Shares Trading for larger profits

What is shares trading and what is a stop loss price and why should we have one?  OK let’s start at the beginning.

Shares trading is buying and selling shares, normally in a time period of weeks through to months to make a profit.  To make larger profits when trading shares it is vitally important to have a top loss for every trade.

A stop loss price is a pre-determined price that we use as the trigger to sell out of a losing trade.  In other words, if the share price falls instead of rising then we sell and we sell at a pre-determined price to ensure that we don’t lose too much money.

Sensible?  Yes.  Logical?  Yes.  Straight forward?  Yes.

Yet in a recent survey of frequent share traders in Australia, 21% didn’t really know what a stop loss was or how to use one.  And of the 79% that did know what a stop loss was, 30% never or hardly ever used one.  At Just Shares we believe that if you want to make money repeatedly and sustainably from shares trading then using a stop loss is absolutely essential – for every single trade. In fact we believe that your first responsibility when trading shares is protecting your money.  And the main way that you protect your money is with a stop loss.  (The other way is through Position Sizing which is the subject of a separate article).

Just a word on why we need to have a stop loss price.  Quite simply because not all trades succeed – some fail.  Even the best trading techniques on the planet struggle to deliver a success rate of much more than 70%.  Therefore even using some of the best trading techniques that exist we will still end up with two or three losing trades out of every ten.  For these losing trades we must keep our losses really really small.

Another way of thinking about shares trading, or investing for that matter, is that any trade, or investment, can only have one of five possible outcomes:

• A large profit.
• A small profit.
• Unchanged or breakeven.
• A small loss.
• A large loss.

That’s it. Five possible outcomes, no more, no less.   Every single trade will result in one of these five outcomes.

Now if we could eliminate one of these five outcomes, which one would we choose?  That’s right – the large loss.

If we eliminate the large loss we are only left with the other four possible outcomes.  If our small losses, breakeven trades and small profits even out over a period of time we will only be left with the rather pleasing occasional large profit.  If we are using trading techniques with a success rate of more than 50% then we will be generating a regular profit stream from the small profits because we will have more of these than small losses.  And we still have the pleasure of the occasional large profit.

By now there should be no doubt in your mind about the wisdom of eliminating large losses when trading shares.  So what do we use to eliminate the large losses?  The Stop Loss is what eliminates the large losses.  So the question then becomes how do you set your stop loss price?

One of the most commonly published ways of setting a stop loss price is based upon calculating 2% of Trading Capital.  Here the Stop Loss price is set at the level where you would lose 2% of your total trading capital.

A Stop Loss Rule, we call this the Golden Rule of share trading at Just Shares, typically has three parts to it:

1. Always, and I do mean always have a Stop Loss in place for every single trade that you do.  No exceptions.
2. The Stop Loss price is set at the level where your loss will be 2% of total trading capital.
3. When your Stop Loss price is hit then you must sell.  No ifs, no buts, no maybes.  No waiting one more day/week/month/year until your trade turns into a “long term investment”.

For those new to share trading, and maybe some not so new, the most difficult part of this rule is part 3, selling when your stop loss price is hit.  It’s the most difficult part of the rule because it brings into play your emotions.  Emotions of fear of loss and the hope of better things to come if you tough it out.  And of course our ego pops up and it just hates us admitting that we were wrong about anything!  Despite this huge emotional drag not to sell – sell we must.  When your stop loss price is hit you sell.  This is about protecting your hard earned cash.  Want some proof?

If I am trading with $10,000 and if I have a losing trade of say 20%, my $10,000 will be reduced to $8,000.  That is the original $10,000 less 20% ($2,000).

Now in my next trade I am starting with $8,000.  If I make a 20% profit my $8,000 will increase to $9,600.  That is my original $8,000 plus 20% ($1,600).

Let’s stop right here.  I have done two trades, one lost 20% and one gained 20% but I am down $400.  This hardly seems fair.  But then the share market doesn’t care about fairness.  Welcome to the reality of share trading!

Want some more proof?  As the table below shows, the larger a loss gets the worse the situation gets:

So hopefully we can agree on the importance of keeping any losing trade really really small. How small?  No more than 2% of our total trading capital.

For example, if my trading capital is $10,000 then 2% of my trading capital is $200.  So if the price of the share that I am trading should fall to the level at which I will lose $200 (2% of my trading capital) then I sell. This is simple and straight forward but it protects your hard earned cash.

One draw back of this very simple method of protecting your money is that the share price that the dollar figure, in this case $200, relates to doesn’t necessarily have any connection to what is happening on the share price chart.  In other words your trading technique my be saying to stay in the trade but your 2% stop loss has been hit and is screaming “sell”.

Most shares trading techniques are designed to give you an exit signal – the technique will tell you when to sell.  Normally the trading technique will give you an exit signal that is connected to the underlying price movement of the price chart of the share that you are trading.  For example a simple moving average cross over will tell you when to sell based upon the averages crossing over in the wrong direction.

So the trading technique manages your exit but if you enter a trade and it goes against you straight away – how can you marry your trading technique’s exit, particularly if it has a lag built into it, with your desire not to lose more than 2% of your trading capital? This is what Position Sizing is about – we look at Position Sizing in a separate article.

The key principle here is always have in place a price that if the share price falls to this price, you sell and cut your losses.  Protecting your hard earned cash is your most important task when trading shares.  A good starting point is to cut off your losses at 2% of your total trading capital, and then combine this with your trading technique through Position Sizing.  Shares trading to make money is more successful with a stop loss.

There are quite a few newspapers, journals and commentators commenting on the fact(?) that Warren Buffet is probably busy in the current market buying up cheap shares …. and that you should probably be doing the same.

Firstly these individuals and publications do not have  a direct line to Wartren Buffet to know what he is and isn’t doing.

Secondly Warren Buffet invests in companies.  He neither invests in shares or trades shares.  In other words he buys enough shares in a company to control the company and put in place his own management philosophy and management team.

Unless you have Billions of dollars to invest and a clear management philosophy and teams of managers ready to deploy, then what Warren Buffet (reportedly) does should have no impact on what you do with your share trading.

Many would argue that the first real trend following share trader was Jesse Livermore.

The unofficial biography of Livermore was “Reminiscences of a Stock Operator”, published in 1923.  Written by journalist Edwin Lefevere, who many believe was a pseudonym for Livermore himself, Reminiscences has become the share trading classic.

Numerous quotes and principles from Livermore’s approach to trading are completely embedded today’s modern trading approaches.

Here are just a few of the pieces of wisdom from Livermore’s biography.

1. “It takes a man a long time to learn all the lessons of his mistakes.  They say there are two sides to everything.  But there is only one side to the stock market; and it is not about being on the bear side or the bull side, but the right side.”
2. “I think it was a big step forward in my trading education when I realised that when old Mr Partridge kept on telling the other customers who would ask what to buy and sell each day, well you know this is a bull market, what he really meant to tell them was that the big money was not in the small day to day fluctuations but the broader market moves.  That is it is about sizing up the entire market and its trend.”
3. “Many men become impatient or doubtful when the market takes time doing what they figured it would do.  That is why so many men in Wall Street, who are not all in the sucker class never the less lose money.  The market does not beat them.  They beat themselves because they cannot sit tight.”
4. “The average man doesn’t want to be told with likelihood that it is a bull or a bear market.  What he desires is to be told specifically which stocks to buy or sell.  He wants to get something for nothing.  He does not wish to work at his trading.  He doesn’t even want to think. You can’t trade successfully if you follow the ways of the average man.”
5. “A man will risk half his fortune in the share market with less reflection than he devotes to the selection of an automobile.”
6. “Tips!  How people want tips!  They crave not only to get them but to give them.  There is much greed and vanity in this and little to do with quality trading.”

Was Livermore the first trend following trader?  Possibly, but he was certainly the first trader to put into black and white many of the principles of successful trading that still apply today.

If you want to know why trend following trading techniques still work today, Livermore’s answer from another time still answers the question for our time.

“Wall Street never changes.  The pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes.”

Our answer follows.

Let’s begin with four principles that we told Harry that he must follow.

1. Trade with an edge.  This means use a technique or method that delivers a positive outcome over the long term.
2. Manage risk – all the time in every single trade without exception.
3. Be consistent – stick to your trading rules always.
4. Keep it simple.  Successful traders often use the simplest approaches to trading.

For Harry we started by looking at Principle 1.  When we examined his trading records we found that he had been taught three trading methods and that the best performing one was generating winning trades only 38% of the time.

We also discovered that his application of stop losses was mixed and that his setting of stop losses was discretionary.  Furthermore he did not use position sizing.

Generally speaking he was consistently sticking to his trading rules but some he didn’t understand properly and some were very complex requiring an analysis of as many as ten different technical indicators.

Harry was also very pre-occupied about being right in each of his trades and felt he should have a better handle on “knowing which direction prices would move in the future”.

Just Shares point of view is that successful trading is not about being right, it is about trading right.   Really successful traders do not care about being right; they care about making money.

Successful traders do not pretend to be able to predict the future.

What we did with Harry was:

1. We taught him two very simple trend trading techniques – one short term and one long term.
2. We got him to agree to use a 2% stop loss rule in every trade and to use position sizing for every trade.
3. We taught him to think in terms of probabilities of likely outcomes not prediction.
4. And finally we taught him to expect to have losing trades and not get concerned when he did – providing he was using his stop loss rule.

The result nearly a year later is in.

Harry has had a profitable twelve months of trading.  His profits for the year are nearly 40% of his starting trading capital and he is a happy trader.

“Wall Street never changes.  The pockets change, the suckers change, the stocks change, but Wall Street never changes, because human nature never changes.” Jesse Livermore.

What follows is a true and factual story. A University in the US did an experiment to understand more about the psychology of success. This experiment has subsequently been repeated a number of times at different places and by different people.

The experiment involved getting people to guess the outcome of tossing a coin. You know how it goes, I toss the coin, you guess the outcome and then you are either right or wrong.

Let me ask you a question, if the coin were tossed 500 times how many times would you expect to guess the outcome correctly? That’s right around 250 times or 50% of the time. It doesn’t matter how clever you are or hard you concentrate the outcome is determined by the laws of probability. Just about everyone understands this and knows it.

What you may not be aware of is that in the 500 tosses there is a fairly good chance that you will put together three or four runs of guessing five tosses in a row correctly. And here is where the psychology of success takes hold. What the university experiment did was asked the people guessing the outcome of the toss how they felt about their performance at various times.

What they found was that when people were having successful runs – four or five or six correct guesses in a row – that they believed that they themselves were responsible for this success. Reasons ranged from, I am getting better at this, to I am now concentrating harder and that is improving my performance.

Let’s stop right here. People who know that the outcome of a guess is based on a strict 50% probabilistic outcome believe that when they have a few guesses correct in a row that it is because of their talent and ability. How scary is that.

Yet this happens with people investing in the stock market all the time – especially people new to investing and trading. After a winning trade or two or three, the investor or trader begins to believe that they have a special “talent” for stocks and shares. They begin to believe that they are naturally better than the average trader.

Before long, the investor or trader’s belief in their own superior ability begins to result in over confidence – trading too many stocks or trading without properly managing the risk. And the next thing that happens is the Market Slap! The stock market has a nasty habit of slapping down over confident traders with a big loss.

The truth here is that every trade involves risk and every trader should be managing risk. This means protecting your capital and not getting carried away with your successes.

Beware the Market Slap!

The results of the Australian February share market predictor are in.

The Australian market moved up in February.  This means that there is a high probability that the market will finish the year higher than it started it.

This means it a great time to learn to trade shares.

To your share trading sucess…

Unfortunately the January Barometer does not appear to hold for Australia – perhaps because of our summer holiday season and other seasonal influences. Over the past 30 years in Australia, the direction of the market in January has a 60% correlation with the direction for the rest of the year.

However, since 1990 the month of February has acted as a reasonable predictor for the remainder of the year in the Australian share market. With an 83% success rate since 1990, the direction of the Australian All Ords. index in February has been a fairly accurate predictor of the direction of the market for the year as a whole. The February Predictor has been 100% accurate where the All Ords. index has moved by more than 3% in either direction during the month of February.

So if you are a longer term trader, or want some probability on your side for the rest of the year, keep a close watch on what the overall market does during February.

Over the coming days, weeks and months we will be keeping you up to date with some of the trades that we are executing and also providing you with educational items.

We hope you enjoy the new website and newsletter.