How To Trade

Let's consider an example that illustrates one common approach of a losing trader.

A stock makes a new high at 55 so he buys it there and places a tight "conservative " protective sell stop at 53, which gets quickly hit for a two-point loss.

He keeps watching, and when it falls even more to 51 he decides to go with the new trend, selling short there and placing a protective buy stop safely above the recent high, at a "reasonable and logical" (and obvious) level of 56.

Sure enough, it does keep going down, to 49, so he doubles his position there and waits for the big trend to unfold.

Surprisingly, it reverses quickly back above his first short entry point at 51 then climbs to 52, 53, 54, 55 and (oh no!) tags 56 where he's stopped out with five-point loss on his original short plus another seven points on his additional short.

Then strangely it pulls back to 55, right where it started.

He scratches his head and wonders how he managed to quickly lose a total of fourteen points on an unchanged stock when he was just trying to follow the trend and be conservative using stops.

Well folks, not only is the above scenario common, it's in fact often created by the market makers. They know where the levels are that will shake people in and out, and they use them to their advantage. They know how people will feel when those price points are hit. This is true whether you're trading stocks or trading commodity futures, although in the latter the action is even more vicious.

So is some type of perverse backwards reasoning necessary to succeed at trading? I believe that depends on your time frame, but over the short term the answer is probably yes.



In our everyday lives, two often-heard pieces of advice are:

"Always look before you leap!"

and,

"He who hesitates is lost!"

Thse two rules seem to contradict each other. When faced with an important decision regarding an opportunity, which rule should you follow? Should you take time to stop and think things over, or quickly jump into action to avoid missing out?

Usually we try to do both. We take as much time as possible to weigh the pros and cons. Then we try to make the right decision before the deadline passes.

Unfortunately life is complicated. We don't have complete knowledge of any situation.

Fortunately trading is much simpler than life. To make money all we have to do is buy low and sell high, or sell high first then buy low later (if we are selling short). What could be simpler than that?

We make trading complicated because we are emotional human beings. Our fear and greed are weaknesses that most of us cannot overcome. As a result, most of us lose money while a small minority ends up getting wealthy.

Of course all the money we lose is not transferred directly to the winners. Much of it gets siphoned off by market makers and brokers. We pay a premium to buy at the ask price and receive less when we sell at the bid price. We get charged commissions and exchange fees too.

To be one of the winners we have to overcome these costs and also be better than the competition at controlling our emotions.

Here's another typical example of what most of us do when we first start out trading: We buy two stocks. One goes up; the other goes down. We sell the one that went up, greedy to lock in a quick profit and afraid if we don't do so it might go back down. We keep holding on to the losing stock. Then we watch as it keeps going down, more than wiping out the small gain we made on the first stock. Finally we sell it and shake our head at our bad luck. To add insult to injury the first one that we sold keeps going up higher, without us.

Well then is making money in the stock market as simple as holding on to your winners and dumping your losers?

Again, I believe it depends on your time frame. Over the long term the answer to this question is probably yes.

Over a period of many years or even decades, "Never Add to a Losing Position" is a rule that works. The idea is to give your stock purchases a reasonable amount of time to start making you money and then sell the ones that don't. Sell sooner if they drop more than a pre-defined amount such as 15%.

Buy more of the ones that show you a profit, with the expectation that over the long term you will thus build a portfolio of successful companies that keep growing their business and increasing their stock price. You don't have to predict the future. You just have to manage your portfolio by pruning losers quickly and adding to winners with confidence.

Keep holding on tight to them unless conditions affecting their particular business take a major turn for the worse, or if the stock price drops more than 15% below the most recent high. Ignore temporary "shakeouts" or dips in the stock price. Ride them out with confidence that a successful, profitable, growing business will eventually translate into a higher stock price.

Don't "average-down" during corrections because that could suck you into a short-term downtrend, causing you more pain than you can stomach so you end up selling out just as the price is about to resume its long-term uptrend. Wait for the corrections to end, then buy more, but only after the stock breaks out to a new high. In this way you're always moving ahead from a winning position.



I could end this article right here if we all were "Investors" (long-term).

But let's be honest.

We know most of us are "Traders" (short-term).

We want to leverage things up and parlay a small amount of money that isn't enough to enjoy the kind of lifestyle we want, into a large amount that is. And we want to do it as quickly as possible.

Sure, we agree the approach described above is the correct way to invest long-term. But we don't have that much time, and we don't have enough money to start with for that approach to work for us even if we did wait a decade (or two!).

So we have no intention of Investing. We're going to Trade!

OK, but let's do it right.

The annual income in your short-term trading business depends on your turnover. You need a lot of trades because you don't have time to wait for a big historic trend to unfold.

The difference between winning and losing at trading boils down to always forcing the odds to be in your favor versus allowing them to be against you.

To win we must sometimes violate conventional wisdom, or at least appear to. Sometimes what works for long-term investing is partially the opposite of what works for short-term trading. Which brings us to the real subject of this article.

For short-term trading, I recommend that you "Always Add to a Losing Position" and furthermore I believe you cannot succeed without doing so, because you will not have the odds in your favor enough to overcome middleman trading costs.

We cannot know in advance, no matter how much technical analysis or fundamental research we do, the direction a stock is going to move after we've placed the trade and put our money at risk.

The key is to use this fact to our advantage.

When buying a stock for short-term trading purposes, buy only one-half or one-third of your desired position at first. Then add the rest only if it goes down.

What? Add to a losing position? No way.

Yes way. And if your initial position goes up, sell it all! Crazy? Let's think about it.

You're running a business here, not torturing yourself trying to predict the future. When other traders are willing to give up some more of their stock to you at a cheaper price, buy it. When they are willing to pay more, sell it to them. Don't get emotionally involved.

That's how market makers think. The only difference is they're also involved in actively manipulating prices. You can't do that. But that's another story.

This approach will require you to be a lot more careful about your decisions, because if you're not sure about your initial position you're not going to have the guts to add to it when it goes against you right away.

Always enter your positions only in the direction of the prevailing intermediate trend, and only after a retracement in that trend. Don't be sloppy and just jump into a trade in the direction of the current trend because yesterday you got some money freed up to trade and today you're anxious to put it to work.

Buy only popular stocks that are on the way up. When a formerly popular stock that has been badly damaged and has recently been responsible for lots of people losing lots of money suddenly starts to rally, don't buy it, thinking it's a good value now compared to recent prices. It's not. There are always plenty of fresh young healthy popular new stocks out there that are safer to buy because there are few people wanting to sell while they're winning.

Short only beaten-up stocks that are on the way down. When a fresh young healthy popular new stock begins a well-deserved correction after soaring to yet another ridiculously overpriced high, don't try to jump in short expecting it to come back down to a reasonable valuation. It won't. There are always plenty of beaten-up stocks that are safer to short because there's a huge crowd of people waiting to get out on any rally.

Always wait for a retracement. This means a decline in an uptrend or a rally in a downtrend. Wait until after that happens. Only by waiting for retracements will you get decent chances to make successful short-term trades. The ones you miss out on because there is no retracement don't matter, because you have nothing at risk in them.

If you are a long-term investor you can be sloppier with your entry points, maybe even dollar-cost averaging once a month. But we've already established that's not what we're up to. We don't have time for that. We want to make some money this week!

So now let's re-trade our first example correctly.

First of all, as a trader, you never buy a stock when it makes a new high, period. You always wait for a retracement. Never forget that.

So you wouldn't buy the stock in that example at 55. Ideally you'd like to buy it at what turns out to be the low at 49, but in the real world that's neither possible to know in advance nor necessary, so forget about it. It's reasonable to buy half your position after the retracement to 53 and add the other half at 51. You don't know how far the retracement will go but you add gradually to your losing position.

Now note right here that if you're not confident enough to buy more at 51 then you won't be increasing your odds. And if you bought your full position at 53 you didn't increase your odds.

Similarly, when the stock falls to 49 if you get scared and sell out you'll be a loser.

So under what circumstances should you sell? Here's where this short-term trading approach is not the opposite of the long-term investing approach, it's partially the same. If the stock falls a pre-defined amount below your average buy price, say 10%, you take the loss. This becomes less likely if you increase your odds by waiting for a retracement plus increase them more by averaging into the position.

So when it goes to 49 you do nothing. Maybe go golfing. Take a nap. Order a pizza. Go to a movie. Your stop is in at 10% below your average entry price of 52, which is 46.80. You needn't worry about fluctuations.

When the stock goes back up to 52 you don't breathe a sigh of relief and sell out even. Be confident, the odds are on your side. You're running a business here, not a charity. You're going to unload your inventory at a profit.

When it gets back to its previous high at 55, you don't get emotionally involved and greedily hold on, hoping to make a big killing on an exciting new uptrend. You quickly dump it all. They wanted to buy it, you sold it.

You traded with your head and not your heart. You neither called the exact bottom at 49 nor the exact top at 56 but you didn't need to. You pocketed three points out of the middle and you did it while keeping the odds in your favor.

A losing trader suffers loss after emotionally agonizing loss, even more so when he tries to be careful -- using tight stops, never adding to a losing position, etc. which perversely actually decreases his odds because of the way he's going about it. Without increasing his odds he has little chance of overcoming slippage and commission costs, let alone making a profit, unless he's a genius - in which case he has virtually no chance! The market is made up of emotional irrational people acting foolishly, often playing with other people's money, or trading on insider information, or actively manipulating prices. The more intelligent a person is, the more likely he will be confounded by such illogical price activity.

A winning short-term trader consistently pockets small profits on a regular basis simply by trading in sync with short-term moves. He occasionally takes a large loss, but that's not his fault. He doesn't feel bad about it. He can't help it if some of the inventory he buys goes bad or if his fickle customers sometimes change their minds about what they want. That's a cost of doing business. He just buys new inventory of the latest popular stocks (or shorts beaten-up former popular stocks) with correct entry points, averages in, and carries on with his business, closing them at a profit whenever customers meet his price.

Note that this profit/loss distribution is the opposite of that obtained by a winning long-term investor, who consistently pyramids a few large profits and prunes a lot of small losses along the way. In both cases there are lots of losers on the other side contributing their money to the few winners. Losing short-term traders consistently take small losses by trading scared and out of sync with short-term moves, and only rarely score a large gain. Losing long-term investors consistently take small profits but hold big losers permanently all the way down.

To summarize, you can actually increase your odds in short-term trading by always adding to a losing position when the opportunity arises. Always start by taking a partial position only in the direction of the prevailing trend and only after a retracement (in our example we waited for a retracement from the new high of 55 down to 53). Always add the rest only on one or two moves against you (we added once at 51 in the example). Always finish by unloading all your position when the current trend continues back to where the retracement started (55 in the example). Use a wide stop.

Usually your average price will be better than your initial partial position price because you will add one or two times. If you get lucky and call the exact end of the retracement when you take your initial position, you will be closing only a partial position because you never got a chance to add, but that's OK too -- just another profitable day at the office.