Trading The ultimate guide to trading shares for beginners - part 6 December 12, 2007 Adam Hamilton CPA, Zeal Research
Are you interested in trading in the stock markets? Do you have questions about getting started? You are certainly not alone. Almost weekly I hear from ordinary folks with basic questions about trading stocks. After addressing these on a consulting basis for years, I’ll outline some of the basics in this series.
The riskier a particular stock trade, the higher the probability for big gains as well as big losses. Remember that volatile stocks that have high potential to rise are also the ones that can fall the fastest. In general the lower the market capitalization of a stock (shares outstanding times stock price), the higher its price-to-earnings ratio (P/E), and the bigger and faster its recent gains, the riskier the stock. If you want to shoot for big gains fast, you have to be prepared for big losses fast if you are wrong. Risk works both ways.
And believe me, you will be wrong often when trading. Losing trades are inevitable and are a normal and expected “cost of business” of trading. Like me you are a mere mortal, neither of us can see the future. So when we guess on the future performance of a stock, we will certainly not always be right. The longer you trade, the better you will get at this, but you will still make bad trades. So don’t let a losing trade or streak of them demoralize you or damage your confidence. Every trader, no matter how elite and experienced, has losing trades.
Ultimately trading is an averages game. Since it is impossible to win on all trades, you want to maximize your winning trades while minimizing your losing ones. If you do this successfully, you will still multiply your capital rapidly despite your losses. Most new traders fail at this because of a natural tendency we all have. We tend to want to let our losses run in the hopes they will eventually return to break-even. And we tend to want to sell our wins fast because a locked-in profit is a far surer thing than an unrealized one.
But just like buying when you are greedy and selling when you are scared is disastrous despite it being your natural instinct, so is letting losses run and cutting wins fast. Instead, when you have a losing trade you should sell out of it as soon as possible and take the loss. If you bet on a stock rising, but it has not risen since you bought it, then it is time to face the facts that you were wrong. Your stock itself probably isn’t a bad choice, but your timing was clearly off. In this case sell the stock right away and take the loss so you can redeploy this capital elsewhere.
And with winning trades, don’t succumb to the temptation to sell right away to realize your profits. If a farmer plants his fields in May he doesn’t expect to harvest them in June. Like crops, winning trades take time to mature into a bountiful harvest. You may be tempted to sell out soon for a 10% gain, but by doing so you may miss the far bigger 100% gain you could have achieved over the next six months. So never be in a hurry to sell a winning trade, unless of course a price stretches way over its 200dma and greed waxes extreme. Give your winners the time they need to reach maturity and grant you a bountiful harvest.
The best way I have found to let my wins run and cut my losses fast is to use stop losses. A stop loss is a conditional sell order you place with your broker. It tells your broker that after a stock you own slides more than a certain percentage from its best price achieved during your trade, say 20%, that the broker should automatically sell the stock. If you prudently use these trailing stop losses, you won’t even have to worry about selling. The stops do all the work, eliminating human decisions. Stops automatically let your wins run unmolested while cutting your losses fast. I highly recommend you use them religiously.
In a winning trade, having a trailing stop eliminates your temptation to sell too early. As long as your winner doesn’t correct by more than your stop percentage, then you’ll keep the trade in your portfolio and it will continue maturing. And in a losing trade, having a trailing stop eliminates your temptation to hold on until you break even. As soon as your loser falls more than your predetermined percentage, you are automatically sold out. This is great because you can then redeploy this recovered capital in greener pastures elsewhere.
And since trading is an averages game and you won’t win all the time, it is critically important to be diversified. Ideally, you should never have more than 5% to 10% of your stock-trading capital deployed in any individual stock. Obviously if you start with $1000 this is hard, but once you get over $10k or so it gets a lot easier. Since so much can go wrong with any individual company at any time, never put all your eggs in one basket. Own a trading portfolio of 10 to 20 different stocks, with your capital allocated roughly equally among all, as soon as you can afford to.
When you are properly diversified like this, bad news in one company doesn’t hurt you irreparably. If you own only one stock, and the company misses its earnings expectations so it falls 20% in a single day, you are going to take a massive 20% loss on your entire trading portfolio. This is unacceptable. But if you own 10 stocks, and one falls 20% in a day, you only lose 2% of your portfolio. To thrive for a long time as a trader and survive all the curve balls the markets will throw at you, you must diversify your trading portfolio.
Another benefit of diversification is it greatly reduces the risk of emotional attachment to any one stock. To be a great trader, you have to be a total mercenary with no loyalties to any particular company. If a stock is doing well for you, that is great and you should keep it. But if a stock isn’t performing as you expected, you should be able to sell it instantly without a second thought. It is far easier psychologically to dump a loser that is less than 10% of your portfolio than one that is more than 10%. Proper diversification minimizes emotional attachment that interferes with timely and prudent trading decisions.
Most of the risk you encounter in trading stocks, which is considerable, should be managed before you even buy a particular stock. Managing this risk includes never allocating too much of your trading capital to any one stock, 10% max. It also includes deciding in advance before you buy what the biggest loss you are willing to accept in any individual position is. Then you effectively lock this in by setting your trailing stop to that level. The less money you lose, the quicker you will multiply your capital in the markets.
And definitely don’t worry about a hot stock you missed out on. There is a constant and endless parade of opportunities coming your way in the stock markets. The markets are like a major airport. If you miss one airplane, there is no reason to fret because another flight is always heading out shortly. So there is no need to dwell on the past and wish you would’ve bought a particular stock. Instead look to the future and try to figure out what the next hot stock will be.
Trading stocks is analogous to the great European sea trade of centuries past. Brave entrepreneurs would finance ships, hire crews, and sail to Asia to buy spices. If they could successfully bring the spices back to the European markets, they would earn fortunes. Trading stocks is about supply and demand and risk too, but the oceans we sail across are time itself. When you buy a stock today, you have to think about whether lots more traders will want to buy it from you later in the future at a higher price. So fill your holds with stocks that, while not highly desired now, are likely to be highly desired by other traders in the future.
Finally, avoid the temptation to use margin. Margin is borrowing money and using this debt to buy stocks. Fully margined, you can double your wins or losses in a given trade. The problem is margin greatly increases your risk and amplifies your dangerous emotions. If you have to worry about paying back borrowed money, it is really hard to make wise real-time trading decisions. Trading with capital you own outright, free and clear, is the way to go. It is usually far wiser to increase your risk and potential returns by trading more volatile stocks than by borrowing money.
Yes, you can excel in stock trading
I realize this is a lot of information if you have never traded stocks before. But you really can do it. Every trader on the planet today started with zero knowledge of the markets. We all start from nothing and that is totally normal. It will seem difficult at first, but with each trade you make your experience will grow and your probability for future success will rise. Like everything in life, the more you trade the better you will get at it.
The bottom line is stock trading is fantastically fulfilling and fun. Not only can you earn big profits doing it, but it will teach you a great deal about yourself. The emotional control that stock trading demands will help you be a more stable and less volatile person in all aspects of your life. And the self confidence that trading naturally builds will be a boon for all your personal interactions. The crucible of trading will gradually forge you into a better, and richer, person.
While there is a lot to learn, the basics are pretty straightforward. And there is no better time to start than today. Cut back on your entertainment expenses to save some money, open a trading account as soon as you can fund it, and start trading. With each trade your confidence and success will grow. And eventually, if you stick with it and practice good trading discipline, you will grow into a successful stock trader.
CFD CENTRE
