Thursday, April 08, 2010

Insight Into Stock Trading

A LOT of retail investors like to trade in stocks. As a result of high losses incurred over the years, especially on stocks that have been delisted, they do not believe in holding stocks for the long term.

They believe stocks are suitable for trading and not for long-term investment.

Stock trading is not as simple as trading based on tips and market rumours. Most retail investors actually rely on tips from their remisiers to help them make quick gains from the stock market.

Investors need to understand that trading involves high discipline, commitment of time and skills. Based on interviews with some top traders, Jack D. Schwager concluded that all successful traders are serious about their trading and are willing to spend a lot of time on market analysis and trading strategies.

The secret to their success is usually a methodology that worked for them, together with having very rigid loss-control.

They always act independently of the crowd and have the patience to wait for the right timing for trading. In addition, all the successful traders understand that losing money from trading is part of the game.

A lot of traders always say that trading in stocks has a lower risk than buying stocks for the long term. Many retail investors like to buy stocks for trading because they do not have the patience to hold stocks for the long term.

But whenever they incur losses, they tend to change their original objective of stock trading to long-term investment, not knowing that the majority of those stocks for trading are not suitable for long-term investment.

While some of them may be aware of this important fact, due to their unwillingness to admit their mistakes by cutting losses, they choose to continue to hold on to the stocks. As a result, they get stuck with a lot of poor fundamental stocks in their portfolio for the long term. Most of the time, they will hold those stocks until they get delisted!

Investors need to understand that stock trading involves constant locking in of gains and cutting of losses. They must always set target profits (profits per trade or PPT) and maximum loss (loss per trade or LPT) for every trade. They need to set the target number of trades that are supposed to bring gains, which is also known as trading success ratio (success ratio or SR).

They then need to set the target number of trades that they are willing to be involved in per month (trades per month or TPM).

Hence, profits that can be made by a trader will very much depend on his SR as well as TPM. Most of the time, the target PPT and maximum LPT are relatively constant and are dependent on individual risk tolerance level and skills.

For example, an investor has set his PPT at RM500, LPT at RM300 and SR at 60%. If he sets 10 TPM, based on SR of 60%, of the 10 trades that he has made, six trades will make gains of RM500 each and four trades will incur losses of RM300 each. The net gain for 10 trades will be RM1,800 ((6xRM500) – (4xRM300)). If the trader intends to increase his profits, he needs to do more trades per month; in other words, increase the TPM.

Given that the movement of stock prices is random, the probability of stock prices moving up or down is 50%. We think it is a great achievement if a trader can achieve an SR of 55% to 60%. Most retail investors hope for 90% because they are not willing to cut losses.

As a result, they will wait for the stock price to break even whenever it drops below their purchase prices. However, the longer they wait, the more losses they will incur. Most of the time, of the 10 trades done, they may achieve SR of 90% where nine trades may give them gains but the one trade that incurs loss may wipe out all their nine gains!

We agree that the above methodology is easier said than done. A lot of times, investors may have the discipline to lock in their gains, but do not have the discipline to cut losses.

Besides, investors need to allocate a certain amount for their trading capital, which is the amount that investors are willing to lose in stock trading. It should not cause financial problems to investors if they lose all the trading capital.

Lastly, investors should not average down their losing position. If they have incurred losses in the past three to four trades, it means they may have lost touch with the market timing and sentiment. In this case, it may be good for them to take a break from trading and analyse the reasons behind those losses before continuing.

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