Stock Trading Techniques

Before we start playing the “game” of stock trading, we need to establish some game rules. Without a strict set of rules to follow, we will let our emotions guide us and, especially where money is involved, that will virtually guarantee failure.

Although we may want to occasionally short stocks (sell a stock we do not own, for which we receive immediate cash, in the hopes of buying it back later at a cheaper price, thus pocketing the difference between the sales price and the eventual purchase price), here we will only be concerned with buying stocks in the hopes that the price will rise and we can sell them later for a profit.

Rule 1: only buy stocks (go “long”), not sell stock you do not own (go “short”).

Next we must determine how much money to put at risk, our initial account balance. It needs to be large enough to suffer some (even large) initial losses and not get wiped out. Too many traders have the right strategy, but lose everything before they even get started because they are underfunded. Had they started with enough cash, they could have survived the down draft and eventually made their fortune. Frankly, if you have less than $25,000 to invest, put it in four or five mutual funds or sector ETFs (exchange-traded funds). ETFs can be bought like any other stock, but they are a basket of stocks for a given industry sector and protect you from any one stock going under. Trading individual stocks is very risky in small accounts.

Rule 2: have a starting trading account of at least $25,000.

Stock trading can be a risky business (and it is a business, not a hobby, which is why our business needs operating rules). We should only trade money we are able to lose and not have it change our lifestyle or our relationships with our family and friends.

Rule 3: only trade money you can afford to lose.

Money management is critical, so we will never take an initial trading position with more than 5% of our trading cash. If the trade proves to be successful, we can double up on our position one time. By limiting the amount of cash we put into any one stock, we avoid the possibility of getting wiped out if that stock goes bad.

Rule 4: never put more than 5% of your trading cash into an initial stock position and never double your position more than one time.

We should only buy stocks that are in an up trend or reversing from a down trend to an up trend. We do not want to “catch a falling knife.” Stocks can go much lower (and higher) than we ever think possible, so we need a clear indication of direction (or a pretty sure sign of a reversal) before we make a buy.

Rule 5: only buy stocks that are in an up trend.

When we examine our stock charts (a stock trading technique, not a rule, thus a discussion for future articles), we’ll pick a price at which we’ll place a sell stop order as soon as our buy order is executed. A sell stop order (sometimes called a “stop loss”) is triggered when the price falls to a certain level. When the price is hit, a market order (it can be a stop limit order, but that’s for a later discussion) is automatically placed to sell your stock. The idea is that if a stock starts to trend down and hits certain key price factors, we need to get out to prevent further loss.

Rule 6:always use sell stop orders to protect yourself from devastating price declines.

If we get stopped out of a stock, we should not repurchase it for some number of trading days. This prevents us from jumping back into a stock we have “fallen in love with” too quickly after getting stopped out when our emotions tell us we “should have canceled that stop order” (almost always a bad idea). Jumping back into a stock we were just stopped out of does work once in a while, but probably 90% of the time we get stopped out, the price decline is not over. In fact, often it is just starting. Take the time to cool down and re-evaluate the stock unemotionally before making a decision to buy it back.

Rule 7: you cannot buy a stock you were stopped out of for 10 trading days.

If a stock has gone up in price more than expected or is in a parabolic rise, we should cancel our static sell stop order and place trailing sell stop orders to protect from price reversals. Trailing stop orders set a price a certain dollar or percentage amount under the current stock price. The sell stop trigger price increases as the stock price goes up. It does not decrease as the stock price comes down. So, if a stock reverses its trend, our position will automatically be sold while we are sunning ourselves on the beach in Waikiki.

Rule 8: use trailing sell stop orders to protect profits.

Remember, we are trading stocks, not buying and holding them for years. This means we will sell some very good stocks once our profit goals are met, then possibly watch them go higher, maybe even much higher. If we absolutely love a stock and cannot stand the thought of not owning it, we can establish a core long-term position then trade an additional amount of shares (our “trading” position), giving us the best of both worlds.

Rule 9: when your profit goals for a given trade are met, sell the stock, regardless of its presumed long-term prospects.

We hope to get very rich and be able to trade large stock positions. Stock prices rise and fall for one reason only, supply and demand. If too many people want to sell a stock (more sellers than buyers - a large supply), the price goes down. If too many want to buy it (more buyers than sellers - a large demand), then prices go up. In either situation, we need to be able to move fast and either establish or get out of a position quickly. That requires that the stock trades sufficient volume to allow us to execute our transaction without our order causing a major price move against us. We need to know the average stock volume for at least the 10 trading days prior to our buy date.

Rule 10: the average daily trading volume for the 10 trading days prior to our buy date should be at least 100,000 shares.

There we have it, 10 trading rules that will drastically improve our trading profitability. There are many other rules that we could discuss, but if you make more than 10 they are too hard to follow and become more harmful than helpful. Also, these are rules which only require discipline, not skill, to apply. They are not trading techniques, which are in a whole different category and require skill and judgement to effectively buy and sell stocks at the optimal time and price. Stock trading techniques will be discussed in future articles.