Trading stocks is one of the lowest barrier to entry investment vehicles you can start. All it takes is for you to complete an application form and post a cheque to your broker and you can get started. Similarly, taking your first trade is equally easy – all that takes is an idea / tip / trading signal and about 30 seconds to place your order!
But are you really ready to trade stocks?
Low barrier to entry…higher barrier to profit
With such a low barrier to entry and the promise of quick profits, it is little wonder so many people are getting into stock trading. There is just one problem – the vast majority of people who start to trade stocks end up losing money and quitting with less capital than they started with (or no money at all!)
The challenge is there is a big difference between opening your brokerage account and actually being ready to trade stocks. This is a low barrier to entry game, but the barrier to profit is higher than you might think.
The good news is that the barrier to profit when trading stocks is not insurmountable, it is just higher than most new traders think it is. This article explains what you need to have in place to actually be ready to trade stocks profitably. These pointers are what you need to get over the ‘barrier to profit’ and beat the majority of punters who will lose in the long run.
What do I need to really be ready to trade stocks profitably?
There are 4 things you need to be ready to trade stocks profitably:
- Written Trading Goals
- A Profitable Stock Trading System
- Risk and Money Management Rules
- A Written Trading Plan
Why are written trading goals so important?
We all have different situations and different goals in our life, so our trading goals are no different. Some people trade stocks for long term wealth building, some for passive income, some for active income.
Just as our reasons to trade stocks in the first place can be different, we also all have different risk tolerances. You may be comfortable with a 20% drawdown in your account but I may only be comfortable with a 10% drawdown. You may be comfortable with being right on 50-60% of your trades as long as you make money overall, but I may be comfortable with being right on 30-50% of my trades as long as I make money overall.
Objectives are important because there are many different ways to trade stocks, and until you are clear on your objectives you will have trouble making informed choices about which strategy or system to use, how to manage your risk and how to size your positions.
As a minimum you should write your objectives for the following areas:
- Maximum drawdown on your initial capital
- Maximum drawdown on your total ongoing capital
- Average annual percentage return
- How much time you will spend on your trading (each day / week / month)
- Longest time between new equity highs (how long you are willing to be in drawdown)
- Reliability of your trading (% of winning trades you need)
- Size of winning trades vs size of losing trades
Once you have these you are in a good position to select or design a profitable stock trading system.
How do know if my stock trading system is profitable?
Let’s take a step back first and talk about trading strategy. If your trading systems are going to be profitable then they need to be based on sound trading strategies that actually work.
A trading strategy is simply an approach to the markets that is based on a sound understanding and hypothesis about stock market behaviour. Here are some valid trading strategies with their associated hypothesis that you can consider:
- Fundamental analysis: Buying stocks that are undervalued and selling when they are above fair value provides an edge which is profitable over the long run.
- Trend Trading: Stocks tend to trend and these trends go on for longer than most people expect. It is profitable to identify trends early and hold until the trend turns around.
- Swing Trading: Nothing in the financial markets moves in a straight line. Most stocks swing above and below the primary trend with some consistency. These swings are profitable movements for nimble traders.
- Mean Reversion: When stocks are not in strong trending phases they tend to oscillate above and below some mean value. Positioning to profit from reversion to the mean is profitable for nimble traders.
There are many other trading strategies, but you need to ensure your system is based on a sound trading strategy that really works (and not some mystical price forecasting technique derived from natural order, astrology or hidden price / time cycles that only special gurus can identify)
Assuming your trading strategy is sound then you need trading system rules which capture an edge in the market. What I find most commonly is that once people have figured out what their entry signal is, they see their signals coming up in the market and want to jump in – This is a mistake!
The entry signal is just one small part of your trading system, and the trading system is just one small part of you trading plan.
An entry signal does not a trader make!
As a minimum, your trading system must have the 5 components listed below. Just like your trading strategy, each of these components needs to be based on a sound understanding and hypothesis about market behaviour. The example provided is based on a stock trend trading system:
- Trade Setup: Trade stocks which are trending smoothly and strongly over several months.
- Entry Trigger: Enter after a small pull back in the primary trend to reduce entry risk.
- Initial Stop Loss: Place initial stop just below the recent low to keep losses small.
- Exit Rule(s): Exit when the stock clearly changes trend using a trailing stop as the indicator.
- Risk Management Rules: Risk a very small fraction of the account on each trade so that each trade is insignificant and losses are emotionally easy to take.
Whatever type of trading system you decide on, it must have a positive expectancy. Expectancy is the amount of profit you expect to make per dollar that you risk over the long run. You can measure expectancy with the following formula:
You can calculate your expectancy from your historical trades, from a back test using historical data or from your paper trading results. Whichever method you use, calculate the value or R for each trade and then average it. The higher the expectancy the better. If it is negative you do not have a profitable trading system and you are not ready to trade stocks!
What do risk and money management rules do?
Simply put, risk and money management rules stop you from losing all your money so that you can trade for long enough to actually make money from your trading system.
If you risk too much on each trade then a short string of losses will wipe you out or at least put a big hole in your account. But if you risk too little then you will not make enough profit to bother going to all the effort.
Many people out there will tell you that you should risk 2% or 5% of your account on each trade. My experience has shown me that even 2% is generally far too aggressive for most traders and most trading systems.
When constructing your risk management rules consider this – most stocks in the market are highly correlated. This means that if the market changes direction, so do most of the stocks in the market. So if you have 10 positions and you are risking 5% on each one and the market suddenly changes direction, you could lost 50% of your account if they all get stopped out!
Backtesting different levels of risk per trade is critical if you are going to meet your trading objectives – particularly drawdown! When you simulate your portfolio in something like TradingBlox or MultiCharts (or any other trading software that does portfolio level simulation) you will probably find that the ideal risk level is much lower than you think. For example, I risk less than 1% of my account on each trade.
Also remember that the optimal historical risk per trade could be too aggressive if things change in the future, so you should probably select a lower risk than the historical optimum.
Why do I need to write it all down in a trading plan?
Unless you have a complete, written trading plan before you start trading then you are putting yourself in financial danger. I believe everyone who is trading should have a written trading plan before they start trading to guide their decisions. This has several key benefits:
1. Reduces the need for spontaneous judgement
2. Reduces the impact of emotions
3. Ensures you treat your trading like a business
Businesses without business plans fail,
So do traders without a trading plan!
A good trading plan will cover just about any situation you come across. When you write your plan you are effectively predefining what you will do in each different situation the stock market throws at you. This works because you are making these decisions when you are calm and stress levels are low. Humans do not make good financial decisions under stress, and so deciding anything in real time when the markets are moving heavily against you creates a high risk of trading mistakes and losses.
So are you ready to trade stocks?
It takes a little more than what most new traders might think, but the effort required to write your trading goals, find profitable trading systems, put sensible risk management rules in place and write your trading plan will pay off in the long run. This really is a path to a fantastic financial future and perfect lifestyle…if you prepare yourself properly!
A consistently profitable trading account can transform your financial future and your life. So do the work to get ready to trade stocks profitably – I guarantee you will not regret it.