you need to reach
to your monthly profit trades target?
Once you select
a trading strategy (trades selection method), before you go ahead
and make trades, test it out- first on paper and then in real life.
Find what works for you and then stick to it.
This
book is also primarily about trading strategies. In
the subsequent chapters I am going to show you how to read daily stock
prices and find trading signals to answer two most basic questions:
What to buy/short and when. I will also show you when to book profit
or close a position, and how to protect yourself in case of a loss
with use of a stop-loss.
How
are we going to monitor or manage our business of trading?
Now
thanks to the Internet, a trader should create a transaction portfolio
on websites like Yahoo! Finance, or should use personal finance software
like Quicken or Microsoft Money. Every trading day, he should look first
at the aggregate portfolio value before looking at the prices/profit/loss
of individual positions. Value of the trading portfolio should be viewed
in context with our trading plan. One of the biggest traps for most
investors is human psychology or emotions. An average individual hates
to look at bad things or admit a mistake. Traders and investors alike
keep looking at or talking about their winning positions more often
than they look at or talk about their losers. This makes them feel happy
and proud; but the neglected losers keep eating up their portfolio value
more rapidly than what their winners are doing to make them wealthier.
As mentioned earlier, winners stay for a short time but losers end up
with a long relationship with most investors/traders. Being happy, feeling
good is definitely a good thing but this has to be a secondary trading
objective. The primary objective in trading needs to be to be rich and
make more money. For just happiness and feeling good, Las Vegas could
be a much better alternative!
Also,
before one enters into a trade, he should write down at least the following
things. Our mind and way of thinking keep changing so often …that they
work as our enemies in trading. Didn't you know that each of our friends
and relatives sort of knew that we were in a big tech bubble during
1999-2000? I don't remember if anyone told me in those days that AMZN
or Yahoo were about to crash from their 200 dollar levels; but if I
ask most my friends today they sound like they were the people who knew
exactly that there was a bubble going on! This does not help anyone!
For success in trading, one needs to be honest with oneself and one
way to achieve this is to keep a diary and enter the following information
for every position he takes.
Stock
Trade Date
Trade Price
Number of stocks (100, 200, …1000…)
Justifications for this position
What are the risks
Trading with trend or against trend
Intended holding period in days/weeks
Profit Target in terms of stock price and in terms of overall amount
of profit
Stop-loss in terms of stock price and
in terms of overall likely amount of loss
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