Anyone who wants to become a profitable stock trader need only spend a few minutes online to find such phrases as "plan your trade; trade your plan" and "keep your losses to a minimum." For new traders, these tidbits can seem more like a distraction than actionable advice. If you're new to trading, you probably just want to know how to hurry up and make money.
Each of the rules below is important, but when they work together the effects are strong. Keeping them in mind can greatly increase your odds of succeeding in the markets.
- Treat trading like a business, not a hobby or a job.
- Learn everything about the business.
- Set realistic expectations for your business.
Rule 1: Always Use a Trading Plan
A trading plan is a written set of rules that specifies a trader's entry, exit, and money management criteria for every purchase.
With today's technology, it is easy to test a trading idea before risking real money. Known as backtesting, this practice allows you to apply your trading idea using historical data and determine if it is viable. Once a plan has been developed and backtesting shows good results, the plan can be used in real trading.
Sometimes your trading plan won't work. Bail out of it and start over.
The key here is to stick to the plan. Taking trades outside of the trading plan, even if they turn out to be winners, is considered poor strategy.
Jack Schwager: Investopedia Profile
Rule 2: Treat Trading Like a Business
To be successful, you must approach trading as a full- or part-time business, not as a hobby or a job.
If it's approached as a hobby, there is no real commitment to learning. If it's a job, it can be frustrating because there is no regular paycheck.
Trading is a business and incurs expenses, losses, taxes, uncertainty, stress, and risk. As a trader, you are essentially a small business owner and you must research and strategize to maximize your business's potential.
Rule 3: Use Technology to Your Advantage
Trading is a competitive business. It's safe to assume that the person sitting on the other side of a trade is taking full advantage of all the available technology.
Charting platforms give traders an infinite variety of ways to view and analyze the markets. Backtesting an idea using historical data prevents costly missteps. Getting market updates via smartphone allows us to monitor trades anywhere. Technology that we take for granted, like a high-speed internet connection, can greatly increase trading performance.
Using technology to your advantage, and keeping current with new products, can be fun and rewarding in trading.
Rule 4: Protect Your Trading Capital
Saving enough money to fund a trading account takes a great deal of time and effort. It can be even more difficult if you have to do it twice.
It is important to note that protecting your trading capital is not synonymous with never experiencing a losing trade. All traders have losing trades. Protecting capital entails not taking unnecessary risks and doing everything you can to preserve your trading business.
Rule 5: Become a Student of the Markets
Think of it as continuing education. Traders need to remain focused on learning more each day. It is important to remember that understanding the markets, and all of their intricacies, is an ongoing, lifelong process.
Hard research allows traders to understand the facts, like what the different economic reports mean. Focus and observation allow traders to sharpen their instincts and learn the nuances.
World politics, news events, economic trends—even the weather—all have an impact on the markets. The market environment is dynamic. The more traders understand the past and current markets, the better prepared they are to face the future.
Rule 6: Risk Only What You Can Afford to Lose
Before you start using real cash, make sure that all of the money in that trading account is truly expendable. If it's not, the trader should keep saving until it is.
Money in a trading account should not be allocated for the kids' college tuition or paying the mortgage. Traders must never allow themselves to think they are simply borrowing money from these other important obligations.
Losing money is traumatic enough. It is even more so if it is capital that should have never been risked in the first place.
Rule 7: Develop a Methodology Based on Facts
Taking the time to develop a sound trading methodology is worth the effort. It may be tempting to believe in the "so easy, it's like printing money" trading scams that are prevalent on the internet. But facts, not emotions or hope, should be the inspiration behind developing a trading plan.
Traders who are not in a hurry to learn typically have an easier time sifting through all of the information available on the internet. Consider this: if you were to start a new career, more than likely you would need to study at a college or university for at least a year or two before you were qualified to even apply for a position in the new field. Learning how to trade demands at least the same amount of time and fact-driven research and study.
Rule 8: Always Use a Stop Loss
A stop loss is a predetermined amount of risk that a trader is willing to accept with each trade. The stop loss can be a dollar amount or percentage, but either way, it limits the trader's exposure during a trade. Using a stop loss can take some of the stress out of trading since we know that we will only lose X amount on any given trade.
Not having a stop loss is bad practice, even if it leads to a winning trade. Exiting with a stop loss, and therefore having a losing trade, is still good trading if it falls within the trading plan's rules.
The ideal is to exit all trades with a profit, but that is not realistic. Using a protective stop loss helps ensure that losses and risks are limited, and that you have preserved enough capital to trade another day.
Rule 9: Know When to Stop Trading
There are two reasons to stop trading: an ineffective trading plan, and an ineffective trader.
An ineffective trading plan shows much greater losses than were anticipated in historical testing. That happens. Markets may have changed, or volatility may have lessened. For whatever reason, the trading plan simply is not performing as expected.
Stay unemotional and businesslike. It's time to reevaluate the trading plan and make a few changes or to start over with a new trading plan.
An unsuccessful trading plan is a problem that needs to be solved. It is not necessarily the end of the trading business.
An ineffective trader is one who makes a trading plan but is unable to follow it. External stress, poor habits, and lack of physical activity can all contribute to this problem. A trader who is not in peak condition for trading should consider taking a break. After any difficulties and challenges have been dealt with, the trader can return to business.
Rule 10: Keep Trading in Perspective
Stay focused on the big picture when trading. A losing trade should not surprise us; It's a part of trading. A winning trade is just one step along the path to a profitable business. It is the cumulative profits that make a difference.
Once a trader accepts wins and losses as part of the business, emotions will have less of an effect on trading performance. That is not to say that we cannot be excited about a particularly fruitful trade, but we must keep in mind that a losing trade is never far off.
Setting realistic goals is an essential part of keeping trading in perspective. Your business should earn a reasonable return in a reasonable amount of time. If you expect to be a multi-millionaire by next Tuesday, you're setting yourself up for failure.
What do I do if my trade is in the money, i.e., profitable?
In bull markets, it can be easy to make money in the market. Knowing when to take profits takes practice. One way to take the emotion out of closing a profitable position is to use trailing stops.
How much should I risk on any given trade?
First off, the answer to that question should already be part of your trading plan in the form of a stop loss. As a stop loss, you can use a financial stop, e.g., $500 or go with a technical stop price, such as if the 50 day moving average is broken, or new highs are made. The key is to remember that you always need a stop loss as part of your trading plan.
What are the key elements to a trading plan?
The starting point is the impetus for the trade. If it's from a fundamental development, such as an economic data report or a comment by a Fed official, your trade is based on those fundamental factors, and your trading plan should reflect that. If your trading plan relies on technical analysis, such as remaining above the 50 day moving average, again your strategy should rely on that. The key is to adjust your position size so that you give yourself enough room to stay within the stop loss and not risk everything on a single position.
How much money should I commit to a single trade?
Position size is the primary determinant of the outcome of any trading strategy. You want to be sure your stop loss can tolerate a minor loss relative to your trading capital. If your stop is $1.50 away from the current market, for instance, you'll want a position size relative to your stop loss that does not consume too much of your trading capital.
For example, say you're only willing to risk $500 on the trade and your stop is $1.50 away (let's say based on a technical price level) from the $20 current market price. That dictates a position size of approximately 333 shares (20-$18.5=1.50/$500= 333.33 shares) to fit your trade strategy, which would require $6,600 in tradeable capital (333 shares x $20 current market level).
Note that a smaller position will use up less of your trading capital, while still allowing you to pursue a specific strategy.
The Bottom Line
The vast majority of the rules outlined above have one thing in common: attention to risk, or losing money. That's because you're in the business of making money in the markets. Losses will inevitably occur. The trick is to keep the losses small enough so that you can keep trading until you find more winning trades.
Experienced traders know when it's time to take a loss and they have incorporated that into their trading strategy. Experienced traders also know when it's time to take profit, so they may move their stop loss in the direction of the trade to lock in some profit or simply take profit at the current market price. Either way, rest assured there will always be another trade set-up coming down the road.