These simple observations or plan will help you avoid losing money trading stocks. While simple in scope, this action plan predicts higher probability winning trades. When coupled with money management, the added benefit will be consistency, which leads to capital appreciation. Since capital appreciation is one of your goals, you better have a plan. We trade the markets LIVE each day.
First: Money Management
The first question you should ask yourself is, “how much am I willing to lose on this trade?” While this may seem trivial, I assure you, money management is the key to longevity in this business of trading stocks. If you have no money, you cannot trade.
Let’s assume 5% as a stop loss. If you lose, 5% you need to make a little more than 5.3% to get back to even. Simple enough, yet so many traders let trades go further in the red, before accepting it’s time to exit. Worse, some traders/investors have no concept of the consequences of ignoring this simple calculation. “If I take a 20% loss, how much do I need to make to get back to even?” Answer: 25%.
Ok, so you know what you are willing to lose because you have money management as part of your trading plan. The second part of this plan is your strategy. We have many tools that we can use, however, most of them employ some variation of the “price relative” strategy presented below.
If you enter a new position and the stock moves against you, do you have some strategy in place to let you know you are wrong? Should you exit immediately? Or, should you wait for a trigger event to exit? If you don’t have an answer to these questions, you’re already at a disadvantage.
Strategy: Price Relative to the Moving Averages
Price relative to the moving averages is a starting point, wherein our “observation” of price action dictates our strategy. We observe the overall direction of price action. Simply put, if price action is above the moving averages and rising consider a long position. If price action is below the moving averages and falling, consider a short position.
We also observe block size institutional trades throughout the day. These trades present an opportunity if read correctly.
If you looked at the chart of AMAT below and were considering adding it to your portfolio, albeit in hindsight, you would have correctly determined a short bias. If you thought you could beat the odds in late May and tried a long entry, you would have been dealing with mounting losses thereafter. Price action failed to remain above the 9/20ema for long, before succumbing to the major downtrend.
“We have a 50/50 chance that a stock will move higher or lower as soon as we enter a position. Employing a strategy increases our probability of success.”
The “observation” that price action had fallen below the declining moving averages in early 2015 would dictate our bias going forward. There is no way we would consider a long position. Instead, we would short rejection, only after a follow-through day lower.
Also note, if you used a mean-reversion strategy when the overall trend is down, you would have been confronted with a headwind for the entire year. This is one reason we seldom employ mean reversion.
Price Above the Moving Averages: Long Bias
Once price action moves above the moving averages, as we saw in February 2016, we began to see a bullish scenario unfolding, looking for confirmation that the new trend would remain intact.
We would monitor and consider new entries once price action 1) moved back to the rising 9/20ema and 2) bounced enough to determine buyers were present. We typically look for a wick in the lower portion of the candle in question.
It is “the bounce” we look for, anticipating the follow-through bullish day as an entry. This follow-through day confirms that buyers are present. A second continuation day from the bounce zone would be our confirmation that we could begin to add to our long position. Examples: last week of February, and the mini-pullbacks thereafter until price moves below the 9/20ema in the third week of April. Gain (+2.00). The fourth week of May and the first week of July are additional examples.
In addition, we would have contemplated entries in all three examples by observing where MACD was relative to its signal line. Momentum is important as well in determining when a trend might end. Pay particular attention to the MACD histogram when trading.
AMAT and Current Trades for 2017
In the past few months, we’ve entered and traded the pullbacks in AMAT. We added on the breakouts. Using this simple strategy dictated that we should consider long positions and use the loss of the rising moving averages as our stop.
The most recent breakout in late September occurred on above-average volume. This “watch list candidate” gained more than 17.50% from the 48.25 entry in the five weeks that followed.
With earnings on deck, we have been taking profits into strength and will exit our Applied Materials (AMAT) positions entirely before the company reports.
Summary: Money Management, Probabilities, and Strategy
Our strategies for trading stocks define us as traders and determine our probabilities of success. We’ve also found, our 30 years of trading with a strategy based approach, create a baseline to confirm when we are wrong or right. And, it’s this baseline that governs when and where we take profits. Since most traders take profits too soon, having a trigger event to tell you when to exit rectifies another issue new traders are faced with; when do I exit and why?
These and other strategies reinforce our success. If properly executed this leads to consistency, which in turn equals capital appreciation. This is the bottom line. We want to make money.