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Getting Started in the Share Market: Lesson 5

/Getting Started in the Share Market: Lesson 5

Your First Trade

The Moment of Truth!

 

Nothing can actually prepare you for the moment when you are about to make your first purchase. It’s rather like the first time you drove a car – pretty nerve wracking and you would probably be happy to accept a bit of help. Before you place an order to purchase your shares, you need to run through a checklist.

 

  • How many will you purchase?
  • What is the cost?
  • What brokerage rate will you pay?
  • What is your risk?
  • At what point will you “breakeven?”
  • Will you pyramid a winning position?

For the purpose of this example, let us assume you are going to trade in lots of $2500. The particular share you are going to buy is trading at $1.00, and your brokerage rate is $60.

 

Calculating the Breakeven Level

The breakeven level is easily calculated, but some traders make the simple mistake of not including all the costs incurred in the trade. It is essential that both the entry and exit brokerage fees are included in the cost.

The total cost for the trade is then:

Total trade cost = (Parcel size * stock price) + entry brokerage + exit brokerage

 

For example suppose we wish to enter a trade at a price level of $1.00 with entry and exit brokerage of $60. If our parcel size is 2500 we have a total cost of: (2500 * $1.00) + $120 = $2620

 

Optimising the Breakeven Level

 

The task of optimising the breakeven price level is achieved by finding a minimum breakeven level for the trade. Given that the brokerage costs and the stock price may be taken as fixed for entry to the trade, the breakeven level may only be optimised by carefully adjusting the parcel size.

 

The breakeven level is calculated by dividing the total cost by the parcel size:

 

Breakeven level = $2620/2500 = $1.05

 

The stock must at least reach this level before we achieve a no loss situation. Any exit price below this level will result in a losing trade. If we increase the parcel size to 5000 shares the total cost is now:

 

Total cost = (5000 * $1.00) + $120 = $5120

 

The breakeven level is now:

 

Breakeven level = $5120/5000 = $1.03

 

As can be seen from the preceding examples, an increase in parcel size results in a lower breakeven level. We reach a profitable level sooner, if we trade a larger parcel. However, the trade off is an increase in capital required to fund the trade and a greater capital risk level within the trade. Care must be taken to balance this risk and optimum parcel size for the trade.

A common mistake made by novice traders in the rush to complete their first trade, is to buy a small parcel of “penny dreadful” shares with no realistic possibility of even covering brokerage costs, let alone reaching a breakeven level!

 

Analysing the Trade

Now that we have optimised the parcel size with the maximum size permitted by our trading rules and the limits of our trading account, we are in a position to estimate the likely success of the trade. We should now stop and ask ourselves some questions such as:

 

Analysing the past performance of the stock, does a significant rise beyond the breakeven level seem possible?

Is this a realistic possibility or are we merely gambling on an unlikely event?

 

Taking the time to do this simple homework will prevent us entering unrealistic or potentially unprofitable trades.

Managing a successful trade is a balance between good risk management and good money management. A common error is to attempt to reduce the trading cost by using cheaper broking services such as online brokers, but this is a foolish economy. The benefits provided by broking services offering stop-loss facilities far outweigh the higher brokerage cost.

A better strategy is to employ the simple money management technique outlined and optimise the trade.

 

Placing Your Order

Once you have found a stock and your breakeven analysis deems it a viable trade, what next? Your first actions should be to place an order to purchase the stock once your buy criteria has been met and at the same time, place an initial stop-loss to exit the trade if the stock trades at a price just below an unacceptable level.

 

Managing Your Trade

A key aspect of trading is the use of a trailing stop-loss to manage trading risk. Let us assume that we are now engaged in a trade. We’ve placed our order and an initial stop-loss. The stock price is moving upwards – what next? All we can do now is adjust the stop-loss level.

This is done with the caveat that we may NEVER lower the stop-loss level (but be aware of the ramifications of a dividend payment) so all we may do is move it up. Where we move it to is the issue, and this is determined by the price movement.

 

As soon as realistic we want to move the stop-loss to our breakeven level. If our initial risk level was 10%, we move our stop up so as to maintain this maximum risk level. Remember, this was the risk level that was acceptable when we formed our trading plan, so we should stick to our plan and maintain this maximum risk level. Once the stop reaches the breakeven point we have a no-lose trade. Always remember that once the price starts to move upwards, if we don’t move our stop-loss up also, we are increasing our risk level. All positive price movement is not just changing numbers, it is your money. If the price rises and you do not move your stop, you are exposing more and more of your capital to the market.

 

Pyramiding the Position

Pyramiding the position is also a part of a good trading plan.

Traditionally we are taught to diversify our investments to dilute our risk. We may have some high performing stocks, and some stocks that are poor performers, but everything should average out in the long run. In my opinion this is nonsense. What we are doing is attempting to reduce risk by accepting mediocre performance. With the risk management provided by the trailing stop, we are refusing to accept poor performance since we will “stop out” of these trades. The stop-loss and market movement will combine to “separate the wheat from the chaff”.

The Pro Trader philosophy is to only accept minimal losses and compound profits.