8 Important Trading Rules
In This Week’s Issue:
- Stockscores’ Market Minutes Video – Should You Diversify?
- Stockscores Trader Training – 8 Important Trading Rules
- Stock Features of the Week – Abnormal Breaks
Stockscores Market Minutes – Should We Diversify?
The common approach to managing risk in a portfolio is to diversify. This week, I discuss why diversification is for those who plan to make bad decisions I then provide an alternative for risk management and my weekly market analysis.
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Commentary of the Week – 8 Important Trading Rules
Don’t Chase Parabolic Trends
A parabolic trend occurs when price runs away from a trend line drawn across the lows in an upward trend. This steepening of the trend occurs because investors are emotional and chasing the stock’s price higher. It is a sign of irrational behavior.
I have never seen a parabolic trend that did not correct downward eventually. Buying when price has run up and away from the trend line is risky. It is better to wait for the pull back to the trend line. However, it is most tempting to buy when price is running quickly higher because the price action arouses our fear of missing out. Don’t do it.
Trust Data More Than Your Brain
It is very common for traders to make decisions based on what has happened to them recently. For example, if you are trading a strategy and go through a period when the strategy loses, it is easy to think that there is something wrong with the strategy. Since the perception is that something is wrong, you begin to change the strategy rules.
Let’s assume that the strategy was developed after testing over a large number of trades. If the testing of the strategy found that it was profitable over 1000 trades, why would you not trust the rules simply because it lost on the last 5 or 10 trades?
Put another way, we know that if we toss a coin 1000 times, we should get 500 head and 500 tails. However, that does not mean that we can’t toss a coin 10 times and get 8 heads out of 10.
The truth is told in large data sets. Our brains make interpretations based on small data sets that are most recent in our memory. Trust data, not your brain.
Trade Within Your Risk Tolerance
A trader’s greatest enemy is him or herself. Our emotions are what cause us to fail in the stock market.
The biggest reason our emotions play a role in our decision making is our emotional attachment to money. More succinctly, it is our desire to feel pleasure and avoid pain. That means we are emotional in our quest for profits and our avoidance of losses. We chase after marginal opportunities because of our fear of missing out and we don’t sell our losers because it brings us pain.
You can work toward overcoming these emotional problems by trading within your tolerance for risk. If it bothers you to lose $1000 on a trade then take a smaller position. Your position sizes, and their risk exposure, should be at the point that you sleep without thinking about how much you might lose if the trade does not work.
For some people, particularly new traders, that risk amount is $0. When you are learning how to trade, use my simulator at Tradescores.com so you can practice with no financial risk. This will allow you to gather experience and build confidence before you risk real money.
Don’t Argue with the Market
The market will often do things that don’t make sense. This happens because you don’t have all the information to explain what the market is doing. The market is made up of millions of people with trillions of dollars at work. Decisions are being made every micro second based on new information that investors receive.
The stock market isn’t fair because some people get information before others. They then act on that information, creating the market action that does not make sense to those who don’t have the information.
Not understanding why the market is doing something doesn’t mean the market is wrong. The market is always right, it is just our interpretation that can be wrong.
Plan to Lose
I have never met a trader who is right all of the time. You can make a lot of money in the market by being wrong more than you are right. The key is how you balance the size of your winners with the size of your losers.
This is an often used cliché in trading but so important. Stop your losses and let you profits run.
Add to Your Winners (Never to Your Losers)
I like to add to my winners. A stock trade that is working shows me that my analysis was correct. In this case, I will add to my position each time I see a new entry signal as the stock moves higher.
A trade that is not working shows me that my analysis was wrong. Why add to a position when, thus far, I am wrong?
Although this seems like obvious logic, far more people average down on losing positions than add to winning positions. We would rather sell our winners because if feels good. We try to buy more of a loser with the hope that they will eventually turn around and we can escape the pain.
Unfortunately, adding to losers usually means more pain. Not getting the most out of our winners leaves us trading below our profit potential.
Follow Abnormal Activity
Almost every stock that makes a market beating return starts its run higher with abnormal price and volume activity.
Not all stocks that trade with abnormal market activity go on to make market beating returns.
To be successful in trading, look for stocks trading abnormally but also learn how to focus in on those with the best potential. (I can teach you my methods, go to www.stockscores.com/learn for more information).
Pay Attention When the Market Doesn’t Make Sense
I love to find stocks or markets that are doing things that make no sense to me. These are opportunities because they are situations where some people are trading on information that is not widely known. When the entire market of investors learns of this information, the stock or market will move even higher.
Consider this example. A Biotech stock goes from $5 to $7 in one day and trades three times its normal volume. A check of the news shows that the company has a lung cancer drug under development but has not announced any news on how well that drug treats lung cancer.
There is no news to support the trading activity in the stock. However, the market activity is telling us that some investors have some new information that justifies them paying a higher price and doing so aggressively by the increased number of shares that are being bought.
2 weeks later, the company formally announces that a larger Biotech company has offered to buy the company for $20 a share. The stock immediately gaps up to $20.
The stock market is not fair. There are always some people who have better information than others. In this example, some people had at least heard the rumor that there may be a buyout. For the rest of us, the trading activity made no sense.
Go look at the charts of stocks that have made big news announcements that caused their stocks to make big moves. You will find that most of them had abnormal trading activity before the news came out.