I will share with you one of my best trading tactics when doing some discretionary morning trades for myself during earnings season. About 2 hours before the market opened I would pour over firms with large earnings surprises – positive or negative – in addition to other numbers in the quarterly report. Next, I would monitor the pre-trading and plan to initiate short and long positions in the respective shares provided the gap wasn’t already extended too far giving me little potential gain. When the market opened I would look to jump in 5 or 6 stocks at once while monitoring them like a hawk. Some of the stocks reversed and I would exit. Others would trade flat and I would let these stocks loose also. I would only keep the one or maybe two profitable stocks and hold them until they started to show weakness over the next 30 to 60 minutes. Lesson learned? You don’t need to be right most of the time to be profitable.
Below is a chart outlining the relationship between the magnitude of your winning trades vs. your losing trades and the percentage you need to be right to breakeven in the market. The Y axis is the size of your wins vs. your losses.
- If you make $10,000 on a winning trade and lose $5,000 on a losing trade (on average), than you have a win/loss ratio of 2. If you make $5,000 on a winner and average $1,000 on a loser, your ratio is 5.
- On the X axis you have the percentage of times your trades are winners. If you are correct in your trades 33% of the time (your winning vs. losing trade is defined in bulleted point above), then you only need a 2/1 win ratio to break even.
- The blue line is the equilibrium break-even point.
What this chart really tells you is that you need a mix of stock picking and timing skills to be successful. If you are an amazing stock picker and are correct in your stock selection most of the time (x axis), your wins do not need to be phenomenal to come out on top. However, this is challenging in bad markets when most stocks drop in correlation. On the other hand, if you are trading high-risk and volatile stocks, you do not necessarily need to be right too often provided you make really big on the winners and quickly cut your losers.
This one chart can represent what is needed to be profitable whether you are a short-term trader using CFDs or a long-term investor in dividend stocks.
Steps for Making Money in This Market
We will take a top down approach to the market going from big to small as to how to come out a winner.
Market Analysis – the market has force and you do well to acknowledge it. Look for macro trends. Is the ASX 200 above or below the 200 day moving average? Can you draw a trendline on the price action? If not, the market may not be trending and in a trading range. Trading ranges are volatile times where the market is undecided and you need to be extremely careful. In general:
- Down trends: stay out of your more volatile stocks and stick closer to cash, deep value dividend stocks, and bonds. You can stay long provided you have a hedge in place. As an example you could have 50% in dividend stocks, 25% in bonds and 25% in an inverse ETF fund.
- Up trends: this is where you start selling off your hedge and selling bonds in favor of equity. In general, the steeper the previous bear trend the more aggressive long you should be. If the market took a small dip and is rising again, you will not be as aggressive as if the market just finished dropping 50% and is on the way back up.
- Sideways markets: you can identify this when index prices bounce between a support and a resistance without really making any headway. Try to take small positions near the support with a hedge. You may want to sell some of your positions near the resistance. You can play this like a game of ping-pong. Just be careful since at some point it will breakout either up or down.
Fundamental Analysis – next I examine sectors, industries and specific stocks that I feel will outperform. In one instance I might be looking for a small stock with upgraded earnings forecasts and another time a stock with growing dividends over many years. Have a basket of your best stocks to examine when deciding to trade or invest. In a bear market I stick more closely to deep value dividend stocks with a long history of raising dividends. Thus, if the market takes the stock down hard, your income yield should be very high and in time it will help the share price come back to the surface. I also like to stay away from volatile sectors and stocks during unsure times. Utilities, healthcare and other defensive plays can make up a portion of your portfolio.
Picking an Entry – you should have a reason to enter the trade. Did the entire market breakout in a bull trend? Did the stock just have good news released? Is it bouncing off a strong support? Have a reason to enter the trade but be careful you are not buying after a strong run-up when it looks like a ‘sure bet’. All too often it consolidates at this point when the set-up seems too obvious. How do you buy during an active bear market? If you have the stomach for it, start to buy when the market falls 20% or more and continue buying every additional 10% it falls. If you burn up your ammo you can start moving your bond allocations into equity. Remember that the further the market falls, the more exposure to equities you want to have. This seems counter-intuitive but if you want to buy low and sell high you need to make a plan for when you start to buy falling equities. Also, buy systematically on a schedule to take some emotion out of it. If you have a hedge during a bear market, it makes it a lot easier to buy at the same time.
Cut Losses – what is your strategy should the trade fail? Look for areas that you will absolutely cut the stock free at. Some areas to consider are if it falls below a major support line or a trendline. This can also be based on the maximum amount you are willing to lose on this one trade. Whatever the case, make sure that your sell point is firmly in mind and you will definitely pull the trigger when the time comes. Some use an arbitrary number like 5 – 7%, but I prefer to look at this on a stock by stock basis. The above rules work well in sideways or bull markets but in a bear market you need to switch gears and start aggressively buying at some point in time. If the market is down 30% and you are buying high quality stocks with increasing deep value, don’t get shaken out just because all the other investors with weak constitutions are dumping in panic. If you feel confident based on your fundamental analysis and all stocks are falling, and have already fallen hard – pick up more shares. But be quick to cut losses when fundamentals start to slide or if dividends are cut.
Profit Targets – have a system for taking profits. Just picking an amount out of a hat like 10% is not a great system in most cases. Again, you can stay invested with a stock provided it stays above a trendline or major support. You can also use momentum indicators and bail when the price advance slows. Or you may prefer to use PSAR or a trailing stop loss lets you stay invested for as long as the stock is rising. Lastly, you may set a target based on previous price moves or when volatility spikes. Have a system that allows you to squeeze the most out of your winning trades. Start slowly putting money back into your bond portfolio to build up ammo for the next big fall.
Making Money in the Market
Making profits in the market is not easy and requires that we control behavioral problems. There are a variety of valid methods to make money in the market that range from low probability/ high reward trading to high probability / low reward investing. The style of investing and trading used will depend largely on you and your ability to stomach risk. You will need to adapt your techniques for a bull and a bear market. Bull markets allow you to ride big profits and cut loses tight. Bear markets might mean big hedges and picking deep value dividend or defensive stocks.
Don’t passively buy and hold a fund thinking that this is your only choice…make your own path. Limit your exposure in down markets (or hedge) and be careful of the whipsaw action in sideways markets. Choose from among your best stocks and have a reason – both macro and firm-specific – as to why you are buying it today. Then manage your trades actively by cutting free the losers and letting your winning trades stay in your portfolio for as long as possible. If you treat your investments like running a business you stand a better chance of actually making a profit at the end of the day.