As more players enter the stock market, profits are becoming more elusive. This doesn’t mean that profits are not there for the taking, it just means different approaches and methods are needed for success.
One of the biggest factors for the increased volatility we are seeing in the financial markets today is program trading. As investors, we must be mindful of this strong undercurrent taking place in these investment waters.
Program trading is where computer algorithms are used to make trades in the stock market. Although they are monitored by humans, these computer programs are making the trades whenever certain criteria are met.
Large institutional traders that are managing large funds and portfolios are the primary users of program trading. Whenever large positions need to be bought or sold, computers are more efficient than humans in executing the trades. This is because small blocks of trades are placed across multiple brokers. Sometimes it takes weeks for these positions to be completed.
As small investors, we must understand the powerful market forces created by changing or establishing huge stock positions that these big players are managing. It is virtually impossible to stand against these forces — we must learn to get out of their way.
5 Critical Factors for Stock Investing Success
Since we have no control over outside market forces, it becomes more vital that we efficiently manage the factors we can control. There is no reason to feel victimized because our decisions will still make a huge difference in our investment success.
Use an Investing System
The majority of successful stock traders use a trading system of some sort. There are very few investors out there that succeed by using discretionary methods. At the very least, they solicit advice from experts — who are using systems.
A trading system is a set of rules that govern your investment decisions. The objective of having investing rules is to take emotions out of trading decisions. This is why your system rules are established when the markets are closed.
When using a stock trading system, you have two choices. You can either use a system that someone else has created, or you can develop your trading system. In most cases, you will have more success with your system because you will typically trust it more than someone else’s system.
At the very minimum, your trading system needs to define the criteria for entering a stock position, how that position will be managed, and the criteria for selling that stock position.
There are a few more things that your investing system needs — which we will be discussing shortly.
Know the Probabilities of Your Investing System
When you have decided on a stock trading system to use, your next step is to find out what that system’s probabilities are. You will need data from at least 30–50 trades.
The good news is that you do not need to use actual money to get this data. You can either backtest your system from past market action, or you can paper (pretend) trade the current market. Of course, backtesting will give you the data much faster.
The first thing you need to know is the percentage of winning trades that your investing system will generate, as well as the percentage of losing trades.
The second thing you must know about your trading system is the average profit produced from your winning trades and the average loss from your losing trades. Ensure that all commissions and transaction costs are included in your calculations.
Keep in mind that average profits or losses per trade is dependent on how much money you invest per trade. These numbers must be consistent in your treatment of the data.
After obtaining these pieces of data, you will be ready to determine your system expectancy.
Calculate the Expectancy of Your System
It is quite surprising how many investors have no clue about the expectancy of the trading system they are using. If they knew the expectancy, they might quit using the system altogether.
The expectancy of your investing system determines what you can “expect” on average to earn from each trade you make. Let’s illustrate how expectancies are calculated:
Expectancy (E) = [(Winning %) x (Average $ Profit)] — [(Losing %) x (Average $ Loss)]
Trading System A
Winning % = 65%
Average Profit for Winning Trades = $75
Losing % = 35%
Average Loss for Losing Trades = $37
Expectancy for Trading System A = [(0.65) x ($75)] — [(0.35) x ($37)] = $48.75 — $12.95 = $35.80
This system will produce an average profit of $35.80 per trade.
Trading System B
Winning % = 41%
Average Profit for Winning Trades = $575
Losing % = 59%
Average Loss for Losing Trades = $317
Expectancy for Trading System B = [(0.41) x ($575)] — [(0.59) x ($317)] = $235.75 — $187.03 = $48.72
This system will produce an average profit of $48.72 per trade.
Systems that have a negative expectancy will lose money — period. When this is the case, you need to look for ways to improve one or more of the four variables in the expectancy formula.
A trading system with a small negative expectancy can often be tweaked into profitability. But a big negative expectancy number means you should probably scrap the system altogether and try something entirely different.
You should realize that the relative sizes of the four expectancy variables will also be dependent upon the type of trading system used.
For instance, a day trader needs a very high winning percentage since he or she is making many traders daily. Each one of these trades carries a commission cost along with other fees for executing the actual trade itself — and these daily costs must be overcome to see profits.
Conversely, many profitable long term traders have an overall losing percentage when it comes to successful trades. But their average profit per winning trade is astronomical compared to their average loss per losing trade.
Establish Your Total Risk
Every investing system needs to determine an overall risk level for the entire portfolio. This is the maximum amount you would be willing to lose if the entire market tanked.
For example, let’s say you have a trading account that contains $10,000. If you were willing to risk 10%, this means you will risk $1000 of your total account.
If you wished to buy ABC stock and it was priced at $50 per share, then you could buy 200 shares. You would then place a stop-loss at $45. This means your broker will automatically sell your 200 shares if the price falls to $45.
If you have to sell your position at $45, this would leave you with $9000 in your brokerage account. This means that when you risk 10% on your next trade — it will now be only $900.
Incidentally, many investors tend to set their risk levels at a maximum of 8–10%. I like to use 8% as a risk level.
Establish Your Number of Stock Positions
Deciding how many stock positions you will hold at any given time is a very important decision. You are essentially determining how much diversity your portfolio will have. And we all know that diversity can minimize our overall exposure.
Of course, we must understand the essence of real diversity. Buying three different stocks in the banking sector is not diverse because they will all react the same way to market news. Diversity means spreading your investment across a variety of sectors.
The idea is when we have a poor performing stock, our other stocks will be performing well enough to offset the one poor stock. The more stock positions we have, the more account protection we have against a losing stock in our portfolio.
However, on the flip side, if we have a stock that is making a monster move, the other stocks in our portfolio will eat away at the profits we would otherwise have from that one winning stock. This is why we need to find a good balance between protecting our investments and allowing profits to run.
Therefore, it is recommended that you maintain 3–5 stock positions at any one time in your trading account. This number provides protection and allows for winning stocks to have an impact on your bottom line. And keep in mind that you are also maintaining an 8% risk level for even more downside protection.
Trade Management Rules
Perhaps the most important facet of your overall investment performance depends on your ability to manage your trades. Most of us spend an enormous amount of time on when to buy stocks and hardly any time on how to manage the stock after it is purchased.
Many professionals claim that they would be just as profitable flipping a coin in deciding what stocks to buy. Because they know that it’s the decisions made after stocks are bought that determine the real success of a trade.
You must first begin with an investment objective. Let us examine some common objectives and how they might be managed:
Seeking a Specific Return on Investment — Suppose you wish to make 20% on every investment. After you buy a stock, you place your stop-loss at your 8% risk level.
When the stock price increases 8%, you move your stop-loss to your purchase price — ensuring at least a breakeven trade. When the stock price increases by 20%, you liquidate the position and take profits.
This objective is very simple with a minimum number of decisions. The rules are easy and straightforward.
Letting Profits Run using a Tight Stop — After buying a stock, you place a trailing stop-loss at your 8% risk level. This means that as your stock moves up in price, the trailing stop moves up as well while maintaining the 8% gap between price and selling point.
The selling decision is then left up to the market. You decide nothing as the market will eventually “stop you out” of your position.
The trailing stop is certainly a nice way to capitalize on a strong market move while protecting profits. But when you use a “tight stop”, you will eventually experience a situation where the market pulls back briefly — enough to stop you out of your position — only to rally big time afterward. And that rally doesn’t include you.
It sucks when this happens to you, but that is one of the disadvantages of using tight stops.
Letting Profits Run using a Wide Stop — You buy your new stock and place a stop-loss at your 8% risk level as always. You will not be using a trailing stop — instead, you will be moving that stop yourself.
As your stock price moves up, you lock in 50% of your paper profits. In this way, you are allowing room for your stock positions to make a huge move.
At any one time, your stop-loss level allows the market to take back half of your paper profits while you keep the other half for yourself. But the good news is that if your stock price pulls back and then makes a big move, you will not miss those new profits.
However, you could be sitting on a $10,000 paper profit one day, and then get stopped out of your stock the next day for only a $5,000 profit. This is the main disadvantage of using wide stops.
Take Some Early Profits — One last consideration in regards to managing your stock trades is taking some profits along the way. With each one of the trading objectives we previously mentioned, you could take some early profits off the table to lock in some earnings.
Whenever your stocks make that initial move allowing you to move your stops up to the breakeven point, consider selling half of your position. You can put these early profits in the bank and then let your remaining position run. Many professional traders do this because it lowers their overall risk.
Keep in mind that if you take early profits this way on two stock positions in your portfolio, you can begin looking for a new stock in which to invest. This is because you have freed up extra capital in your account.