The stock traders best kept secret
A stock trader’s trade management strategy forms the basis for successful trading. Without it most stock traders simply end up losing money. Many beginner stock traders are under the impression that any trade they enter will simply yield a profit as long as they incorporate technical analysis techniques. The reality is that it is more difficult to make money from stock trading than it is with long-term stock investing strategies.
Trade management is even more important for a stock trader than technical analysis is. While technical analysis provides a sound rational basis for deciding on whether to enter a proposed trade, it does not guarantee that the stock trader will be trading at a profit.
The trade management concepts are discussed in the following sections.
Stock Market Knowledge
This is extremely important for the stock trader and is probably the single biggest reason why beginner stock traders fail. At the heart of stock trading is technical analysis and any stock trader who does not have a sound knowledge base in technical analysis has no rational basis for their trade entries.
Even stock investors with a sound knowledge of fundamental analysis will have a difficult time with short-term trading since the short-term stock price movements do not directly follow the long-term fundamental valuation of the stock. While it is true that the stock’s price will generally alternate between being overvalued and being undervalued at some stage, this typically takes years whereas short-term trading typically lasts several weeks up to several months. Therefore stock investors who are seeking some short-term trading will do well by obtaining a sound knowledge base of technical analysis.
In addition to technical analysis stock traders benefit immensely from having a good working knowledge of market dynamics. This includes the role of market makers, the Bid-Ask spread, long-term market cycles such as bull and bear markets, short-term bullish and bearish cycles and industry groups.
Excessive Trading
One of the pitfalls that stock traders (especially beginners) find themselves in is that of taking on too many trades consecutively. This exposes the stock trader to a significant amount of market risk and when the market turns (which is usually sooner than later) these stock traders will endure a large portion of their trades yielding a loss.
The problem this creates for the stock trader is that emotions take over and the stock trader typically becomes obsessed with trying to recoup these losses which leads to what is known as revenge trading. The stock trader now becomes aggressive which leads to a lot of poor trades being entered which only further increases their losses. The end result is that excessive trading generally leads to failure.
Keeping Trade Records
Successful stock traders keep detailed records of all of their trades entered whether they yielded a profit or a loss. The purpose of keeping these records is so that the stock trader can analyze their trades and determine the profitability of their trading strategies. This analysis will also highlight market conditions that are not favorable to the stock traders chosen strategies.
Should the stock trader’s post-trade analysis show that they are only marginally profitable or worse that they are running at a loss, then the stock trader can temporally postpone taking on any new positions while they determine the source of the problem.
Trading in the direction of the market is generally easier and more profitable than trading against the market. In addition it is easier and more profitable to trade a trending stock in the direction of stock’s trend. Not trading with the market or with a trending stock typically leads to poor results.
Stop-Loss Exits
A stop-loss is simply a predetermined price level where a trade is exited when the stock’s price moves against the chosen trade direction.
Stock investors often wonder why a stock should be sold if it moves downwards rather than holding the stock waiting for the price to recover.
A small profit can be offset by a small loss,
however a big loss requires a big profit
The consideration here is that stock investing is a long-term process which yields significant gains (which can be many hundreds of percent). These large gains significantly outweigh the losses from a losing investment. However with short-term trading the gains are only small (somewhere around 10% or less) so holding a losing trade can largely outweigh the relatively small gains from a winning trade.
The general rule is that large gains can withstand large losses and small gains can only withstand small losses. The only way to keep losses small is to exit the trade before they become large losses.
While holding onto a losing trade waiting for it to breakeven tends to work in a bull market, it is absolutely disastrous in a bear market and leads to a massive loss.
Risk-Reward Analysis
The Risk-Reward is a ratio that stock traders use to determine whether a proposed trade has sufficient profit to justify the risk taken. Beginner Stock traders are renowned for not evaluating the risk and reward of a proposed trade which results in them taken positions that have very little profit potential relative to the losses their incur when a trade goes against them. They generally assume that all of their trades will yield a profit, however the reality is that the stock trader can incur upwards of 50% of losing trades.
To be successful with stock trading, more money needs to be made with the profitable positions than what is lost with the losing trades. By conducting an analysis of the Risk-Reward ratio of a proposed trade, the stock trader can select the more favorable trades to enter and bypass the less profitable trades.
Trading Psychology
An important aspect of trade management is Trading psychology which is something that all successful stock traders are fully converse with and essentially deals with the emotional attitudes of stock traders.
When a stock trader is making money their emotional state of mind is positive and they tend to make logical and rational decisions. However when stock traders lose money (especially beginners), they become anxious and determined to recoup their losses which puts pressure on themselves. As a general rule when most people are under pressure their ability to make logical and rational decisions is impaired. This is no different for the stock trader who now starts to make poorer trade decisions which has the undesirable result of yielding poor results thus increasing their already poor trading results.
Understanding human psychology helps the stock trader realize when they are under pressure and that they still need to think and analyze each proposed trade logically and rationally. Simply being aware that ones ability to rationalize diminishes with stress helps the stock trader by controlling their own emotions and not letting it override their logical reasoning.