10 Steps to Profitable Trading

The secret to winning big in the market is not to be right all the time but to lose the least amount of money possible when you are wrong. As long as you win larger than you lose, you will be a profitable trader at the end of each year. Pride, ego and stubbornness prevents a trader from reaching the levels that very few can master.

To become a profitable trader, you must:

  • 1. Manage Risk: Learn to trade a manageable portion of you portfolio (I recommend to risk less than 2% of you overall portfolio equity on each trade). Always establish a risk/reward ratio before making a trade. Without the ratio, how do you know your risk?
  • 2. Understand Position Sizing: All traders must learn to know “how much” to trade on each position. Do not overtrade or you will runt he risk of ruin. Position sizing is rule number one of managing risk.
  • 3. Cut Losses: Do not allow losses to run wild. You must learn to cut losses and understand that losses are a part of the game, a large part of the game. Check you ego of winning at the door. We are here to make money, not go undefeated. Play sports if you want to keep score with a record rather than your bankroll.
  • 4. Learn when to Sell: You must learn when to sell. Selling is more important than buying as it ties directly to risk management. Use stops if you haven’t yet developed the discipline to get out at your predetermined stop or profit goal.
  • 5. Average up in Price: I will never hesitate to add shares in a stock that is moving higher (see Mastercard) but I always avoid averaging down. Remember, cut losses and never throw good money after bad because we know that’s a quick way to the poorhouse.
  • 6. Have Patience: It takes years to master trading as an advanced skill; even then, you are never done learning or adapting.
  • 7. Buy 52-week Highs, not 52-Week Lows: Don’t be afraid to buy stocks making new highs. The garbage sits at the bottom of the market along with poor earnings, weakness and further downward pressure. Buy strength and the momentum moving higher. Stocks are typically priced at the levels they trade for good reason. This applies to most premium items in life.
  • 8. Ignore the Talking Heads: Do not listen to the stories, gossip and rumors flying around on network television, stock forums or the major financial newspapers. It a surefire route to bad information and clueless advice. Do your own research; you’ll come out much further ahead. This applies to crappy blogs and internet sites as well.
  • 9. Understand Technical Analysis: Fundamental analysis is a solid part of my trading system but technical analysis brings in the dough. You must learn, understand and use technical analysis on a daily basis. Fundamental analysis tells me what and technical analysis tells me when, where and how.
  • 10. Control Emotions: Enough said – You must control your emotions or the game is over! Understand you!

How to Trend Trade Shorts

To short means that you borrow stock from your broker to sell to a third party. The idea is to buy back the stock at a lower price, returning the shares to your broker while leaving the remaining cash in your account as a profit. A short seller does not own the stock before they sell it as they borrow it from another investor who already owns it. At a later date, the short seller buys back the stock they shorted and returns the stock to close out the loan. If the stock has fallen in price since they sold short, they can buy the stock back for less than they received for selling it. The difference is your profit. Please note that short selling is a transaction made on margin.

Characteristics of Trend-trading Shorts

Most ideal longer term trend shorts take four to twelve months after the peak price to setup on the weekly chart with the majority of these shorts triggering between six to nine months.

  • Look for stocks that had prior up-trends and support levels that can now act as downward resistance or entry areas.
  • Once a stock tops and starts to consolidate, you want it to slice through the 50-d moving average and then the 200-d moving average.
  • A crossover between the 50-d m.a. and the 200-d m.a. is ideal and is graphically presented on the KNOT chart
  • The odds of success increase with each failed attempt for the stock price to recover these major long term moving averages.
  • Head and shoulder tops can also serve as ideal setups for potential shorts if they take at least five months to develop.
  • A decreasing relative strength line and a negative pattern on the point and figure chart can also confirm that the stock is rolling over and setting up an ideal short.
  • Finally, volume should be increasing and the stock should be under distribution as it violates the major moving averages and starts to break former support levels.

CROX Example:

To initiate a short sale, you must place the order with your broker or online brokerage by determining the size and price at which the trade will occur. Your broker or brokerage company will check to see if shares are available in the specific stock selected or if they can borrow the shares. Once they are available or can be borrowed, they will be sold in the open market on the first plus tick or continuation of an up-tick also known as zero-plus tick (the stock must move up for the transaction to complete). To close the short position, the broker will purchase the shares using the original proceeds and return the shares to the third party.

As a short seller, you believe that the price of a particular stock will fall in value over time. For example: by establishing a short position for 100 shares in XYZ at $50, the broker will place $5,000 into your margin account. If the stock falls over the next few weeks and you decide to cover the short at $40, you will initiate a buy for 100 shares in XYZ using the money placed in your account when you sold short. The cost to buy back the shares in this example will be $4,000 or $1,000 less than the original short sale amount. This difference in price will result in $1000 cash that will now become your profit.

On the flip side, if the stock was to jump to $60, you would most likely cover your short or have your stop loss triggered, buying back the shares at this price. The cost would be $6000 or $1000 more than the original short sale, resulting in a 20% loss. The broker would take the additional $1000 from your cash account to cover the loss in the short sale. This is how you can lose money when shorting stocks. The higher the stocks rises, the more money you can lose, theoretically resulting with an infinite loss (excluding stop losses and broker margin calls).

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Sell in May?

It’s that time of year again, “Sell in May and Go Away”, so I will upload up my annual post of statistics using the help of the Stock Trader’s Almanac written by Jeffery A. Hirsch and Yale Hirsch.

For the record, I don’t sell just because the calendar says May but I do enjoy sharring the statistical data (it is very interesting):

Worst six months of the year begin in May:
* All data is from the DJIA from 1950 to 2005

  • A $10,000 investment in the DJIA compounded to $544,323 for the period beginning in November through April over the past 56 years (termed the best six months)
  • Compare this to a $272 loss; yes I said loss for the same investment in May through October (termed the worst six months)
  • 44 of the 56 periods ended with a gain in the November through April period
  • Only 33 periods ended with a gain versus 23 losing periods in May through October
  • The average gain for the November through April period is 7.9% (56 yrs)
  • The average gain for May through October is 0.3% but the period did have an overall loss of $272 as mentioned above
  • The best six months gained 11,691.79 Dow points over the 56 yrs (data ends in 2005)
  • The worst six months actually lost 538.98 Dow points
  • Top performing period for best six months was a gain of 29.8% in 1985 and then 25.6% in 1998
  • Top performing period for worst six months was a gain of 19.2% in 1958 and then 16.9% in 1982
  • The poorest performing period for the best six months was a loss of 14.0% in 1969 and then 12.5% in 1973
  • The poorest performing period for the worst six months was a loss of 25.2% in 2002 and then 22.4% in 1974
  • The best six months has only had one losing period in the past 22 years and that was only 2.2%
  • The worst six months has had eight losing periods over the past 22 years with several in double digits
  • Seven of the past eight years have been losers for the worst six months
  • All of these results are based without timing the market using technical analysis
  • Using a simple MACD indicator to time the entries and exits, the gain during the best six months rises up to $1,548,121 while the loss during the worst six months increases to $6,646.
  • Finally, five of the last nine May months have been down for the markets; starting the period of the “worst six months”

One side note: the Stock Trader’s Almanac notes that the Nasdaq actually has a best eight month period from November to June.

For further detail, grab a copy of the Almanac as I buy one every year for the excellent statitical information and the great quotes.

For all CP sell articles, visit my category on selling or short selling!

Smelling Trouble

Well, DRYS is now down 16.81% this week and volume is peaking at the largest level we have seen in years – huge distribution!

This is what I had to say a few weeks ago in my post titled DryShips (DRYS) Drying up?

All in all – I am not a buyer of the stock at this level. It may be a solid short term buy for traders that make these types of plays such as Blain and Rajin but it does not fit into my criteria for a trend trading opportunity.

I see a decent consolidation over the past few months but I have a problem with the current pattern that is forming if it does not test former highs near $130. Volume is increasing as it moves higher but the stock is starting to struggle near the last peak of $88.

I stick to my original analysis as I am watching the stock from afar or the weekly chart. I am not day trading DRYS or any stocks for that matter so I can cut through the noise and view the market on a weekly basis to assess the “true overall trend”. Don’t get me wrong, many traders made money on the recent spike in DRYS but I wasn’t touching it with a 10-foot pole. I look for the big runs and couldn’t be bothered with a few points here and there (and I am not about to support my broker with constant buy and sell commissions, even if they are minimal).

The easiest way to characterize this trade and the market in general is to view it all as a risk/ reward potential or an expected value, as I wrote yesterday. DRYS was not a +EV trade in my trading system but, it very well may have been an excellent +EV trade for a shorter term day trader such as Rajin or Blain.

Anyway, here are a few more charts that are starting to look suspicious (some more than others). The bottom line or point of today’s rant is the fact that I still feel that the market is headed for a decline or as I phrased it a couple weeks ago:
The Big Decline (long term perspective of course).

These charts are just examples as many more exist but they were some of the first I viewed Thursday night:

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Market Distribution

“Higher oil, rate-hike fears and new regulations in the financial sector handed stocks their biggest beating in nearly a month…”

– Stocks Get Hit In Heavier Volume, By Vincent Mayo of Investor’s Business Daily.

There is some truth to the statement above but the charts have clearly been raising red flags that this market may be heading lower. I highlighted this trend over the past week or so I as I started to see the same faulty charts appearing on my screens. Visit these posts to see what I have been saying over the past week:

The NASDAQ, DJIA and S&P 500 fell about 1.8%, 1.6% and 1.8% respectively as crude oil was up $1.69 to close above $123 a barrel (a new record).

I originally started to point out market troubles back on March 14, 2008 in a post titled Snapshot Friday; I highlighted both the Dow Jones and NASDAQ with clear yellow shaded areas showing the 200-day moving averages pointing down for the first time since 2003 (that’s huge if you ask me).

Yes the market is now higher than it was in March but the recent bounce is smacking up against the 200-d m.a. for the first time since 2003 for both indices. The last time the market crossed below a down-trending 200-d moving average and couldn’t recover was back in 2000 and 2001.

So what does that mean? As I said yesterday, I think it means a possible Big Decline.

The Dow Jones is now back below the 200-d m.a. and is failing to challenge recent highs. The day’s action came on above average volume which makes today pure distribution.

I hate to pick tops but we may be coming off the official top of the bull market that lasted from 2003 to 2007.

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