If you know how to analyse a stock to determine good fundamentals and if you know how to read a chart to pick the right time to invest, that's all you need for successful trading - right? WRONG! I hear you saying, what do you mean wrong? What else is there? Well, there is a thing called managing the trade. This one aspect could be the most important part of trading. Let me say it again - Managing the trade - by avoiding stock trading mistakes.
No matter, how healthy the fundamentals of a stock are, and no matter how under-priced you may think a stock is, there is one thing experienced traders know. Stocks rarely move in a logical way. Oh sure, if you analysed one thoroughly and believe it is a great buy, you, could be ultimately correct about its direction. I say ultimately because what path that stock takes before it does what you expect it to do is anyone's guess. And it is in its path to your goal that a trade can tear one apart both financially and emotionally. Oh, but you say, so what if it takes a long time to reach my goal. I'm tough and I can take it! Well, way to go my brave trading friend! But not so fast.
Let's take a look at what can go wrong with a trade and why it is important to diligently manage it. If stocks always responded to fundamentals they would always be fairly priced. The fact is, there are other factors that influence the direction of a stock and make it move in an illogical way compared to its fundamentals. The factors include, for one, the health of the industry a stock is in. You can have a stock that has great fundamentals and is growing substantially, but if for whatever reason the overall industry is out of favour, guess what? That's right, your stock can easily get caught up in a down trend. Another stock trading mistake to avoid is to not buck the direction of the overall market. You may have just invested in the greatest stock but if the overall market is crashing, it doesn't matter how strong your stock is.
Did you know that when the market is in a severe down trend, about 85% of all stocks go down with the market? Conversely, when the market is in a strong up trend, about 75% of all stocks go up. But what happens in a roller coaster market in which it goes down big, then up big, then down again, and so on? Well, your stock will go up and down with the market, but the problem is, extreme roller coaster markets are often attached to unstable, even negative times. So even if there are big up days, stocks in general do not seem go up as much as they have gone down. Finally, stocks are subject to news. And it could be specifically about your stock, about the industry your stock is in, or about the overall market. All these things can affect your trade. If it is good news, your stock will go up but if it is bad - you've got it, your stock will go down, and if it is bad news about your specific stock, it could go down substantially - and fast. Hey, if the news is bad enough, technically a stock can go to ZERO.
Let me give you an example. You have spent a lot of time studying XYZ stock. You see it has great fundamentals, has an increasing growth pattern with big growth expectations for the future, and is in a great industry. According to your analysis, you think XYZ should be priced at about $65. But because the market has been in a general down trend, XYZ was caught up in the trend and is now trading for $55. The market appears to now be stabilizing and the economic news is getting better. Therefore, you have determined that this is a great time to buy XYZ. So you buy 500 shares at $55 for a total of $27,500. The next week, news comes out that XYZ is being investigated for possible accounting fraud and may have overstated their earnings. If that kind of news came out, what do you think would happen to the price? BOOM!
The price would start tumbling. Now this scenario is a little extreme but it does happen. But even if the news is less extreme, it can still hurt your trade. Of course, it is possible that after the investigation, it is found that there was no problem after all and XYZ comes back up in price. But that can take a long time. Do you want to live through all the gut wrenching emotion in such a case? I sure don't. Under these circumstances, most traders go into emotional trading, making panic decisions and that is the worst place for a trader to be. And there is also the possibility that the investigation discovers a real problem and it could take years for XYZ to recover. So what should you do to avoid getting caught in this kind of scenario? Manage your trades!
You say, well how do I do that? That is what I am about to tell you. You manage a trade by knowing, even before you make a purchase, what your exit points are. And when I say exit points I mean, know how much profit you want to make and know what the most is that you are willing to lose should the trade go against you. Then watch the trade closely and exit when either point is hit. Don't start second guessing when either of your points are hit. That becomes trading on emotion and that is almost always not good. Stick to your plan. Even better. Once you enter a trade, immediately put in a GTC order to sell the stock when it hits your profit point and at the same time place a stop order at your tolerance loss level. For example, you buy XYZ stock for $55.
Your analysis says the stock is worth $65. Giving the play some room you make your goal $62 and put in the GTC order. That's an $8 profit (14%) - and that is a good profit. Don't get greedy! You then decide that the most you are willing to lose is $5. so you place a GTC stop at $50. You then stand to win more than you would lose and that is a good ratio. The other thing you can do with the stop is place a trailing stop. This has its pros and cons which we will discuss in another article. But one pro is this. If you put in a $5 trailing stop, and the stock moves up, the stop will trail it by $5 and go higher as well. So your loss point becomes less and less as the stock moves up.
Hopefully, you hit your profit point before you get stopped, but you get the idea. Stops can also be set with a percentage amount. You just have to think about it and decide if you like a dollar amount strategy or a percentage strategy. Either way is good. The main thing in managing your trades however, is to map out your strategies and keep them consistent from trade to trade. And by the way, these managing ideas can be applied to trading options as well. There are other things we could discuss about managing multiple trades but we'll leave that for another time. This is enough for today.
Article By Anthony Ponzo |
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