ZYTrade Editor: We often hear advice warning investors not to think like traders and vice versa. They represent completely different approaches to the market. But certainly, there has to be some kind of crossover in domains where both may benefit. This article explores that crossover, its focus on using a trader’s mindset to make longer-term investment decisions. Does such an approach add value to investment thinking? Find out for yourself.
This is not about how to get rich from the stock market. If I knew that, I wouldn’t be writing this. This is about my journey as a Stock Trader, and what I’ve learned along the way. I have been following the market as a trader for the past three years. The first year I made. . . wait for it. . . 1%! As many new traders famously blow up their accounts and lose everything, I considered this success.
First a few definitions. “Traders” buy and sell stock on a short-term basis. I consider myself a “swing trader” that holds stock for a few days, to a few weeks at most. Some days, I become an accidental “day trader” in and out the same day. Traders are trying to make money, either as a side-hustle or as their full-time job.
Investors, on the other hand, hold stock for the long-term, years and decades. Investors are savings for a long-term goal, such as the kids’ college education or retirement. Traders have long-term goals too, so it’s important to keep the trading accounts and investment accounts separate.
The most important thing for a trader is to keep records. Every single trade must be recorded: purchase price, sale price, number of shares, and gain (or loss). Why did you make that trade? Are you making money or hemorrhaging? What is working, and what is not working?
I use Microsoft OneNote, but any spreadsheet will do. There are excellent third-party programs, such as Edgewonk, which will also generate your personal trading statistics (disclaimer: I’m an enthusiastic user, but not affiliated).
Develop a process
Traders are like snowflakes, no two are alike. As a new trader, your tendency is to copy another successful trader but copying their success can be elusive. Everyone has a favorite style, where they feel most comfortable, or rather, more tolerant of the risks. Some prefer to trade the big blue chips, others prefer growth, and still, others prefer “penny stocks”. Some look for technical indicators, some look for fundamentals, and some do both. Some look for “momentum” stocks that are acting strong, while others prefer the beaten down “value” stocks. And so on.
Every trader has a process. First a “universe” of stocks that may meet an initial set of criteria. Then a shorter “watch list” of stocks for that day or week that meet a more stringent set of criteria. And then the watch-list stocks are watched for a specific set of things to happen, which would trigger a buy action.
For example, I’m a breakout trader. I start with a universe of stocks with strong fundamentals, that are trending upward. Then I look for those that are forming a base (moving sideways). Every day when the market opens, I look at my watch-list and see if any have “broken-out” and are now moving above their base. If the volume is surging (the “gas” behind the price jump) I’ll consider a buy.
If you’re a trader, you probably do something completely different.
Risk and reward
The key to trading is simple: make more money than you lose. Easier said than done. There is no such thing as a 100% success rate.
Those famous traders you read about that have made a gazillion dollars have about a 50% success rate.
They make more money on their winners than they lose on their losers. It’s about the math.
As part of your process, you must decide, ahead of time, when you will sell the stock. If it goes up as expected, where will you take profits? But more importantly, when it drops, where are you getting out. Every single trade needs a “stop”, preferably one you set in your trading platform that triggers automatically when the price drops below your threshold.
Back to the math. Your success rate can be as low as 25% and you can still make money. Know your RRR, Reward: Risk ratio. Perhaps you’re a 4:1 trader. If your stop is at $1 (your risk) then your target is four times that or $4 above the price you bought the stock.
Determine your required winrate: 1/(1 + R multiple) or 1/(1+4) = 20%. At a 20% winrate a 4:1 trader breaks even; anything above that you’re golden.
Did I mention that more than half your trades go south? If those bad trades make you nauseous or keep you up at night, then your trading position sizes are too large. (Or simply, trading is not for you.)
In order to keep from blowing up your account you limit the percentage of your account you place in any one trade. If you put too much in, a “bad run” of 4–5 losing trades could wipe out your account. Most traders follow the 1% or 2% rule; risk no more than 1–2% percentage of your account per trade. I do significantly less.
Remember, your risk is the amount you’re willing to lose based on your stop level. Given how often you place a trade (daily? Or several times per day?) can you lose that amount without it messing with your head?
Because once it messes with your head, then bad decisions tend to follow. You may not stick to your plan and take bad trades in a futile attempt to “make it back”. This never works.
I have an additional rule: if two trades go south, I’m done for the day. If five trades in a row go south, I don’t trade until the market indices make it above a predetermined level. Either the market is bad or I’m off; either way, I need to step away from the computer.
When it comes to trading, we can be our own worst enemy. Despite what we’d like to think, we are emotional creatures, that act accordingly. Therefore, it’s important to have a plan, one you decided on when the Market was closed when you were calm and collected.
It’s important to know your own “weaknesses”. Sometimes its best to simply step away from the computer screen and take a walk outside. There will always be more trades.
One of my weaknesses is FOMO: Fear Of Missing Out. Many times, I’ll see a breakout that has gone without me, now many dollars above a good entry buy-point. The worst thing to do at this point is to get in too late when the price move is almost done. When the price takes off, it could go for a day, or even a week or more; or only just an hour, before it reverses direction, plummeting down.
But there’s no way to tell that ahead of time. You’re playing the odds and hoping the math will prevail.
There are days (weeks) when seemingly every trade is a winner. Then there are days (weeks) when every trade falls over. In a weak, or especially volatile market, sometimes it’s best to simply sit on your hands and watch from the sidelines.
Repeat after me: there will always be more trades.
Keep it simple
When the market is rallying and many stocks are breaking out simultaneously, there’s a tendency to go all in and overtrade. Sometimes this works, but sometimes the market will turn on a dime, and you’ve just lost far more than expected. . .
Don’t be greedy; place limits on yourself. I do that by restricting myself to a small “universe” of stocks.
When things aren’t going well there is a tendency to change strategies. Nothing wrong with trying new things but keep records. Certain markets favor certain styles of trading. Most traders have 2–3 set-ups they trade. Like anything, practice makes perfect.
But the more strategies you have, the more you risk splitting your focus and missing out. Sometimes its best to get better at your go-to strategy, before adding a new one.
Be a better investor
As an investor, you also need a plan. It’s a much simpler plan: a percentage allocation of stocks, a percentage allocation of bonds, and a rebalancing schedule. Most of us should be buy-and-hold investors, but for those who aren’t, a “stop” needs to be identified.
History has shown us that the market goes up more than it goes down. Over decades you will make money, mathematically. But in the interim, your two biggest enemies may be a miscalculation of your risk tolerance and FOMO.
“Corrections”, or a drop of less than 20%, commonly happen about once a year or so. Under more serious circumstances, during a Bear Market, the market may drop as much as 50%. Considering the percentage of stock in your portfolio, will that keep you up at night?
Will you do something stupid, like violate your plan and sell it all low?
If you need to reduce your stock exposure to align with your risk tolerance the best time to do it is when the market is up.
There is too much in the news of the individual who made it rich quick, or somehow “predicted” the recent correction and shorted the market. We question whether we should be doing something “more”.
There is a tendency to stray from your index funds and dive into a fund with a much better return. But that sexy fund (or sexy investment strategy) probably has far more risk, and although it did well the past few years, may not necessarily do well the next few years. Are you still aligned with your Plan and risk tolerance?
Again, keep it simple.
Trading has also helped me make better life choices. All decisions we make involve risk, but it helps to know the risks and your own risk tolerance.
If you’re planning to go for it, are there real benefits or simply FOMO?
There will be small setbacks (“corrections”) in any life decision, but in the long-term, our course of action should prevail.
Originally posted on Medium
Trading futures, options on futures, and forex involves substantial risk of loss and is not suitable for all investors. The use of leverage is not suitable for all investors and losses exceeding your initial deposit is possible. Carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources and only risk capital should be used. Opinions, market data, and recommendations are subject to change at any time. The lower the margin used the higher the leverage and therefore increases your risk. Past performance is not necessarily indicative of future results.