Stock trading requires four key decisions to be made for each position the stock trader opens:
When to open: entry timing. What to buy or sell: stock selection. When to sell: stop management, exit timing. How much to buy or sell: position sizing.
I’ll post more articles on each of these areas later. For now, let’s look at them from a high level.
Stock traders, especially beginners, use technical analysis to determine when to open a trade. Generally they look at patterns in historical prices and volume, such as moving averages, oscillators and chart patterns. Some traders also use sentiment indicators. Sentiment indicators try to read what traders and advisors are thinking about the future market direction. Examples of sentiment indicators are advisor bullish/bearish readings, and the VIX. Stock traders also sometimes use events to determine their timing. Several years ago I swing traded based on company earnings announcements and stock splits.
What stocks are you going to use? There are many ways to pick the stocks you will buy or sell. Technical and fundamental analysis are two popular techniques: looking at the price/volume history and the characteristics of the company. My current favorite stock selection tool is called VectorVest. I have also used Valueline, Morningstar and various technical analysis products. Some people pick stocks based on what they hear on TV, like Cramer. Think of a beginner trader searching for a hot tip! Whatever you use, you have to narrow down the thousands of choices to the ones you will buy or sell.
Once you have a stock position, what do you do with it? Profits and losses are not realized until the position is exited. For everyone but the buy-and-hold-forever investors, the position must be closed at some time. Stock traders use a variety of stops (preset points when to close the position): stop loss, trailing stops, time stops, or maybe just when you feel the urge to sell. Most non-professional stock traders do not put nearly enough thought into exit timing. Beginners usually use tight trailing stops, and pay for it with more losses than winnings.
Let’s say you have decided when to buy, what to buy and when to sell (you do do that before you actually open the position, don’t you ), but how much do you buy? And once you have opened the position, do you change the size (add to it or close some of it) during the life of the trade? Most traders do something like this: “I’ve got $100,000 to invest. I want to buy 10 stocks, so I’ll put $10,000 into each and let it ride until each hits my exit.” In my opinion, position sizing is the best way to limit risk. This is contrary to what many think: move up your stops. Determining how much to have at risk at any one time is critical, but is the area most beginning stock traders almost completely ignore.
Trading vs. Investing
Investors plan to hold for a long time. For investors, stock selection is the most important of these. Position sizing is also critical. Investors expose themselves to the market, industry and company risk for long periods of time (years), so being diversified across many companies in different industries, markets and even asset classes is important. It may also prudent to take some profits (scaling out of a position). Entry and exit timing, while still important, are not as critical as the other two.
Traders do not stay in positions as long as investors. Entry and exit timing is much more important than for investors. Professional traders use position sizing as their primary risk management technique. Stock selection, while still important, is not as critical as the other three.
Emotions are a stock trader’s enemy! While some traders can rely on gut feel and emotions to be profitable, most traders, especially beginners, find that fear and greed are cause losses. Entry timing and stock selection are done with little emotion. There is no money on the line. You are just researching and scanning. Much emphasis is given to these two decisions, especially by those who are analytically inclined. But once a stock traders puts real money into a position, emotions often take control. Most of the stocks I buy go down the next day. That causes fear of loss. Some react to that by selling or second guessing. I just follow my trading plan. Also, when a position has doubled or more in value, greed can take over. How many traders have seen profits turn into losses because they wanted to squeeze every penny out of a position. Exit timing and position sizing can be highly influenced by emotions, and can become a beginner stock trader’s downfall. I deal with this by having a trading plan, and I follow the plan like a robot. In future articles I will dig deeper into these key four decisions and show how I use them to be profitable, and how to not let your emotions rob your profits.
Your comments and criticisms of this article are very welcome!