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Trading 101- How to Approach Stock Trading

Trading with a business like approach

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I believe trading is a business and hence I strongly recommend a prospective trader to treat his trading as if he is starting a new business. For any new business, a business plan is very valuable. The same is true for a trader. A business and trading both have considerable similarities. In a conventional business, we sell things at prices higher than what we have paid for them. The same objective is there in trading- buy low and sell high. Trading and business both require capital and are carried out with one objective- to earn profit. Success in both greatly depends on our ability to buy and sell smartly- buy as cheap as possible and sell as expensive as possible. However it is not difficult to see many businesses lose money or fail over time. Similarly, some traders lose money in trading and are forced to quit trading.

Every business has considerable risk and hence a business plan is helpful in planning for the future. Every business plan has some stated objectives and it contains strategy about how to reach there. A business plan acts as a guide for its owner and keeps him focused on achieving his goals. The same can be said about a trading plan. It can help a trader formulate his goals and develop a strategy to reach there. Once in place, it acts as a guide to keep efforts focused and as a control to keep one's behavior in check. As there is no one-plan-works-for-all business plan, there is no one-size-fits-all trading plan. What is good for one person may not work well for others! As no two people have exact similar circumstances, constraints or preferences, there is no ready-to-use trading plan that I can offer to you all in this book. Every trader will need to create his trading plan by himself, and to provide some guideline, I will write about what I think should be included in a typical trading plan.

How do most people get into trading world? As most people usually don't bother to create a trading plan, let us think for a moment what brings them into stock trading. As I know, most people start trading without putting any serious thought into it. Quite often, an individual hears a friend or a stranger talking about some impressive profit in some trade. This acts as a temptation for him to trade stocks for seemingly easy money. First, he starts by watching a few stocks, say around 6-8, but as time passes, his list gets narrower as stocks that are not doing well get dropped 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 on those 2-3 stocks that are doing well. This fills him up with false confidence that he has exceptional stock-picking skills. At this point, he genuinely believes that he has skill-set necessary for success in trading and now he doesn't want to waste any time. He makes his first trade. It may be just a coincidence or there may be a lot of research behind it, but his first trade is more likely to be in profit than in a loss! Maybe that is a hidden law of Capitalism to bring more and more people into trading so as to keep the cycle of wealth rotation running smoothly! After the first trade, there is no looking back! Before one even realizes it, he is hooked up. He is addicted to stock trading! As there is no formal trading plan, in the end, most traders fall in known trading traps: small profit-big loss, taking positions against the trend and ignoring use of stop-loss. Hence I recommend that every trader create a trading plan before he enters 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:

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.

  1. 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 ___.
  2. 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. 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.

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

Update information as required. After you close the position, write down when it was closed, why it was closed, at what price and with how much profit or loss. What are the lessons learnt if any.

Miscellaneous Trading Business Rules:

  1. Keep a limit on Open positions. Decide in advance how many positions you can have open at any point of time at most. You can choose any number from one to ten. One natural trap in the market is overconfidence. When the market is around Top, there is good news everywhere. Everyone is talking positively. So we are tempted to exploit current opportunity in a big way. We start trading more aggressively, cross our limit and our portfolio gets overloaded. This is a too much risk if the market stages a reversal. What we might have earned over last few months vanishes over a short period of time. So avoid this trap, never ever let your open positions exceed your predefined limit.
  2. Take a break when all of the last three (or five) trades turn into losers. Take this as an indication that you are getting out of the sync with current market trend.
  3. Never average in a losing position.
  4. Never try to recoup from the same stock just because you lost in it last time. Similarly, resist the temptation to repeat a success story in the same stock in which you had a good profit last time. Trade objectively. Trade in the same stock only if you have a strong signal.
  5. Control emotions- particularly greed and fear.
  6. Follow all above rules.

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A Sample Trading Business Plan

Trading Business Plan

Date Created: October 10, 2002
Last Updated; October 01, 2003

Risk Capital: 20,000$.
Trading Objective: 1,000$ Profit per Month

Target Success Rate: 70%
Desired Profit Per Trade (PPT): 400$ per Trade
Planned Maximum Loss per Trade: 200$ per Trade
Intended Holding Period for a Trade: 2-4 Weeks
Average Trades per Month: Around 6 -8 Trades
Average Amount to be invested in a position: 20% or 4000$ per Trade
Maximum Open Positions permitted at any point in time: 3 Open Positions

Stock Selection Criteria:

  • Stocks with strong Trend Reversal signals.
  • Trade in the direction of the main trend.
  • Trades in stocks with average daily volume of 500,000 or more.
  • Trade in stocks with Market Capitalization of 300 million or more.

Disclaimer: This trading system/signal, like any other system, may fail at times. Exercise caution when trading and decide suitability of any trade by taking into consideration market conditions, your financial situation, investment objectives and circumstances. Always keep a stop-loss when you are trading.

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Updated on 11-Feb-2018