1. Plan your Trade then Trade your Plan
Before one goes into a trade, one must have done the requisite research. I do this by reading reports mainly from ATR-Kim Eng and by actually putting down a plan in writing. In very simple terms, before any trade, one should plan:
- What exact stock are you buying? Choose and choose well. Understand what industry this company belongs to and what are its fundamentals as well as that of the industry.
- How much stock are you buying and what is your purchase price? Remember that you should allow for the fact that price movements may prevent you from buying at the price you want. You may want to set a ceiling on your purchase price instead and aim to buy a stock for as low a price as you can get.
- What is your target price? The broker’s reports will usually state their price target. You can plot your own based on that figure. A lower target if you want to play it conservative or higher if you want to be more aggressive. From purchase to target price, you can then compute your percentage growth and your projected profit.
- What is your cut-loss price? If things go south – and you should accept the fact that not all of your trades will be successful -- at what price will you decide to cut your losses and sell quickly? This is probably the most important number in your trading plan.
Put this down in writing (I put down everything in a matrix on an excel sheet) and stick to it. Do this for ALL your trades and keep a record that you can review and study. Learn from your good and bad trades and keep improving your trading system.
2. Cut your losses short and let your profits run
Tip #1 helps you to do this. When a trade is losing and the stock’s price has touched your cut-loss level, don’t hesitate to sell right away. Your trading plan is there to protect you. Use it. However, when a stock hits your target price, you can choose not to sell right away. Nicolas Darvas, in his book “How I made $2,000,000 in the Stock Market” recommends that you should never sell a rising stock. If a stock is trending upwards, hold on to it even though it has surpassed your target price. Just watch it for potential signs that the trend is reversing and exit with a comfortable profit. Many of my early trading mistakes was exiting too early and missing out on long term trends that would have given me upwards of 150% growth. I enjoyed 20 – 30% growth on my target prices which by the way isn’t bad at all. But it’s a pittance compared to more than doubling your investment!
3. Take windfall profits when you get them
Don’t be shy to cash your huge profits when you get them. While you should let your profits run, at some point you should cash in and lock in your gains. When to do this? Alas, that is a decision you have to make yourself. On one end of the spectrum, Warren Buffet is known to hold on to stocks for decades! And on the extreme short end, some trading gurus are exponents of shorter trades taking advantage of price movements counted by mere hours or even minutes. I don’t recommend the latter. Don’t feel guilty cashing in on huge gains made in a year or less. Be comforted that there are many other opportunities to make even more money in other stocks or even other investment vehicles.
4. The trend is your friend
Recognize a trend and ‘befriend’ it. Don’t fight it. Some of my friends enjoy looking for exotic stocks with questionable fundamentals and weak trend lines. I could never understand their fascination for them when fundamentally strong stocks with solidly trending prices are there to see in plain sight! Just ride the wave.
5. When you are not sure, stand aside
I cannot overemphasize this. If you can’t read the trend, then don’t trade. If the trend is strong but the fundamentals are weak which leads you to doubt, stand aside and don’t trade. If a stock suddenly jumps for no apparent reason, don’t trade. So what if you miss out on “the biggest trade of the year”? Sudden price jumps are usually followed by steep drops so don’t be tempted to join the bandwagon. I’ve lost too much money doing this before. I was stubborn. Don’t make the same mistakes I did.
6. Never add to a losing position
Early in my trading career, I tended to do this a lot. I figured if the stock was going down, I could buy more of the stock at lower prices and bring down my average purchase price. I only learned later that this strategy has a name -- averaging down. Does it work? More often than not for me, it didn’t and only worsened my losses. My recommendation is to follow tip #1 and #2. When your trade is losing, be unemotional about it and cut your losses immediately at your preplanned cut-loss level. Just make up for your loss on your next winning trade.
7. Always look for good odds; maintain a 1:3 Risk/Reward ratio
Risk/Reward ratio allows you to better assess potential trades. A 1:3 risk/reward ratio means you should look for a potential gain of P3 for every P1 that you risk. Here’s a crude example, URC or Universal Robina Corporation is priced at P21 and you believe (or your broker projects) that the price will go up to P24. This is a potential price movement of exactly P3. To keep a good risk/reward ratio, you should only allow yourself to lose P1 for the potential to earn P3. Therefore, you should set your cut-loss price at P20 which is P1 lower than its current price in tandem with your target price of P24 which is P3 higher than the current price.
If the price wavers and drops to P20, sell right away and cut your losses. If the price moves up, wait until it reaches at least P24 before selling. Better yet, let your profits run (tip #2). The idea is that if you practice this on ALL your trades, then you can be correct only half of the time and still make a profit overall. This is because even though you lose on half of all your trades, your total winnings will still be larger than your total losses. This is risk management and it is the single most important task a trader must do to ensure trading success. Ironically, this is most often overlooked and is not discussed enough in stock investing discussions and strategies.
8. Trade active stocks; avoid thinly traded issues
My rule of thumb is to trade only stocks whose daily value traded is more than P5,000,000 on average. If a stock trades only a few hundred thousand pesos worth of stocks in a day or less, don’t trade it. You’ll have trouble buying or selling it at the prices you want. Also, it’s boring.
9. Do not overdiversify: concentrate on a smaller list of well-selected stocks
I totally agree with this and must recommend this tip. Carefully choose a few really good stocks and no more. My rule of thumb is 6 stocks maximum. If I have more money I want to invest, I just time a good entry using technical analysis and buy more of the same stocks effectively just adding to my existing positions. Overdiversifying dampens growth in your portfolio. For example, if you own 30 stocks and three of them suddenly rallies, you’ll hardly notice the growth in your overall portfolio if your other 28 stocks remains unchanged. But if you own only six stocks, a jump in three of them dramatically affects your whole portfolio. Owning only one stock however is far too risky. If that one stock goes down, your whole portfolio goes down with it. The whole point of diversification is achieving a certain level of protection against losses. My technical analysis teacher recommends owning only four stocks. I however think six stocks is a good balance. It’s certainly worked for me.
10. Visit CitisecOnline’s Research Page regularly for the latest Top Picks
Citiseconline.com is a wonderful trading tool and their technical assistance is superb. They always answer my questions by email in a timely manner. I don’t recommend their research and reports however. They are a good starting point for sure, but I have found ATR-Kim Eng’s reports (my other broker) to be much better in terms of quality and depth. Their track record has been really good. In fact, I now use their reports almost exclusively whenever I assess potential trades. Currently, I don’t buy a stock unless ATR-Kim Eng hangs a “buy” rating on it. As of this writing, all my six stocks have grown by an average of 17% and I’ve only held on to them for 65 days, or just over 2 months. What are these stocks? Just check out my previous blog entry. I listed 5 there. The 6th stock I own is RLC – Robinson’s Land Corporation which I bought using ATR-Kim Eng.
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