Two Short-term Trading Rules
By William McKinley, Investing Systems, Inc., Investing-News.Com
Nov 26, 2004, 17:50
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Recently, while webcasting our radio program, Market Toolbox Live, I received the following email:
"I am just starting out swing-trading without a lot of money. I want to know how much is the minimum amount I can trade on a stock and how to manage my starting capital. I also want to learn how to prevent losses since I am new to trading."
These are very good questions. To help explain some basic concepts of trading, risk, and money-management, let?s compare short-term trading to playing poker.
Between the time I sit down to play (purchase shares of a stock), and the moment I see all hands (sell my stock), events will occur that will affect my outcome as a gain or loss. In poker, unforeseeable (random) events include the cards that are dealt and the amount the ?ante? (my cash at risk) may be raised by other players. In short-term trading, the central event of interest to me is whether my stock?s share price will rise, or fall. Unforeseeable factors that may affect that include such things as rumors, breaking news, institutional activity, etc.
Preparing To Play
In light of all of this uncertainty, my key concerns, whether as a poker player, or investor, are: "What can I know"? And,"To what degree can I exercise some control over risk"?
If I'm sitting at a table playing poker with four friends, I know the probability of a winning hand is one in five, or only 20%. Assuming comparable skills, this never changes (regardless of the number of hands I win or lose-successively, or otherwise). At least in short-term trading, my odds get better, one in two-50%, up or down.
I know I'm not likely to win every hand dealt. The more hands I play, the more I'll accumulate an increase in the number of lost hands. Likewise, if I'm going to make a habit of short-term trading, I'm going to accumulate numbers of lost trades.
Playing poker requires that I "ante up,"-risking the amount of cash I could lose-before cards are dealt; this can only increase during play, as others "raise the ante" required of me to stay in the game and play out any chance of winning. In short-term trading, my share of the ante (my cash at risk) can increase (share price drops) or decrease (share price rises), but the final result will not be known, or established, until my stock is sold. My gain, or loss, is calculated as the difference in share price (from the "buy" price) times the number of shares traded minus commissions.
When short-term trading, I can exercise some control over risk by observing a couple of simple trading rules. This entails pulling out my calculator, or opening my spreadsheet, and crunching the numbers according to a plan mapped out in advance. This plan includes the amount of capital I'll tie up in the trade, how much I am willing to lose, and the correlated "stop loss" stock price at which I will tell my broker to sell at market to get out of the trade. Thus, the key to success with short-term trading lies with position sizing and the placing of stop-losses on every trade.
(Flexible) Trading Rule #1 - Size your share trading position: 20% to 35% of available cash, inclusive of commissions.
As a rule of thumb, I seldom invest more than 20-35% of my available cash (or, bankroll) in any given short-term trade. This represents a cash range within which I can size my trading position, i.e., it limits the numbers of shares I can purchase at a selected share price. For example, I have a $10,000 bankroll in my cash account, my first step is to calculate a position worth roughly $2,000 to $3,500 on the first trade, inclusive of buying and selling commissions (say, $10 one way). If the stock I'm placing an order for currently sells at $30 per share, a position size of 100 shares will keep me within my range. If I have good information on a stock, I'll push the number of shares to the high side:
$3,500 - $20 (2-way commissions) = $3,480 / $30 ≈115 shares
If I want to be conservative, I can keep the numbers of shares toward the low end:
$2,000 - $20 = $1,880 / $30 ≈ 60 shares
As my bankroll increases, my position sizing range will increase. I can purchase more shares (stock of similar price) on my next trade and, thereby, stand to gain (or lose) more with price movement. If, however, my bankroll decreases, I'll have a smaller bankroll; my position sizing range will decrease; and, I'll be able to purchase fewer shares on my next trade-unless I'm able to find stocks of lesser share price (which segues into "stock-picking strategies," and that is the subject of a future column.)
"Playing My Hand," or In The Trade
Once I've looked at my cards (my order to purchase has been filled): If my hand is good (the stock price is climbing), I may stay in to see if I can increase my gain by raising the ante (increasing profit, by staying exposed to momentum reversal). If my hand is questionable (the stock price is dropping mildly), I can stay in the game and trade-in a number of cards to seek a winning hand (banking on momentum reversal to the upside). If my hand is bad, I can fold because others are upping the ante (sell the stock because its share price is dropping precipitously) and I must conserve my bankroll - in order to play the next hand. The sooner I quit a bad hand, the more bankroll I'll have left to play new ones.
Where much time and energy has been spent on looking at cards (or watching stock price fluctuations), and trying to determine whether to ride with it, or fold, the success of the game is ultimately determined by the size of the bankroll one has when leaving the table.
Novice poker players can be fooled by the bluffing of more experienced players. And novice traders can get too closely involved in watching their stock's price movements, and reacting emotionally. In both cases, each may lose with what would have otherwise been winning hands. New traders, particularly, fail to learn broader money-management strategies that, when applied to their trading, will mitigate risk, minimize losses, and enhance gains.
When To "Fold," or Sell At Market
I personally will never lose more than 5% on my position in any trade?ever. (In fact, I prefer 2-3% for the most part.) And, I would strongly advise you not too, either. Repeat after me: "I will never lose more than 5% on my position in any trade, ever." This brings us to the most important?thus, inflexible?rule of trading:
(Inflexible) Trading Rule #2 - Set your Stop-loss. Specify a tight stop-loss, or standing "sell at market" price, at no more than -5% including commissions.
Just like finding myself with a bad hand in poker, once my trade's share price drops to the stop loss price, I'm stopped-out, and a sell-at-market order is executed. While I've lost my ante, the stop-loss order has gotten me out of a trade before disproportionate further losses - from which I may find it difficult to recover - can be incurred.
(You must actually set your stop loss with your broker; don't keep it in your head. Physically place the stop-loss order with your online broker so there is no chance you will change your mind. Your emotions are your worst enemy, and it is imperative to calculate all the details of your trade in advance and stick to your plan once you are in the trade. Setting the stop-loss, and permitting it to execute without interference, will protect you from holding a stock like Lucent Technologies from $40 to $2; it will protect you from ever holding a CMGI from $140 to $1.40.)
There may be times when I prefer setting the stop-loss at about 3%, if my information on the stock is less than I normally would desire. This permits me to balance the increased risk, losing only my "lunch money" if the stock goes down. But setting it less than this may not permit a reasonable volatility variance, and I'll get stopped out too soon. Looking at our initial example, above, our effective stop loss was -4.33% (decline) from purchase price, which took the cost of commissions into account:
Set your "stop-loss" share price - a standing order to "sell at market."
With my bankroll reasonably intact, I can get back in the game. Of course, I'll need to make 5.3% on the next trade to get back to even, but that is acceptable.
Where your trades are moving positive, let the stock price rise, and simply move the stop-loss up as the stock goes up. Using the above example (-4.33% stop-loss, or 96.67% of current share price), and demonstrating the profit/loss differences between initial positions of 100, 500, and 1000 shares, we set up a simple spreadsheet that forecasts sliding the stop-loss with every 3% increase multiple from the original purchase price.
In strong upward trends, plan to slide the "stop-loss" to protect gains.
Setting up such a spreadsheet is relatively simple. You can establish a sliding schedule that suits your own trading style. Always be ready to get stopped-out and "lose your ante," however, and get your money back into your account so you can go on to the next trade. (Alternatively, good stock trading software can assist you, here.)
The Next Trade
Let?s look at probability afresh. No matter how many trades we make that have the same outcome in succession, the belief that an opposite outcome is more likely on the next trade (greater than 50-50) is called "The Gambler's Fallacy." If, however, we accept the unlikely occurrence of 5 straight losses followed by 5 straight winning trades (using the previous selling price as the next purchase price in both cases), how do we fare?
Determine what constitutes an adequate share price appreciation.
On the last 5 trades where share price appreciation compounds at 4.33% on each trade, we're still in the hole because of commissions. At 6.50% appreciation on each, we've got some profit to show for our work - good profit at higher share positions. However, at lower share positions, we make better progress at a share price appreciation of 8% and above. Like in poker, the amount of money on each of the 5 hands we win will vary, but hopefully one of them will be a full-house, big-pot, or 30% gain on our trade. That's where our real money is made.
Since we know we'll risk 3-5% on any given trade, over the long term any winning trades demonstrating share price appreciation exceeding 6.5% will accumulate gains (all share positions being averaged), though, theoretically, we do not know for certain what minimum number of trades are required to realize the gain. But, using only a small sample of 10 trades, normalized for distribution, the logic of using tight stop-losses and good money-management is demonstrated.
Keep in mind: We could have eight straight wins, and we would be no less likely to have a win or loss on the ninth trade than on any other trade. It is important to bear this in mind, especially when we find ourselves in trading streaks. The truly successful investor does not gloat with many wins, nor despair with many losses. The successful investor strives only to stay focused, increase analytical skills, and learn more about tools that can assist this analysis and sway the odds in his/her favor.
Conclusion
Poker, which has been around longer than the stock market, is experiencing a resurgence of players in casinos throughout the country. This is due, in large measure, to cable television's promotion of the World Championship of Poker, and special matches of attending / playing celebrities.
But, as we've seen here, the odds of making money "playing the market" are far better than with playing poker. I'll continue to play poker for entertainment while trading stocks to make money. And, with each trade, I'll continue to use these simple rules of position sizing, and stop-loss placement, to help tilt the odds in my favor and prevent any trade from doing irrevocable damage to my overall trading account.
My hope for you as a new trader is that you get stopped out of every single trade you make - most of them with a nice healthy profit!
William McKinley is President of Investing Systems, Inc., Amelia Island, Florida. Bill is senior software development consultant for Investing Systems, Inc. He is a longtime investor and avid student of markets and stock trading software. Bill can be reached at W.McKinley@investing-systems.com.
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