You and Your Broker
Your choice of brokers, and even if you use a broker can make or break you! Most beginners have a false expectation of what a broker should be or should do. If you believe that a broker’s main role is to make your fortune for you, you will more than likely fail miserably in your attempts to be a profitable investor. Your broker should not be your friend, keep your dealings at a business level.
In order to succeed and constantly beat the market averages you need to follow these guidelines:
- Do-it-yourself and become the best investor that you can.
- Do your own research and make your own decisions.
- Your broker is only there to help you transact your business.
- Develop a trading plan
- Be persistent – always refining your trading plan.
While you may need a broker to transact your orders for you, we would recommend that you are extremely careful about the advice that you accept from others. This includes brokers, newsletters and the media in general. As technical analysts, we believe you should make your own trading decisions based on the price movement and trading volume data, with only minimal fundamental information.
Types of Orders
A start-gain is a buy order to be transacted once the price has risen to a particular level. You may choose to buy a stock once certain conditions are met. It may be a break of long-term resistance, the penetration of an ascending triangle or the break of a Darvas Box.
Whatever the reason, you will only want to buy as prices begin to move upwards. The beauty of a start-gain order is that it can be placed long before the event occurs. A start-gain order also saves pre-empting a buy and then holding for an indeterminate period while waiting for a break that may never occur. Make sure your broker will take start-gain orders.
The constant use of a stop-loss has been statistically proven to improve a trader’s profitability. Do not trade without a stop-loss if you are serious about making money.
REMEMBER. KNOW ONE KNOW’S THE FUTURE.
A stop-loss is an instruction given to your broker ordering him to sell your stock “at market” if prices fall to a pre-determined level.
Professional investors have been using stop-loss orders for more than fifty years but there is reluctance on the part of many Australian brokers to accept this type of order.
This is an order to sell your stock as soon as possible at the best available price.
Why Use a “Stop-loss”
As the name implies, the use of a stop-loss helps you to stop losses! There are risks in almost everything we do on a day-to-day basis. Crossing a road can be dangerous enough. There are risks owning houses, cars, boats and the like. Overcoming the day-to-day risks is a natural subconscious act. Responsible house and car owners take out insurance policies to minimize potential financial losses. It is almost an automatic reflex action. Why not take this approach when share trading? No one wins every trade. Although this must surely be your ultimate goal – there is no point in a heart transplant surgeon being happy with an eight out of ten success rate! It is the odd losing trade that you need to protect against.
How Does a Stop-loss Work?
Assume you wanted to purchase a stock only if it breaks through a resistance level at $1.00 per share. What is a reasonable risk to take in an effort to see whether your decision to purchase is correct? In other words, what is your pain barrier? Ten cents, fifteen or perhaps even twenty cents? This is your decision and your decision alone. No one can help you, but let’s assume you have chosen to place a stop-loss at 94 cents.
This is an instruction to sell your stock at MARKET immediately the market trades at 94 cents.
So 94 cents is the trigger price that sets off the broker’s selling action. By the time the broker goes through the process, the price will possibly have fallen lower than the stop-loss price. Your order may be executed at 93 cents, or even lower if there are others selling stock at the same time.
A “trailing stop-loss” facility is equally important to lock in profits as stock prices rise. The trailing stop-loss forms an essential part of any trading plan. Again, make sure your broker provides this facility. This simple process requires a review of your stop-loss on a daily basis. Keep raising the stop as the market rises. At some stage the market will turn down, trigger your stop-loss and the stock will be sold. This method overcomes the problem of when to take profits. Let the market decide for you! A trailing stop-loss, along with a plan that defines where to place the trailing stop, is the best way to safely stay in a stock that is trending upwards for a long time. The trailing stop-loss is similar, in some ways, to insurance. You should increase the value of a house and contents insurance policy as the value of your property increases!
Percentage value stops
How do you then choose the price point at which to place the stoploss? Some so-called experts recommend a percentage stop-loss. This method sounds right but is it? To use a constant 5% of the entry price as a stop-loss is flawed logic; 5% on a 5-cent stock is far too close and 5% on a $50 stock is too much to risk.
The key to successful stop-loss placement is to have the stop at a level where you do not expect the market to trade. This stop-loss needs to be below a recent price support level.
In other words, if the stock drops beyond a certain level, it is an alarm bell that something is going wrong with the stock and it’s time to get out. You cannot place a stop-loss at a level simply because it is convenient!
Dollar value stops
Talking about placing stops at a convenient level is another suggestion made by “expert” presenters and the same flawed logic applies. You will hear them suggest that you should not risk more than say five hundred dollars on any stock. These people are also the ones who tell you that if you take a $1500 profit on your winning trades and use a $500 stop, you have the key to great wealth. If it were that easy, we would have been doing it for the last 150 years.
Unfortunately, even in an upward trend a stock price may fluctuate far too much for a five hundred dollar stop to survive those fluctuations. For instance, you buy 100,000 shares at 10 cents each in a small speculative company; your outlay is $10,000. A five hundred dollar stop-loss would knock you out of the market at 9.5 cents per share. This could well be within a normal daily fluctuation.
Moving average stops
A sensible way to set stops is to use methods that take into account longer term trends and iron out the effect of daily fluctuations. A moving average is a good practical method to manage risk as well as a sensible way to place stop-loss orders. If the price today is above the average price of, say, the last thirty days, the trend is up. If the price is below the average price of the last thirty days, the trend is down.
Place a stop-loss order at a price level below the level of the thirty-day moving average.
Moving averages were part of a trader’s tool-kit long before computers came on the scene. These days, the calculation is done for you by any software analysis package, making it a quick and simple operation to find where to place this type of stop-loss.
Stops under support
The safest place to have a stop-loss is under a strong price support level. The trick is to buy stocks just on or just above that support. Assuming that you will place a stop-loss underneath a strong support level, the closer you buy to this support, the lower your risk becomes.