Lesson 1 – Steps to a profitable trade

/Lesson 1 – Steps to a profitable trade

Step 1

Global Rules

Background
Trader or investor? Short-term or long-term? Capital gains or dividends? Perhaps you will address these issues prior to making your first stock market investment, although that is unlikely. I imagine most people will jump into the market without any great thought given to any aspect of planning the trade. Usually the first investment that someone makes is based on word of mouth from a well-meaning friend. No plan, no exit strategy and no idea of controlling the risk.

This course is about how to structure a trading plan regardless of whether you are a short term trader or a long term investor. Your trading plan will give you results provided you have the strength and discipline to follow your plan.

Invest Visually
By investing visually I am strongly suggesting that you look at a price chart of any stock prior to any purchase. Too often people say to me, “Every time I buy a stock it goes down one or two days later.” I would suggest that these purchases are generally made when the price is in an established downward trend and far too many people fall for the trap of trying to “buy cheap.” By looking at the price history of a company you can determine in a broad sense whether the price is rising or falling at that time.

Trading is a business
Trading is like any other business. As with driving a car you need to understand and obey certain rules before you turn the key on. Things like stopping at a stop sign and driving on the left (in Australia – don’t try it in America) are pretty handy rules to obey. Let me give you some of the concepts that you need to at least consider, preferably prior to starting your trading career. If you have already done some trading I am sure you will find some of this chapter very relevant. Most people reading this book will have already taken the leap into the market, however the purpose of this chapter it to show you how to set up your trading plan as if it were a new business venture rather than a spur of the moment decision.

Consider the following:

• Are you a risk taker? Anyone who enters the stock market must be. Taking risks comes with the territory. If you don’t accept some risk, place your funds in a safe bank and take whatever interest they are prepared to offer. The issue really is “How much am I prepared to risk?” Work this out before you enter the market.

• Are the funds that you are about to invest really “spare” funds? Everyone uses “spare” money when they first invest, but then realize it wasn’t so spare when the first trade is a loss.
• If you lose this money will it affect your lifestyle? It is very difficult to know the answer to this question prior to trading. Perhaps the best outcome for a newcomer is to lose that first trade, then you either drop out of the market altogether crying the market is rigged and too dangerous or you will go back to the drawing board and work on becoming a better trader and developing a plan.

• Are you trading to pay the bills? It borders on the impossible if you intend trading profitably to pay bills. (If this is your intent then perhaps you should go to the horses next week and put it all on number one in the seventh. Now I should put a disclaimer on that idea and tell you that this book does not constitute financial advice and you had better check with your financial planner before heading off to the horses).

• Is the current market strong or weak? Too many people enter the market during a strong market and make a good profit. Unfortunately you learn very little about the art of trading during a bull market. It’s all too easy. However when the inevitable downturn comes most people lose all their profits plus a bit more and turn a few short term trades into long term investments. It doesn’t really matter if the “market” is strong or weak, you just need to be in the right stock at the right time.

• Are you trading your own superannuation fund?
• Are you aware of current legislation concerning SMSF’s?
• While considering your move into the market there are many issues to address, one of the first being where will you work, from home or in the office? I do most of my “homework” during the weekend. If you want to do something market related during office hours, buy a book on trading and read and study. Do your analysis at home, uninterrupted. Once you are proficient your trading analysis will probably only need 30 to 40 minutes a day.

• When I first began trading I subscribed to one newsletter after another. After a while I felt they were all rubbish and not once did I renew my subscription. In hindsight this was unfair. Many of the newsletters were full of good information but generally the timing was terrible. There are several good tip sheets out there, but they need to be read in the context of being a source of information as opposed to rushing out and buying every good story you read.

Personal Factors.

1. Will my partner be involved? If you are slightly unsure of the answer to this question my suggestion is to learn and study together and perhaps work on a joint account together, but also have a small individual account for those occasions when you disagree.

2. What accounts do I need? You may need to consider whether you need to open an account for your super fund if you are running a self-managed superannuation fund. You may also have a spec account that is separate from any other accounts and you may want to consider a joint account if required.

3. Will I use an internet broking platform or a traditional broker? I have a word of advice for you. There are inherent problems with both forms of broking. The internet appears to have several advantages, price, portability and the possibility of being able to watch prices flutter across the screen all day until you become a cross eyed antisocial misfit. Sitting in front of a screen has its own problems and more than likely will not help you make any great trading decisions. Each trading platform has its own idiosyncrasies with very few traders that I have met being aware of some of the pitfalls of their particular platform. I have never been totally comfortable with any online platform that I have used. The traditional broker is usually more expensive and it may be very difficult to find a broker that will do precisely what you require of them. However a good broker is worth far more than the brokerage that they will charge you.

Having considered all of the above, you should then come up with your set of “Global Rules”. I have a couple of suggestions for you. Whether you adopt them or not is up to you. You may also add your own rules to the following list.

Pro Trader: Personal “Global Rules”

One: I will never risk more than 15% of my total portfolio.
If the Financial Industry and Fund Management Industry applied this rule during 2008 it would have saved the majority of Traders/Investors close to thirty percent of their capital. You need to have a process in mind if you adopt this rule. If you are in a situation where your portfolio falls by 15% what action will you take? Will you sell everything and stand aside, or perhaps place close stop loss orders on all stocks?

Two: I will never make a trading decision during market hours.
This may appear to be an odd rule however watching a screen all day is not only boring, it rarely has a positive effect on profitability.
Decisions made during market hours are generally based on emotion whereas a decision made when the market is closed will be based on your trading plan.

Three: I will always use a stop loss.
While I endeavour to adhere to this rule there are occasions in very low priced speculative stocks where this rule is not practical so there has be a degree of flexibility in the application of this rule.

Four: I will never purchase stock in an Airline company.
This is a favourite of mine and has been one of my global rules for over twenty years. I have never been able to understand why any thinking person would own stock in an airline. The returns have never been great, the growth is often negative. (I love that financial expression – xzy had a negative return in the last financial year – for we mum and dad investors that expression is actually a very cleverly disguised way of saying that xzy made a loss.) You may wish to lean towards being an “Ethical” Investor and not invest in certain companies for personal reasons.

Five: I will often split my parcel on exit.
Rather than selling all of your parcel in a company at one particular moment I find it easier to split my parcel and sell at two or three different times.

Six: I will add to a winning position whenever possible.
Very few people add to a winning position yet this is the best method of capitalizing on big moves. You need to have very clear buy signals if you are to successfully follow this rule.

Seven: I will never add to a losing position.
This is another rule where a little flexibility can apply. When trading in the top 20 companies it can make sense to buy on dips in the price. However far too many traders tend to add more and more stock as the price falls, often buying until a company enters bankruptcy.

Eight: I will always take “windfall profits”
With any stock priced over $2.00 I will take profits if at any stage the price jumps 20% in any consecutive 5 day period.

Nine: I will limit the number of stocks in my portfolio to 14.
You may need to change this according to your account size.
I suggest that a $10,000 account should hold a maximum three stocks, a $20,000 account five stocks, a $50,000 account ten stocks, $100,000 twelve stocks.

Ten: I will have a monthly “health check”.
At the end of each month I will look at my portfolio and if there is a stock price below my entry level but above my stop loss, I will more than likely sell the stock. My thoughts are that if my entry is according to my rules then I expect the price to rally in the short term. If after a month the price is below my entry point then I am probably wrong and should quit the stock.

Eleven: Lookout for laws.
As one of my accounts is a superannuation fund, I need to keep abreast of some of the rules applicable to super.

Twelve: Pro Trader rule #19 – Be flexible.
You never know what the market may throw up so you need to be able to cope with the unknown. I once read a set of 18 rules put together by a U.S. “guru”. A couple of those rules were contradictory but both had an application in different market conditions so I added my own “rule 19”.