2Bull Forex Blog

When trading any security you really need to do your homework. If you do not, and the price per share drops, you have no one to blame but yourself. Stock picking sites and bulletin boards often allow a trader the benefit of finding many emerging companies. These are great places to start but you must always do your own “due diligence”.

In the interest of full disclosure, There are many different types and styles of pick sites. Most are not very good, a little shady, or sometimes even completely illegal. Just recently I saw a site pick a stock on one day, but post that it picked the stock 2 days earlier. These types of practices are “shady” to say the least. The SEC investigates these companies as “pump and dump” scams and has many convictions.

Stock picking sites you should avoid using are ones that use false advertising and misleading statements. These sites will often state unrealistic gains, “this stock will go up 10,000 percent” or “this is the greatest company ever”. As I said earlier, some sites will even tout a false history. Saying that their picks go up a certain% when they never picked these stocks or changed the dates on their picks. In reality no one knows how a stock will do, through solid charting and research you can put the odds in your favor.

Also watch out for these trigger words “guaranteed”, for a “limited time” we have “insider information”. If you feel pressured to invest, it’s probably not a good thing. Sometimes you will want to get in at the bottom, or the support level of a stock, especially of a penny stock. If you feel pressured to buy though you should probably think twice. If you think you’re a victim of internet stock fraud or a pump and dump scheme report them to the SEC at enforcement@sec.gov.

This type of “pump” follows into bulletin boards and chat rooms everywhere. Sometimes these are just novice traders attempting to make their stocks rise, at other times they are paid representatives of the company making misleading statements in order to keep the price per share higher while the company dilutes.

Trading in penny stocks and micro cap stocks can be very treacherous, but can also be very rewarding. You must look at what type of trader you are when trading these stocks. Are you a day trader, do you “flip” stocks that are running, or are you an investor. Often “day traders” will buy a stock that had news or had been “picked” by a site right at the opening bell then attempt to sell the same stock a few minutes later. An investor on the other hand will buy a stock to hold for long periods of time in hopes that the security becomes the next greatest thing on Wall Street. Know what type of trader you are, plan your trades ahead of time and do your “due diligence”.

It is fair to say that many technical traders are constantly searching for the holy grail of systems, and there are clearly some approaches that work better than others, though very few approaches work all the time in all markets.

What is more important is to have a basic set of rules which cover the emotional aspect of the trading process. If one uses the basic starting rules of going with the trend, limiting risk by using stops, and careful money management, then that is half the problem solved.

But there are many times when things start to go wrong, and during these times it is human nature to question your methodology, or tweak the entry/exit points to try and try to ‘fix’ the problem, or even to abandon the existing system and start again. Many traders become so frightened of losing again that they will then miss out on some of the best trades that occur purely as a result of the law of averages. They may begin to choose the trades that feel good to them, rather than treating every trade as a production line of potential winners.

So it is useful to look at a simple list of additional rules which will help you sleep at night as a trader and take away some of the emotional damage that can be caused by stressful conditions in the markets.

1. Don’t make your system too complicated

Modern trading software often has hundreds of built-in technical analysis indicators, plus any combination of custom strategies and expert analyzes which can be baffling in their complexity. One technique that you favour might indicate a buy signal, whereas another says sell, and a third indicator might not be conclusive or suggest perhaps adding to positions. The key is to find a simple methodology that generally works bearing in mind that no one indicator works all the time. Try and keep it simple and stick to a strategy that you feel comfortable with.

2. Always buy strength and sell weakness

As a trader you don’t have to act like Warren Buffet with the luxury of being able to wait ten years before value shows itself for your stock. If you are using margin, you want results. So the point to bear in mind (remember going with the trend) is that the public continues to buy when prices have fallen, whereas the professional buys because prices have rallied.

This difference may not appear logical, but buying strength works if you are trading. The rule of survival is not to “buy low, sell high”, but to “buy high and sell higher”. If you are comparing various stocks within a group, buy only the strongest and sell the weakest. This works on the downside, too – don’t be frightened to sell and sell again until there is a trend change. Many times in our research we have put out buy signals in a stock that has already moved up sharply and regular CFD traders know that stocks that are bid for are invariably already strong before any announcement.

3. Every trade should be the same

You just never know when you might hit the jackpot in this business, but you should take the view that every trade should have the potential to be the biggest trade of the year. It might be, it might not be, but if you are following a disciplined strategy the whole point is to take every signal. Don’t be disheartened if your favorite trade doesn’t do what you hoped – there are plenty more every day to choose from.

4. Patience is a virtue

This may be the greatest trait of a successful trader. Once you have the set up to enter a trade, allow it time to develop and give it time to create the profits you expected. Taking small profits is the surest way to ultimate loss, as these are never allowed to develop into enormous profits. The real money in trading is made from the one, two or three big trades that occur every so often. If the thought of losing a profit is toying with you, take some money off the table and let the rest of the position run using a trend indicator. Alternatively, simply set a realistic target that is much higher than your allowed loss. If your trading system is valid, you should make decent long term gains.

5. Take your losses

Small and quick losses are the best losses, however annoying they may be. It is not the money that is important, but the mental capital that is used up when you are preoccupied by a losing trade that is obscuring other opportunities. You should expect occasional drawdowns as part of any valid trading system, but you must take them and move on.

6. Forget the urge to ‘get your money back’

If you do have a series of sharp losses, which happens to every trader at some stage, take some time off. Close all your trades and stop trading for several days, or go on holiday. The mind can play games with itself following losses and the urge “to get the money back” is extreme, and should not be given in to. To do this risks losing discipline, which is the cornerstone of winning traders.

If you can master these simple rules, you are already far ahead of the majority of traders. By the law of averages, and given that this is essentially a ‘zero sum’ game, you have every opportunity to make steady profits and of course enjoy trading – it’s not supposed to be a stressful business, but humans have a tendency to make it one.

The three basic orders that are normally used in placing trades are market, stop and limit orders, but there are certain subtle variations of which traders need to be aware. These give added security and precision, and there are times when more than one type of order is applicable.

MARKET (AT BEST) - The basic trade

Here the trader buys or sells at the best price available in the market for the size of trade in shares or index points. Variations on this include a Market on Opening trade, which is where the trade is to be executed during the opening range of trading at the best possible price obtainable within that range. At the end of each day’s session, a Market on Close order is completed during the final minutes of trading at whatever price is available.

LIMIT ORDERS – Buying lower or selling higher

The idea behind a limit order is to define the entry or exit price, and here the aim is to buy below the current price, or sell above it. Clearly this will not always be possible, but a time limit can be set as in “Good for the day” or “Good till canceled” orders (see below). As with most orders, the instruction can be changed at any time prior to execution. The word limit is often replaced by ‘target’, but generally the latter is only used with reference to closing positions.

STOP ORDERS – More complex

Stop orders can be used both to open and close positions, and in effect are the reverse of limits, so that instead of for example a higher price triggering a limit order to sell to close an opening long position, here the stop provides a buy signal. This can be to protect a loss on a short position, or to initiate a new buy order. Traders often use these orders to open a new long position by entering a share on a breakout upwards, and this is known as a Buy stop.

On the downside, the idea is to sell if the price falls to a certain level (Sell stop), and typically this is the most common way of protecting open long positions. Again, however, these orders can be used to open new short positions if a share breaks down below a pre-set level.

It should be remembered that execution prices are not guaranteed with stops, nor limits for that matter, as an adverse news event or a gap opening on the next session may mean that the share price does not trade at the stop level. In these cases, the stop is triggered at the next trading price in the market. Traders can however use Guaranteed stops (see below)

A Stop limit order consists of two prices and is an attempt to gain more control over the price at which a stop is filled. The first part of the order is placed as a normal stop order, and the second part of the order specifies a limit price. The rationale here is that once a stop is triggered, the trader does not wish to be filled beyond a set limit price. Stop limit orders should usually not be used when trying to exit a position, as the limit side of the instruction might not be filled if there is a sharp price movement.

There are times when a trader wishes to protect ongoing profits by moving stops accordingly, and here a Trailing stop order can be used. A trailing stop to sell raises the stop price as the share price increases, but does not lower the stop price when the market price decreases. Although trailing stops are useful for backtesting an existing trading system, most online systems do not have a facility for automatic adjustment, and the trader simply needs to amend the stop as needed. Once the stop price is reached, the order becomes a market order.

Guaranteed Stops are used by many traders and here the stop level is guaranteed by the broker, so that the client is fully protected in the case of a sharp adverse move. There is an insurance cost for this, so the commission paid and the spread on trading is often higher and the order is not flexible.

VARIATIONS

Market if touched (MIT)

These orders are used similarly to limits in as much as buy MITs are placed below the current price and sell MITs are placed above. Once the limit price is touched or passed through, they become a market order, so execution may be at, above, or below the originally specified price.

One cancels the other (OCO)

This is a rarer order, where a combination of two order instructions is left in place to confirm an action dependent on how the share performs in either direction. As an example, an investor may have an existing long position, and wish to add a further position should the holding show strength. If, however, the price falls, a stop may be set for protection, and if executed this clearly alters the strategy and cancels the first order.

Fill or Kill

This type of order gives an instruction to buy or sell at a specified price and to immediately cancel the order if it is unable to be filled in total. There is a slight variation on this, the All or none order, which differs from a fill or kill order in that immediate execution is not required.

Good for the day (GFD)

An order either to buy or to sell a security which remains in effect until the end of the trading session, at which time it is canceled.

Good Till canceled (GTC)

An order either to buy or to sell a security which remains in effect until it is canceled by the customer or until it is executed by the broker. Traders should be aware that if an order is left in the system having been closed manually, that order may be filled at a later stage giving in effect a reverse position, so close monitoring of all pending orders is advisable.

Many traders believe that the obvious way to make money is simply to have more winners than losers, but this is too simplistic, and what often trips up the unwary player is a lack of money management and attention to risk. Clearly, entering positions correctly and where to place stop losses are of great importance, but one area that is rarely examined because it is very complex is money management, and the reason is probably quite simple.

Certain trades or investments appeal to different people, and who is to know what their overall financial position is before giving them the correct advice on what amount to trade or invest. Furthermore, it is very easy for an investor to confuse a trade with a portfolio investment of stocks, or make a long term purchase but with one eye on a quick buck. For these reasons, money management rules must be adhered to for each trade.

A typical experience

One of the experiences many of the great traders have in common is that they blew a fortune early on, simply because they had no conception of money management. A typical story was that they had traded well, running a sum of say $10,000 up to $15,000 in six months, and they began to think that because they had a good trading system, they would have done better by leveraging up for super fast profits. In some cases they simply doubled up trading positions, but ran into a string of losses. As they did not reduce trading size accordingly, the account equity was wiped out and they ended up actually owing money within days – it was that quick.

For sure, they probably were not limiting risk with stop losses, but in some cases the share or commodity gapped up or down, and just one big trading position was all it took to blow away months of hard work.

Extreme events and the problems they can cause

One of the more remarkable aspects of trading is the frequency of extreme events, but these are simply statistical anomalies which occur with random regularity (forgive the lapse into chaos theory, but it’s important). There have been instances of a doubling of a share price overnight – this occurred with Psion twice in 1999. At the other extreme, there was a fall of 70% in a day with Marconi on the 21st March 2002, where they opened at 92.5p (adjusted for share consolidation), and the next day hit 27.5p. At the time, these were both FTSE 350 stocks at the time, and not small companies.

How to reduce the risk of wipeout

These might be extreme examples, but the bottom line is that events often happen when you least expect them. You must treat your trading account as distinct from all other investments, and once you’ve done this, there are three things you can do:

1. Accept that occasionally there will be an extreme event, so if the worst that can normally happen is a 30% fall on a profit warning, or an equivalent rise on a bid overnight, work out how much that would impact your equity.

2. Don’t feel that by buying five blue chips of equal amounts, you’ve diversified your risk - if they are highly correlated i.e. high beta stocks, or they are all tech stocks, then it is virtually the same risk as buying five times the amount in one stock.

3. If your equity is falling, and statistically you can expect a run of eight or more losses in a row more than once within a typical trading lifetime, keep reducing your size until you start winning again.

How much should you risk on each trade?

From experience, if you aim to lose an absolute maximum of 5% of your account equity on one trade, and combine a wide range of trades in different asset classes with long and short positions, then you should have at least 20 consecutive attempts before it’s time to give up.

So if you have to set a stop loss on a volatile share which is wider than normal, then simply reduce the trade size for that share so that your maximum loss is no higher than usual. Furthermore, if you do run into a string of losers, if you keep reducing position size, then your losses will slow down.

Finally, all trades should be treated in the same way, and if you don’t feel that a potential trade looks as good as others in your list, then don’t do it. The converse is that you must take every trade that fits your entry criteria, whether or not you have won or lost recently. The whole point is that a good disciplined system will only work when all trades are taken with equal amounts using realistic targets, stops and money management.