Category: Stock Trading

Always put a protective stop loss once a stock is bought!

The stop loss could by 1 or 2 Average True Range (the approximate variation a stock does on e.g. daily basis i.e. if you are looking at daily charts). Or the stop loss could be one or 2 points below the last low the stock made. What ever the criterion you choose to put a protective stop loss, calculate the per unit risk which is the price the stock – stop loss price i.e. the money you can loose on the stock if stocks goes in the wrong direction and hits the stop loss.

Rule: The total risk on all your stocks should never exceed 2 percent of your total trading money.

e.g. You have 10000 to trade with. 2% of 10000 is 200 dollars. Bought AT&T 9symbol T) at 24.95 and placed protective stop loss at 22.95. Risk per stock is 2. Since the total maximum risk you are allowed to take is 200, you can buy 200/2 i.e. 100 stocks of T. If you buy more than you are taking more risk than necessary.

Also only trade those setups that you think are going to give atleast 2wice or 3rice your risk. In the above trade you are doing the trade because you expect the stock price to jump 4 or 6 dollars from the current price of 24.95 vs your stop loss of 2 dollars below the current price. i.e. you reward to risk ratio should be 3 or above before you get into any trade. See the coin toss analogy (lesson 10).

Moral:
Trade with small risks (i.e. less than 2% of equity). This way you can sleep tight without ever loosing a lot, yet making decent profits.

If there is one single rule one should always follow, its to follow the direction of the market. If the market is up only trade long. If the market direction is down trade shorts. Markets can only be in 3 states.

 

• Up – The market is in bull moving up
• Down – The market is in a correction moving down.
• Side Ways – Market is range bound

80 percent of stocks follow the market direction. So to increase your chance of success , one needs to know the direction of the market. Remember trading is about increasing your chances of success (see lesson 1 analogy gambling with coin toss), and your chances increase if you trade in the market direction.

How does one find the direction of the market.
1) Apply technical analysis on the market index. e.g apply the concept of moving average i.e. strategy 1 on the whole market e.g. on the Dow Jones Industrial Index or Nasdaq, or S&P 500. See if the moving average for each of the market points up or down or sideways.
2) Read market news. e.g. Investor Business Daily publishes daily news and tells the overall market condition as confirmed uptrend, confirmed downtrend or market under pressure. The daily videos also mention the market direction.

Last lesson was a strategy on trading using the direction of the moving average. If a long term moving average (50 or 100 day) direction is up one must buy stocks. If it is down one must short stocks.

The strategy can be improved. Add this as a qualifier to the moving average strategy.

“Buy a stock when the moving average direction is up” and “Wait for a pull back”

When the moving average turn upwards wait for a pull back. This point will be more favorable in terms of odds (see lesson 1 comparison to coin toss gambling). The idea is to buy the stocks when odds are most favorable to you.

Now that you have an account setup we need some base trading strategy. This strategy can work in any time frame, for the purpose of discussion lets assume this is a daily graph of company XYZ (symbol XYZ).

 

The line in black is the actual daily price almost in zigzag fashion as you would see chart of any stock. The line in red is the moving average. The x-axis are the days (or any time frame e.g. hours) from left to right, and y-axis is the price of the stock.

Moving Average
Moving average is drawn using the last n points (e.g. closing price) and dividing by n. For each day the last n points (e.g. last 50 days price) is used to compute the price on the graph. The net affect is a smooth graph whose underlying data is the actual stock prices.

Choosing Moving Average
Moving average is based on number of days to use to lookup back to compute the average for every bar (bar means daily bar in our case). The longer the lookback time the slowly it will change. A 50 to 100 bar moving average is a good choice.

The Strategy to Buy
Buy when the angle of the red line relative to x-axis is greater than 0 i.e. the line has steered “up”

The Strategy to Sell
Sell when the angle of red line has less than 0 relative to x-axis i.e. when the direction or the line has started to “bend” towards the bottom.

This strategy is simple and profound. When the angle of the curve changes it means the “slow” curve is convinced that the trend has changed. On a daily graph for example it could take months or weeks before a curve changes direction. The longer the moving average duration is the more convincing this curve tells you the long term trend. Always trade in the direction of the trend.

Tip. This simple trading strategy can be applied even to your long term investments e.g. 401 or IRA accounts. Simple look at the graph of S&P or DOW and look at the 100 day moving average. If the angle is positive i.e. upwards stay invested in stocks. If the angle turns downwards start moving your assets into “safer” class.

After you have setup a trading account and transferred funds, it is time to get started. Initially trade with very small amounts about a a few hundred dollars. There are various types of orders and it is very important to understand how and which ones to use.

Market Order
e.g. Buy 100
Buy and sell at market price. Never ever use this type of order. Only in cases of when you have to sell in panic or trading long term and dont care what price you pay. If you are starting then it is ok. You can use market for both buying or selling.

Limit Order
e.g. Buy 100 APPL at 110.5
e.g. Sell 100 JPM at 41.5
When buying it means, I will not pay more than the limit price e.g. 110.5. You will be guaranteed that your order is filled at 110.5 or lesser or it does not get filled. For selling it means that i will not sell for a price lesser than my limit e.g. JPM not less that 41.5. Limit order is what one should always use. Be patient and get at the lest price you can get when buying. You can use or bar 1 minute chart if you are a day trader or a 60 minute chart if you are a few weeks trader or longer trader to decide the price to put limit on. Just make sure its not too low that you never get filled.

Stop Market
e.g. Sell 100 APPL at 105.5
This order means if the price touches 105.5 sell at market value. Stops are very important and act as protection against massive losses. When ever you buy stocks put a protective stop loss, so your damage is always limited to a certain amount.

Stop Limit
e.g. Sell 100 APPL at 105.5 with limit 105.5
This order means if the price touches 105.5 sell but till i get atleast 105.5 . Its a stop with the restriction of a limit. The order might not get filled if the price is falling sharply as your limit might not get filled. So either keep the limit lower that the stop or use a Stop Market.

In summary buy with a limit order and always put a stop loss of a certain percentage or a couple of Average True Ranges.

Before one can trade it is important to sign up with a trading platform. There are many trading platforms and based on trading style one should choose one appropriately. Remember trading cost can quickly add up and burn through your trading profits, so choose one which gives you the optimal cost. Here are some based on my experience

http://www.TDAMERITRADE.com
9.99 per trade i.e. when you buy or sell. Quite costly and is suitable for traders who are long term investors and choose value trading as their strategy. Buying frequency of 1ce or twice a month. Though ameritrade provides free features like Strategy Desk which is an excellent tool if you want to do rule based trading or charting and technical analysis. They also have online java version of charting tools. Also provides mobile cell trading interface.

http://www.tradestation.com
Platform fees of 100 a month and a few dollars for data feeds. Stock buy or sell for a dollar. If you are serious about trading and planning on making at least a few dozen trades a month this is the best option. Also the emphasis of tradestation is on strategy trading i.e. you can program in a language called easy language using automated trading rules. The platform is superb. Also it provides a simple web based trading site beside the windows platform.

http://www.sogotrade.com
3 dollar a trade. If you are going to be trading passively i.e. on and off based on season and allowed time, this is the best option, because it is much cheaper than ameritrade, and you are not commuted to 100 bucks every month like tradestation. There are a few others like http://www.just2trade.com and http://www.zecco.com that also provide cheap trading. With these options you may want to look at other sources for technical analysis/charting tools.

So the trading platform should be chosen based on your style and how much you want to loose per month or per trade and the feature trade offs.

This is my first post on stocks trading. It is one of my interests, and have spent a great deal of time reading books, and trying various techniques. I will regularly make posts with tips and techniques and trading strategies, and will compose all my posts into a few articles and publish them on my main website http;//www.navacron.com. There are many aspects to trading stocks, and I will add posts with standard knowledge and my experience and tips with it which include.

Aspects of trading

• Trading Fundamentals i.e. how to place an order. Place a stop loss, limit order etc.
• Fundamental Analysis i.e. how to evaluate a company e.g. earnings ratios
• Technical Analysis i.e. how to read a stock graph and analyze it
• Trading psychology i.e. how to maintain your head and not panic
• Sources of knowledge i.e. magazines, books, seminars
• Trading strategies and how to tune them to your style
• Trading platform analyzing fee strutures
• Rule Base trading and back testing strategies
• Trading time frame, e.g. investing in 401K vs day trading vs week to month trading
• Risk Management
• Trading Plan

Is trading like gambling? Analogy to betting with coin tossing
Some of my friends think that trading stocks is like gambling. And to a great extent my friends are right. One never knows what the future beholds. If you flip a coin it could be heads or tails, you win or loose. So whats the point so many people go for stocks. Are all playing for the thrill of it? Why do they not all go to a casino instead.

Lets play a game to better understand what trading is. Lets say you have 100 dollars and I give you a special coin. Also i make the coin slightly skewed such that on average the heads come up 51% vs 49% tails i.e. i slightly skewed the coin in favor of heads. Also suppose you have a millionaire friend who is willing to bet with you as many times as you like. He does not know that the coin is skewed for the heads. And also you get to call heads or tails and the amount of the bet. Do you think you can play such that you can double your 100 dollars? Or even better become a millionaire i.e. win all your friends money?

The answer is yes. Do you know that casinos build their huge empires of wealth just with that much odds in their favor?

How does one play such a game. An obvious answer is always call heads (this is like trading the best stock e.g. AAPL or GOOG of these days). But there is another aspect to it. What should be the bet size. Should you bet all 100 dollars, so you can immediately double your money in the beginning? Should you bet half of it, so you only loose half worst case if the first bet is lost? How do you increase your changes of success. If you were to bet staight with all you money you are taking a risk of 100 percent. You could go clean on your very first bet, so that doesn’t seem to be good idea. If you were to make a 50 dollar bet, you could loose all your money in 2 bad bets, but it is still better than 100 dollar bet, because you at least have 2 chances. How about bet with a dollar. That makes a lot more sense. Because you know how unlikely it is that you will get 100 tails in a row. If you could, you should bet with the lowest possible risk lets say a penny, and bet a gazillion times with your friend. One day you will have all his money. I.e. bet with a coin which is slightly in your favor, and bet many times with small amounts (e.g. a penny). Out of every 100 win you will win 51 times and loose 49 times i.e. on average on every 100 bets your bank balance will increase by 1 penny and your friends balance will decrease by the same amount. Once you earn upto a 1000, you can increase your betting size from a penny to a dime. Now after a 100 bets your bank balance will increase by 10 cents. And then when you become more richer you can bet with a dollar and so on. The power of compounding will exponentially accelerate your path to richness.

The above game is simply what trading is all about. In real stock trading replace coin flip with stock going up or down. Going up means you got a head. Stock going down means you got a tail. Trading with a small amount means that you have placed a stop loss i.e. a fixed amount that you would loose on a trade, and invested a small percentage of your trading capital. The part that the coin is skewed, is a valid tested trading strategy. And yes you can develop a trading strategy that is “skewed” in your favor!