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Getting Started in the Share Market: Lesson 4

/Getting Started in the Share Market: Lesson 4

Your Trading Plan

 

Strange though it seems, most people will spend more time planning their annual holiday than they will large investments. The general approach promoted by the financial industry and brokers alike is the BHP plan. The BHP plan is simply “Buy, Hold, Pray” and throw in some diversification. Beating the market averages requires a more proactive approach.

 

A trading plan allows you to revise and improve your performance to a level where you can constantly out-perform the market averages regardless of economic conditions. A plan brings consistency and discipline to your trading and ensures correct management of risk.

Without a plan you are simply gambling.

 

There are two key elements to a trading plan. The first element is your entry and exit criteria and the second element is money management.

We strongly recommend you read the book “How I Made $2,000,000 In The Stock Market”. This book was written by Nicholas Darvas – the man who developed the best and simplest trading plan I have ever seen. The Darvas method has been incorporated in the ProTrader software.

Four Trading “Secrets”

You need to:

 

  1. Know what stock to buy – trawling for trades
  2. Know when to buy – entry criteria
  3. Know when to sell – exit criteria
  4. Manage risk while holding a stock – money management

 

Trawling for Trades

When seeking a company in which to invest, what are we looking for? What can we rely on to assist with an informed decision? We can forget about using the “tip sheet” type of newsletter or last week’s broker research. This type of research is no more reliable than tossing a coin. If these methods worked with anything approaching a high degree of success, everyone would be wealthy from their share market profits.

Let’s assume we are going to use a planned sophisticated approach to stock selection. We also need to make another major assumption.

That is we want to purchase shares that have a good chance of rising in value in the near term – not just a possibility of rising at some stage in the future. My view is that when you purchase shares in a company, you are lending the company your funds and you want a reasonable return.

 

So, we agree that we want to buy stocks that are rising – this is where software comes to the fore. Good software should be able to scan the total database of whichever market you are trading and find investing opportunities in literally a matter of seconds.

 

The ProTrader software is specifically designed to perform high speed scanning. There are various scans designed to find rising stocks. The software has several “world firsts” such as the “active trend line tool”, key reversal scans, the trend channel indicator, many pattern recognition scans and the unique Darvas Scan.

Entry Criteria

There are many ways to enter the market. For many Australians the first taste of the share ownership was their participation in new floats.

As successive governments sold off public instrumentalities, Australians rushed to buy shares in the Commonwealth Bank, Telstra and various other companies. Over a million Australians were introduced to trading when the AMP Society de-mutualised. Participation in floats is certainly a method of entering the market. However I am suggesting you look for specific buying criteria that you use time after time to ensure the timing of your purchase has the odds of success heavily in your favour.

 

The book “Exploding the Myths” I has devoted a full chapter to entry signals, detailing five tried and proven methods of entering stocks at the right time. Those five entry methods are:

  1. Buying once you see a pattern of higher highs and higher lows.
  2. Key reversal bottoms.
  3. Buying a break of resistance.
  4. Buying on support
  5. Buying as prices break above moving averages.

 

Exit Criteria

When do you sell a stock? At what precise moment in time do you choose to ring your broker and tell him to take profits on a particular stock? Or do you just wait and pray? I believe the days where you could buy something and sit and wait for 20 years are gone.

Unfortunately profit taking is the least thought about area of trading, therefore causing the most problems for a new trader. Most traders find themselves in a situation where they have been in a profitable stock, only to see those profits drift away and turn into a loss.

It is unacceptable to hide behind outdated thinking that all you need is time in the market, time for a stock to recover. We can no longer afford to have our capital tied up for years on end in a non-producing investment. I make two strong suggestions:

 

  1. You must have exit rules as part of a trading plan. These rules should be robust enough to cover all eventualities in all market conditions. These rules need to be written down prior to making any investment.

 

  1. Let the market tell you when to take profits. This may seem an odd statement, however with the correct use of what we call a “trailing stop-loss” the market will tell you when enough is enough.

 

I use five exit signals. Again, these are detailed in the book “Exploding the Myths”.

Managing risk

Managing risk can be broken into three categories:

 

  1. Market risk
  2. Individual stock risk
  3. Money management risk

 

Market risk

Market risk is with us all the time, however as you can see from the table below, it can also be a buying opportunity. Newcomers are often concerned that “the market will crash” when they buy shares. To allay your fears, there were two “great crashes” during the last century one in 1929 and one in 1987, nearly sixty years apart. I’m positive that the next great crash is a long way away and there is an extremely good chance that you will recognize the signs and avoid any significant losses.

Perhaps the table below sums up the best way to look at market risk; it is in fact an opportunity.

 

Individual stock risk

When purchasing shares, pick a level of risk that is appropriate and place an order to sell the stock should prices fall to that point. In other words, work out how much are you prepared to risk in order to see whether your decision to buy is correct.

A stop-loss is the educated trader’s insurance policy. A stop-loss is what lets you go to work each day or play golf without worrying, secure in the knowledge that if your stocks fall to a level beyond the amount you are prepared to risk, your broker will sell the stock.

It sounds simple – and the concept is straightforward. In practice, the only difficulty is choosing the sell point. You should always calculate your risk and place your stop-loss order prior to purchasing a stock. This is because a stop-loss should be part of your total trading plan, worked out at the same time as you work out how much to invest in the stock and how much profit you plan to take from the investment.

A sound knowledge of how to apply a stop-loss is one of the very first steps towards a profitable trading career. The trick is to minimize trading risks. Most newcomers enter the market on a tip they have picked up from a newspaper, a friend or, surprisingly, a stranger! They do so with little consideration for the risk they are taking.

 

 

 

 

“A word of caution on “Blue Chip stocks”

Owning a blue chip share does not reduce risk. Newcomers are led to believe that purchasing a blue chip share almost assures them of risk free and profitable trading. This is not the case. Blue chip shares are subject to the same large price fluctuations as any other stock.

Money Management Rules

Successful trading is as much about money management as choosing the right stock. If you constantly let your profits run and restrict your losses, you will be a profitable investor. Money management is all about:

  • How many stocks you will hold?
  • How much will you risk on any one trade?
  • What portion of your capital will you invest in any one stock?

 

How many stocks will you hold?

 

This is an individual choice – I offer the following suggestions as guidelines.

  • A $10,000 account should hold a maximum 4 stocks. The least you want to invest in one stock is $2500, less than this and brokerage becomes a large consideration. Some newcomers may only have $2500 spare to begin with – that’s okay. You will need to look after it very carefully and stick to a well defined plan.

 

  • A $20,000 – $50,000 account should hold between 5 and 10 stocks. There may be the temptation to diversify and hold 20 stocks with $2500 invested in each company. Unfortunately diversification alone will not contribute to your success.

Far better to specialize, and buy fewer stocks but stocks that are rising in price.

 

  • A $100,000 account should hold a maximum 10 stocks.

 

How much will you risk on any one trade?

This is another individual choice and will reflect the amount of money that you have to invest. As a guide I believe the stop-loss that you place at the time of entering a trade will protect at least 90% of your capital. You need to find trades where the stop-loss can be placed below a recent support level but within 10% of that entry price.

 

What portion of your capital will you invest in a stock?

My belief is that you should invest an even amount of your funds into each stock. There is little point investing $5000 into one stock and $3000 into another based on the belief that one stock will perform better than another. People that trade in that manner are usually reliant on stories or fundamental analysis. The better a story is told, the more money they will invest. Logic should tell you that this is not going to work. If you are operating from a plan with strict entry rules, logic will tell you that your chances for success are the same with each stock.