In today’s Money Weekend…ask the right questions…concise questions are best…creating a free call option…getting rid of stress…and more…
When you first get involved in trading the markets it can be an overwhelming experience.
There are so many competing views about what you should do and there is no way to tell if someone is full of baloney or giving you great advice.
All I can do is give you some ideas based on the path I found through the morass.
The first thing to do is work out exactly what questions you want to ask of the market.
If you keep things wishy-washy you will never know whether you are on the right track or not. There will always come a time when the market will force you into making decisions in the heat of the moment and they rarely work out well.
You have to be proactive rather than reactive.
Every decision you make has to be on your terms and not the stock market’s. If that means giving up some potential upside so be it.
The questions you ask of the market have to be as simple as possible because the market is an incredibly complex place.
You will get lost in the complexity if you ask questions that can’t be answered.
People toss around things like ‘You have to have a 3 to 1 risk/reward’. That means you should be making three times as much on your winners as you lose on your losers.
If you can achieve that it means you can get 75% of your trades wrong and still breakeven. If you get 50% of your trades right you will be making money.
But you don’t achieve a 3:1 risk/reward by choosing a target that’s three times your stop-loss and then hoping for the best.
It is a lot harder than that.
My stats at Retirement Trader over the past two and a half years have a risk/reward above 3 to 1 and I’m going to tell you how I did it.
Instead of shooting for 3 to 1 straight off the bat, which is incredibly hard to achieve, I go for 1:1.
Concise questions are best
So, the question I ask of the market is ‘what are the odds of this stock going up 30% versus down 30%?’.
That is a much easier question to answer than ‘Is this company’s product going to take market share off the market leaders?’
I form a view of the fundamentals of course. It is imperative. I wouldn’t be asking my simple question without doing all of the work necessary that leads me to the stock in the first place.
But all of that work relies on many assumptions about the future. It’s wishy-washy.
I may think the stock is going to go up 500% in the next three years but that’s a huge statement to make. I don’t know if that will happen or not, despite my conviction.
Working out whether the stock has a more than 50% chance of rising 30% versus falling 30% is a nice clean, manageable question.
Getting the odds in my favour is a lot easier said than done. I have been discussing many of the pieces of the jigsaw with you over the past few months, so if you are interested and haven’t read many of my articles you should go here to check them out.
The quick version of how I do it is that I use the propensity of prices to mean revert to get the odds in my favour.
Whether prices are trending or rangebound they often mean revert. That means they oscillate around a price level before shooting off into a new trend.
Once prices have returned to the mean (average) of the current range or wave the odds fall back to 50%.
If the odds of prices going up or down have returned to 50% then that is the point where I want to take some money off the table.
Creating a free call option
My risk management process involves selling a third of my initial position at the mean or ‘Point of Control’ (POC) as it’s called.
Once I’ve done that I adjust my stop-loss to the level where I’ll breakeven on the whole trade.
So if I make 30% and sell 1/3 of the position, my breakeven level will be 15% below my initial entry price.
In other words, by taking part profit at that point I have lowered my entry price by 15%.
If I commit to exiting the position at the breakeven level, the payoff will be similar to a free call option with a strike price at the breakeven level.
So the future outcomes of the trade will have changed from possibly losing 30% or making money to possibly losing none of my initial capital or making money.
An important part of the process is that the stop-loss is 45% below the current price.
That leaves a lot of wiggle room for prices going forward.
We all know how volatile prices are and how stressful it is watching prices go up and down each day. You can feel elated one day and sick the next.
Getting rid of stress
All of that stops once you realise the worst you will do is breakeven.
But you don’t want to get stopped out by normal volatility and then watch the stock go up 500% over the next three years as expected.
You have to be certain that the level where you get stopped out definitely proves that you were wrong about the trend.
Once I’ve achieved the first profit target, my job is done. I can stop worrying and become a detached observer of what comes next.
If my analysis of the prospects for the company is proven true and a trend develops, I will take another third profit at a point that will be determined by the price action.
There is no hard and fast rule. If prices are trending incredibly strongly I will let it run and see how far it can go. I may wait for a sign of weakness on the weekly or monthly chart (a sell pivot, for example) before taking the next chunk of profit.
Or I may base it on the numbers.
If I have become completely free carried on the trade I may decide that is the point where I want to take another third off the table.
It is a strong position to be in when you know that the company can go bankrupt, but you won’t have lost any of your initial capital.
I quite like making sure that there will be a positive return even if they go bankrupt.
If I have a third of my original position invested and the company can go bankrupt and I will still have a 25% return on the investment, for example, that is not a bad place to be.
I have moved from a free call option where I will breakeven or make money to a win/win situation.
It is by following this process that I have achieved a more than 3 to 1 risk/reward on stock trading for the past few years.
The task of achieving a 1:1 risk/reward as my initial target may not sound very impressive, but it is the launching pad for the whole trading system and ensures that the questions I ask of the market remain simple.
For Money Weekend
P.S: Promising Small-Cap Stocks: Market expert Ryan Clarkson-Ledward reveals why these four undervalued stocks could potentially soar in 2021. Click here to learn more.