Traders and investors spend too much time, money and effort trying to find a trading system, methodology or get rich quickly scheme to make money in the stock market. Instead it would be more helpful to develop their own trading style if they study the markets and using smart money management to their trading skills.
Stanley Kroll once said:
“It is better to have a mediocre system and good money management than an excellent system and poor money management.”
If you are in search of a get-rich-quick formula, then you have come to the wrong place. These rules are the basic foundations that have made me a better trader.
Step 1: Cut Your Losses Quickly!
As simple as it sounds, failure to keep losses small is the #1 reason why most traders blow out early in the game. As a matter of fact, it almost happened to me early in my trading career.
When I first started trading, I was fascinated by the money I was making at day-trading stocks. I thought I knew everything. But it wasn’t long enough before reality kicked in. In the hope of making quick money, I was caught short on one position and by the time I exited, I had lost nearly more than half of my account. It was at that point that I realized the importance of limiting my losses.
Very few traders understand the seriousness of losses and risk. But understanding the following concept can turn a losing trader into a winning one because it can help you to focus on doing the right things and turn you away from the wrong things.
Here is the concept that I strongly believe in:
“When you lose money in trading, you wind up having less capital to work with. Therefore, to make back what you lost you have to earn a substantially higher percentage return than what you lost.”
This principle keeps many losing traders from digging themselves out of the hole they’ve dug for themselves. They lose a big chunk of money and unless they add more money to their account, they are not able to recover and get on their feet to trade again.
As I have studied the qualities of the most successful traders, I noticed the common quality that all of them strived is to keep cut their losses (preferably, to 10% or less).
When you trade, you always have to be aware of the dangers of suffering big losses. You not only lose the money, but you also have the potential to be knocked out of the game permanently. Realizing this fact will develop a fear in you that I assure you will be quite healthy for you to become successful trader and it is this fear that will help you to remember to keep your losses small and religiously apply stop-loss methods.
Step 2: Studying the Market is the Key
Almost every trader is in search of finding the secret formula, that is, a trading system with potential to generate huge returns and which removes all the emotional elements from trading.
Many traders reading this article will deny this, but they are in constant search of a system that would make them millionaires in a year or two.
The truth of the matter is the markets are always changing. It goes through bull and bear phases. The key to long-term success is to understand the flow of the markets to adjust your strategies and trading style. Learn from your experience and your trades that have made you money. There is simply no substitute for experience and certainly no mechanical trading system can replace that.
Step 3: Always use Stop-Loss and Trailing Stop-Loss
A Stop Loss is an order to exit a long or short position should the prices move in the opposite direction. It acts as an insurance against an unusually large loss. A trailing stop-loss is a moving stop-loss order which shifts your position as the price moves away from your original entry point.
A trailing stop-loss for a long position would follow the stock up as it moves higher, so that if the market moves down from its highest level, one would automatically take profits. As the price moves up, the stop order trails the stock price by moving up with it. A trailing stop-loss for a short position trails the stock price down by moving lower as prices make new news.
Always plan a trade beforehand so as avoid getting caught up in emotions. Successful traders know it’s important to not only use stop-loss but also, position them so that the risk is contained.
Step 4: Reverse Pyramid Technique
Reverse Pyramid is a technique where you start with a small position (similar to the top of pyramid) and increase your position size as a trade moves in your favor.
For example, let’s say you are interested in buying 500 stocks of XYZ and the stock is trading at $25. Use reverse pyramid style to initiate a small position of 100 shares. As the stock moves in your direction, increase the size of your position as long as your trailing stop is above your entry price.
In this way, our commitment is to average up into the position as price moves in our favor.
Step 5: Let Your Profits Run
If look closely, in the above example, after the stock breaks out instead of taking profits, we give the stock a little room to wiggle and let it test the break out. You need to practice patience in an trending market as the stock you’re positioned in will often continue to move much longer than you originally thought. Getting into these markets and then staying with the trends until you get stopped out will be key to your success as one big winner will overcome all your small losses.
Step 6: When in Doubt, Stay Out or Get Out
You should only enter a trade when all the technical indicators, chart patterns, valuation and a myriad of other factors show strong profit potential in relation to risk. One of the key position to take in trading is “waiting on the sidelines”. This will help you avoid losing capital when the time is not right to trade. At the time of this writing, the general markets were in the midst of bull and bear struggle and it was difficult to derive any particular direction based on daily market action. Never let the urge of trading take the best of you and it would be prudent to stay in cash until the right combination of risk/reward opportunity shows up.
Step 7: Review Your Past Trades
In a trading, it is essential to keep a journal in which you should write down what your thoughts are about the general market trend, the positions you took, and the reason for the taking the positions that led you to make the trading decisions you made. Follow every trade to its completion and record the profit/loss and the reason of getting out of the position.
Also review you trades on a periodic (weekly or monthly) basis. Analyze the results of your trading techniques by looking for common patterns between losing trades and winning ones. Make every effort to fine-tune your techniques
Over the period, this journal will serve as the best self-improvement book you could ever find in the market for yourself.