START TRADING 101 | Lesson 2
Kickstart your Trading System with a Strategy that fits your Personality
Welcome to Lesson 2!
This lesson is all about you… because the success of your trading system starts with adjusting it to your needs and your personality.
But first, let me tell you what happened to me when I traded in a way that did NOT fit my lifestyle.
How I went into Day Trading… and quickly out again
Once I decided that I need to try day trading.
It’s a simple concept: make many trades during a single trading day, then sell everything at the end of that day. No stocks kept overnight in your portfolio… no exposure to price jumps over night!
I thought it would be a great fit for me. It’s exciting during the day, and at night I can sleep without worrying about potential portfolio crashes… and having a good sleep is important!
Don’t believe me? Just wait until you have kids… 🙂
After doing it for 3 days, here is what happened…
- I lost a good amount of money, but even worse…
- My sleep… was a disaster. I was like a zombie each morning!
- I dreaded the next day. I became grumpy and very stressed out!
Something had gone wrong here, badly! So, I stopped and investigated. What had happened? And why had my promising strategy gone all wrong?
My mistake was… that I did not think it through before I started trading!
But seriously… “do day trading because I can sleep well at night” … what kind of strategy is that? That’s not even a proper English sentence!
After some thoughts, I figured out where things had gone so horribly wrong. Day trading is intense… 7-8 hours staring at your screen (or multiple screens), looking for opportunities, making decisions within seconds all day long, etc.
It needs concentration. Quiet surroundings. No interruptions. You get the idea.
So, what should I have done… and what did I actually do?
In hindsight, it’s obvious that this would never have worked. I just did not think about all the issues before trading… and it cost me, money and health wise.
That’s what I mean when I say, “adjust your trading system to your lifestyle”. Review how much time you can spend without compromising on your usual day-to-day life.
It’s all about time management
Think about how much time you can spend on trading, and when.
Don’t think about “when is the market open” or stuff like that. Your habits and daily job and obligations matter most.
Here is what you might come up with (but don’t feel you are limited to it):
- I can spend 15 minutes per day, usually during my lunch break
- On some days, I can spend 30 minutes, but on others, I have no time at all
- Every second night, after kids are in bed, I can spend 20 minutes
- Never on weekdays, but every Saturday morning 1 hour is available
- I am sometimes away for weeks, but when I am home I can catch up
- Weekends are for family and friends! So only during weekdays.
Many people think that regular attendance is required for trading stocks, but… it isn’t.
Maybe you think it works like that:
Every day, read business news, check the markets, do some trades, etc. If you can make that work and if it’s what you like doing, by all means, go for it.
But it’s absolutely not required for having a profitable trading system. That might be surprising…
I experimented a lot with different trading systems. Sometimes I left my system unsupervised for weeks at a time… and it was still doing its job.
That’s what building a robust system is all about – it does the heavy lifting so you can do more important things. It remains stable in times where things around you might be in chaos.
There are always surprises in life. A friend’s wedding that was not on your calendar, a surprise business trip, an unscheduled family event, you name it.
With a robust trading system, that’s not a problem.
It can also be beneficial not to interfere for some time. Markets often fluctuate, and newspapers come up with all kind of reasons why that happens. But most of these price moves are simply noise.
If you ignore them and just act if your system cannot do it by itself, you are usually better off. Financially as well as mentally!
I will discuss more psychological aspects later, but for now, just think about when can you reliably pay attention to your trading (and when not).
Finances impact your strategy
Your financial goals and current situation will affect your trading strategy. Here are some examples of different financial situations:
- You have $100,000 ready to go for trading.
- You have $10,000 to invest right now and you plan to add $1,000 to the account each month on regular basis.
- You have $200,000 ready for investing, but you need to withdraw every month $5,000.
- You have 0 to invest now, but you can save $2,000 every month starting now.
And so on. You get the idea. Everyone’s situation is different. Do you depend on your trading income or will you reinvest your gains? Big difference.
When I left my employer, I took the benefits package as lump sum cash payment and used it as my starting capital.
And I felt safe – my spouse had an income that kept us financially afloat, so I did not expect to make frequent withdrawals.
You can start investing with very little amounts – however, there are practical limits to it.
Cut to the chase – how much do I need to start?
The short answer:
If you have less than $10,000 available at the beginning, then you should start by buying index fund shares regularly instead of trading stocks actively. They are low cost and their performance is very close to the market performance.
I wrote an article about mutual funds and related investment types if you like to know more about that.
Where does that number, $10,000, come from? There are two reasons for this limit:
- Online Brokers often ask for a minimum account value – usually in the range of $10k
- Even if you could trade with less, trading fees would cut down your gains dramatically
Accounts below a certain value might also ask for monthly fees. I will talk about the effect of fees in a later lesson in more detail, but for now, simply imagine that for every trade you make you need to pay $10.
If you trade with small amounts, your gains will also be small. And once you subtract the trading fees, they will even be smaller. At some point, most of your gains will be eaten up by fees.
In practice, I believe you should not start trading stocks actively with less than $35,000.
The reasons are that
a) you need a bit of a buffer,
b) fee impact is getting acceptable and
c) you need at least $25,000 to open a margin account.
A margin account is a stock brokerage account that allows you to borrow money from the broker AND you are allowed to short sell.
Both options are not necessary to trade, but they are additional tools at your disposal that can boost performance and reduce risk (if used correctly).
What if I am below the $10k limit but I can add cash monthly?
That’s a great way to start.
You can either start with investing in an index fund and wait until you passed the $10k limit with trading stocks – or you keep saving your cash until you reach the limit and then start trading right away.
The important thing is to make a plan – how much can you use to trade stocks? You might want to diversify and not risk all your savings!
One of the “common wisdom” of trading is to only use the money for trading that you do not need – i.e. if you lose it all, never mind.
I understand, yet I do not fully agree.
It is OK to be careful – if you can, invest half of your capital elsewhere. Just make sure you understand the risks and potential returns of such “other” investments well!
As I will discuss later in risk management, there are many ways to reduce trading risks. After all, it’s not like gambling where the casino always wins (in the long run)!
Up next – the psychological aspects of trading!
How much does psychology affect trading results?
Based on what experts say about that topic, as well as based on what I experienced during trading, I can safely say: psychological aspects affect trading results A LOT – probably more than 50%!
Why is that a problem?
It’s a massive problem because stock trading is about decision making. And anything that affects our decision making is usually not helping… it hurts trading results in most cases. But why does it happen?
There are two issues: 1) our emotions, and 2) cognitive biases.
Stay away from trading during emotional roller coasters
A large part of our brain is dealing with our emotions.
We all have them, and we are all affected by them. Usually, that’s a good thing! If you could not feel happiness or sadness or all our other feelings, that would be a boring life!
But in trading, it’s a problem.
Once emotions take over, we are not making rational decisions anymore.
If we are overjoyed we tend to think everything is going great! Nothing can go wrong… so we might buy more stocks than we should and take risks that we would usually not take.
Or vice versa: if we are feeling sad, angry or depressed, we think nothing will work out at all.
And we might sell promising stocks before they reach their full profit potential… or we might not buy any stocks at all, while, looking at it rationally, we should.
There are many situations where our emotions affect us more than usual:
- Losing your job and/or income
- Relocating to a new city or country
- Getting married (or divorced)
- Having a sick child
- Celebrations or traveling
- Losing a loved one
- Making tough business decisions, like letting go of employees
The list is endless, and it often happens out of the blue.
When I got the news that my grandma had passed away, I knew I would need to travel and it would be an emotional ride. I prepared my trading system and portfolio so I would not need to look at it for 2 weeks.
And I am glad I did!
When your mind is not in the game… don’t play.
The good news is that knowing about it is half the battle. It is possible to create your trading system in a way that it can account for such events… but it’s up to you to enforce your own trading rules to make it work!
How cognitive biases affect us
Cognitive biases are tendencies to think or make decisions in a certain way, but which are not rational or good judgment.
These biases have been subject of extensive research, especially in behavioral economics.
I will explain the most important ones related to investing and trading; for additional reading, I recommend Daniel Kahneman’s excellent book, “Thinking Fast and Slow”.
There is also an excellent graphic about this subject available (from Samantha Lee and Shana Lebowitz at Business Insider), from where I got the short descriptions in the titles below.
My favorite example of hindsight bias in action is when looking back at Apple stocks.
I have written before about the outcome of buying Apple stocks for $500 a month since 2001. And I often look back and think, why did I not do it? They invented the iPod and it did great, why did I ignore such an obvious opportunity?
And the answer is… it was not that obvious at the time.
Yes, there are other reasons (I was lazy and did not follow up on my hunch), but in the end, today it all looks crystal clear, while back then, it wasn’t.
At the time, Apple was a struggling computer company. Its market share was a joke. And there were 50 other competing MP3 players either already on the market or being released in the same year.
Apple was just one competitor in a crowd without a clear outcome. And many of the other competing companies went bankrupt later… imagine you would have spent $500 a month on them…
That’s hindsight bias at work.
And it happens all the time when trading stocks. So, while it’s sometimes painful to look back, don’t beat yourself up over it.
Try your best to catch potential opportunities (as much as your trading system and finances allow), and then move on.
With anchoring, we tend to fixate on a value or number that in turn gets compared to everything else.
Think about a sales sign in a store. We see the price difference (and we like it), but we do not know if the prices we see are still overpriced in comparison to a different shop.
In a famous experiment, people were asked about the percentage of African countries that were part of the U.N.
Before being asked they spun a (rigged) wheel of fortune that landed on either 10 or 65. People who landed on 65 estimated that percentage consistently higher than people who landed on 10.
There is a brilliant article about the Anchoring Effect (by David McRaney) if you like to know more about it.
When trading stocks, you might see a stock chart and conclude that this is a buying opportunity because the price today is lower than it was a few days earlier.
But maybe the price was overvalued anyway and the current price is still far from being cheap. It will also affect your ability to predict how trends develop.
By following the rules of a trading system, you can avoid making decisions that are based on anchoring.
That’s a classic… small sample size means jumping to conclusions without knowing about the bigger picture.
The “secret information” from a friend of a friend about a particular company… or the “I have seen it before happening with…” notion… it’s all the same.
It’s cherry picking of information and in the long run, it will not hold up to scrutiny.
One way to see this in action is when reading business news about commodities, for example, the oil price.
Day 1 headline: “Oil rises on supply worries because of crisis XYZ”.
Day 2 headline: “Oil prices lower as production cuts might not be effective”.
Now, what is it going to be? Higher prices, lower, or no change at all? Should you buy or sell?
There is no way to find out by looking at such headlines, as this is mostly noise. Only the longer-term price trend will show the true price direction.
I am sure you have encountered the bandwagon effect before somewhere.
Think about being with friends out, someone voicing an opinion and everyone nodding, nodding and nodding more in agreement. We like to think the crowd is always right. And often it is!
The reason why trends tend to continue can be explained by this effect.
If a trend starts, more and more people will follow it, such strengthening its effectiveness.
And when the trend appears to get stronger (and hence, more obvious), ever more investors get “on board”, creating a cycle, or self-fulfilling prophecy… until there are no more investors left and the trend exhausts itself.
Unfortunately, the trend is most noticeable at the end… just before the crash (or reversal). Indeed, “the trend is your friend” … just make sure you jump on it early enough!
How to do that we will discuss in Lesson 4!
Now one thing upfront: the stock market is not random.
But… it is so complex and chaotic, that it might as well be. The difference is (in my opinion) mainly philosophical.
And there are patterns! Some are subtle, others are very visible, and even others are only visible in hindsight. Some of these patterns can be used to pick stocks (see Lesson 4), while others, well, might not work so well.
But this bias is not related to such patterns. Our brain is a pattern recognition machine, and it does a great job in doing what it does.
However, often things that appear like patterns are just random events, coincidences. And our brain overdoes it… telling us that there is something going on when nothing is happening at all.
Every time I hear someone say, “everything happens for a reason!” I am cringing… until I tell myself, yep, correct. Just that the “reason” might be nothing but a random event.
Think about coin flips – after tossing multiple heads, the tail toss “must be due now”.
It is still a 50-50 chance. Previous coin tosses have nothing to do with the probability of the next toss. That’s what statisticians mean by “independent events”.
So, if you see a stock that has been going down in price for a long time… that does not mean that it’s now the time for it to go up. It might do just that, but it might as well continue to drop lower in price.
After all, the trend might still be ongoing.
Sometimes I see something that I just like – for example, a new laptop that looks great or a new mobile phone. I already made up my mind about it!
Now I start looking for “more information” … reviews, videos, spec sheets etc.
And then what happens?
I read and I like what I read… because it confirms what I already thought (that it’s a great product to buy). Then there are some reviews that say “…but, there is this kind of problem…”. And I think, well, not a big deal.
Once I bought it and the pink glasses come off after a couple of days I think again about these reviews.
Did they not mention that the laptop screen does not display the color yellow as it should? Or that the WiFi speed is only mediocre? Indeed, they did… and I read it… and ignored it.
That’s confirmation bias at work! And it happens all the time when selecting stocks.
Despite additional facts that say “don’t buy that stock”, you might decide that you will buy it because you like what you see. Or simply because you are convinced that this is the next best opportunity.
And that’s OK.
As you will see in later posts, that’s not really an issue, as long as you manage your risk. If you hold on to a trade because you think that it will turn around, while the price keeps falling… then your portfolio is in trouble.
Maybe you heard this term before: Analysis Paralysis.
It happens when we have too much information to make a decision, and we get stuck in analysis mode. But how can more information be a bad thing? Is it not better if we are more informed than less?
Scientists did an experiment in a supermarket to figure that one out:
- On one day, they offered customers to try from a selection of 24 jams, with the opportunity to buy from that selection afterward.
- On another day, they showed only a selection of 6 jams.
On which day you think they made more sales on jams?
The numbers are clear: one the first day, 60% of customers tried jams, and 3% bought after trying. On the second day, 40% of customers tried jams… but 30% of those bought afterwards!
That was more than 6 times as many customers buying jam… when they had fewer choices.
It means we make better decisions (or we make decisions in the first place, instead of doing nothing) if we stop accumulating additional information at some point.
Information about the finance world is all over the place; you can watch and read business and finance news all the time. But most of that information is simply noise – it does not help making decisions.
And not to mention… it wastes a lot of your time. I should know… I am a hopeless news junky!
But it never helped me to make better stock trades… in fact, it usually made it worse. That’s why I let my trading system do most of the work for me, using the absolute minimum amount of information possible.
Overconfidence… we know it’s usually not a good thing. It lets us take too much risk because we think we know what we are doing.
A good example is an experiment that was done by social scientists about drivers assessing their driving skills:
90% of drivers believe that they are “better than average” drivers. How can that be? Either the remaining 10% must be truly horrible… or, more likely, most drivers overestimate their skills.
But there is a twist. Imagine that indeed you are a better than average driver (I will assume now that this means being a more careful and safer driver).
What about your surroundings? Unless all drivers around you in traffic are also “above average”, you are in danger of having an accident that is out of your control or at least difficult to prevent.
When I did my driving training in the Oil & Gas industry, the instructors hammered it into my head:
There is no such thing as accidents – only mistakes, and they can be avoided through training.
But you know what? That’s BS nonsense! Because there are many things around us that are out of our control. I call them “random events” – you might call them luck (or bad luck).
Do you attribute your successes to your skills and your failures to bad luck? ? think about it…
And the financial markets are full of random events – or at least events that appear random and that cannot be predicted.
Following your trading system rules will prevent losses that happen because of overconfidence… unless of course, you circumvent them (out of overconfidence!).
Beginner traders tend to lose large amounts of their money because of overconfidence, because of wanting to be “right”.
Don’t let it happen to you. Let your trading system protect you from this bias.
That’s a tricky one. It often makes sense to assume that the latest information is more important than old information.
But it depends on what you are looking at. If you look at finance news, then I beg to differ… the newest information, in that case, is NOT more important (because most of it is simply noise, means no real information at all).
But again, if we assume that trends tend to continue, then newer information is not a bad thing.
We want to ride the trend and make the most out of it. On the other hand, we do not want to bail out too early because of information that says otherwise.
So really, it depends on the situation and you will need to practice your good judgement on that one.
It is important to realize that a large part of the stock market is driven by human fear and greed.
Past crashes can be attributed to that, and it will repeat in the future. Thinking that a stock market will always go up, because “this time is different” is extremely dangerous.
Chances are, this time is not different… because us humans, we have not changed so much in the last thousands of years.
We are still as greedy and fearful as we were millennia back.
That’s a very common bias and it can lead to serious misjudgments.
We only see the “survivors” and their success… because the failures disappear, never to be seen again. Why is that a dangerous thing?
Firstly, we might make decisions based on the wrong assumptions.
- Switching career path because we see how successful people became once they did it.
- Choosing a financial product because of its excellent track record
- Testing a trading system with historical data (listen up here!)
- Thinking “in the past everything was better”
- I will become an actor because they earn a lot (just look at Hollywood!)
Secondly, it makes us prone to be fooled by others about their abilities. Here is how that might happen:
You receive an e-mail from a company, claiming they found a way to predict major price moves in the stock market using “latest Artificial Intelligence Algorithms”. They say they will prove to you that they can do it!
And they make a prediction, saying that during this week the market will move up.
And they were right! After a week, you receive another e-mail, saying their algorithms predicted that the market will move down again. And it does…
After 6 emails that all predicted market moves correctly, you are convinced. They found the “Holy Grail” of stock trading! Where can I sign up?
Email number 7 tells you not only how you (from a selected group of especially eligible customers) can sign up, but also how much it will cost. So, you happily spend $1,200 on a yearly subscription upfront and invest $100,000 into their brokerage account.
One month later… your money is all gone and nobody replies to your e-mails… what happened?
How did they do that? It can be easily explained by survivorship bias (no fancy AI stuff needed).
They wrote emails to 12,000 people. In 6,000 emails, they predicted the markets will go up. In the other 6,000, they predicted it will go down.
After a week, they discarded the “clients” to whom they predicted wrongly. Now they sent 6,000 e-mails… 3,000 predicting one way, 3,000 the other… I think you see where that goes.
In the end, they wrote to the “selected eligible customers” (187 of them, to be precise) and asked for money. If 100 of them signed up and “invested” $100,000… that’s 10 million of “earnings” for that company.
Enough money to disappear somewhere and enjoy some cold drinks for a while.
So, if you receive calls or e-mails from people offering such “to-good-to-be-true” stuff to you… back off. If it was working so well, they would use it themselves instead of running after you (and your money).
Always be aware of survivorship bias. It’s sometimes hard to spot, but for doing system based stock trading it is usually not an issue.
Just remember it next time someone offers you to invest in their “top track record” mutual fund.
Why we hate to lose and how it affects us
Social scientists have proven it over and over again: we hate to lose more than we love to win.
Professor Kahneman explains in his prospect theory that the ratio that balances our emotions between winning and losing is about 2.5 to 1. In his example, people were asked at what potential gain they were willing to accept a coin flip bet when possibly losing $10.
And on average, people were willing to take that bet if they could win $25.
That also means that if you take a loss, it hurts you 2.5 times more than winning the same amount.
It also explains why beginner traders tend to sell winning trades quickly and keep losing trades.
The winning trade gives them a psychological boost (Yay! Won something!) while selling a losing trade is like accepting the loss (not selling, in their interpretation, means that there is still a chance of recovery).
What are the implications?
Well… it means that stock trading does come at a psychological cost: Stress. Losses are unavoidable in investing – after all, we are taking a risk to make a gain, and taking a risk means that at least sometimes, we will fail.
So how can we mitigate stress because of trading losses?
My favorite way is simple: Avoid unnecessary information.
Don’t read business news all day long. Check on your portfolio only once per month, and then only check total trading gains vs. losses.
Studies show that we look on our smartphone screens 180 times per day.
If you would check your portfolio that many times (and that’s no problem with mobile trading apps), even in a market with a strong up trend, you would likely observe 89 times a loss in your portfolio, and 91 times a gain.
That’s because of the daily noise, the “price wiggles”. But we now know that this will be a problem for our mind… because we need more wins than losses to feel emotionally balanced.
If you check your portfolio on monthly basis, it is more likely to observe a gain in 8 months of the year, and losses in 4 months of the year. That’s a much better ratio than checking many times daily.
Be aware of the loss-gain ratio and the mental costs it can bring. Try to shift it in your favor by avoiding information overflow.
Building your strategy
Now it’s time to think about building the foundation of your trading system: your overall strategy.
“A strategy is nothing else but a plan to achieve something in a certain way, while applying a bunch of constraints.”
Here are some ideas for trading system strategies as an example:
- Buy a new stock once a week, but only if the stock is showing an uptrend
- Buy a new stock once a week if it shows an uptrend
ANDif more than 50% of the market is also showing an uptrend
- Buy a random stock once per week and control the risk with a fixed stop price
- Buy one stock per week but sell it if it shows no gains after 2 weeks
And so on. You can become very specific with your ideas, but it is better (in my opinion) to keep it generic because your constraints will add many rules to your strategy anyway.
We already discussed constraints earlier in this lesson; they come in different categories, like
- Time and lifestyle constraints: when and how often you can attend to trading
- Financial constraints: how many trades you can afford to make over a period of time
- Mental constraints: don’t trade if your emotions are controlling you
In later lessons, we will add more categories, e.g. signals that indicate that a stock is a buy candidate, risk management rules, rules about when to sell a stock to take profits or to avoid large losses.
But for now, we will stick to the above: overall trading strategy and basic constraints.
There are many different trading strategies – if you drill down to the details, there are probably as many as traders.
But there are some generic ones that we will use as a starting point. All of them will use the same kind of historical data as input – the daily trading data. This rules out day trading, which I will not discuss at this point.
I will explain a few general trading strategies with their pros and cons. Later, you can decide which strategy fits you best. These strategies are:
- Trend Following
- Buy and Hold
- Band Trading
Let’s look into each in more details.
Trend Following Strategy
The idea behind trend following is simple: find a stock that appears to trend up, buy it and ride the trend as long as possible.
Once the trend reverses, sell and pocket the profit.
The above chart explains how it works.
As we do not know the future, we assume that once we discover a trend that it will continue. How a trend is detected will be the subject of Lesson 4 – for now, let’s just say that we can detect potential trends.
If the trend discontinues, we will bail out of this trade at the Stop Price that we set before buying the stock. It will be a losing trade – it happens all the time.
The longer the trend continues, the larger will eventually be the profits.
Sometimes trends can persist for a year or longer. These types of trades are the “big winners” and they often contribute to 80% or more of your yearly gains. That’s why it is important to
- Catch as many opportunities as possible so you don’t miss the big one, and
- Discard losing trades quickly to free up cash for the next opportunities
This strategy is my favorite strategy.
It is the basis of most of my trading systems and it has served me well. It needs a medium amount of supervision, but a lot of it can be automated.
Buy and Hold
The buy and hold strategy can work well if the entire market is in an uptrend, or if a downtrend is of short duration.
It is a strategy that is very easy to implement and it requires little supervision.
In this strategy, we buy relatively small amounts of stocks on a regular basis, for the same amount of cash each time. In a way, it works like a savings account, only that the money is used to buy stocks.
If the stock price falls, instead of selling, we buy more stocks. As we always spend the same amount, lower prices will buy us more stocks. That is called “averaging down”.
There is usually no definite intention on when to sell stocks in this strategy. It can be in a year or in 20 years. Usually, the longer you do it, the better.
While this strategy can work well, it is easier and in the long run safer to invest in an index fund instead of individual stocks.
Index funds require to pay a maintenance fee, but the amount can be very low. Most mutual funds (and traders) cannot beat the general market performance in the long run, and often they are below it.
An index fund is an easy way to match market performance.
It can be a stressful strategy though. Sometimes, downtrends can take a long time to recover, just to result in the next downtrend right afterward. If that happens, it can be a terrible strategy or one that needs decades to recover.
If you would have started to invest with this strategy by mid-2000, you would have started at the top of the Internet bubble.
What followed was a 3-year downtrend. The market took until the end of 2007 to reach former heights – just to crash again in the financial crisis. It reached the same heights as in 2000 only be 2013…
That’s a long time to see your investments turn into dust!
But if you are lucky enough to start this strategy at the bottom of a solid crisis… then you will do extremely well.
Contrarian investing is an investment strategy that is characterized by purchasing and selling in contrast to the prevailing sentiment of the time.
Meaning, when the crowd thinks that things look really bad in the markets, then it’s time to invest for the contrarian investor (and vice versa).
It is a bit like the opposite of trend following. If a stock price reaches new highs (and the crowd goes wild), then it’s time to sell. If a price reaches new lows (and the crowd is depressed), then it’s time to buy.
This can work… if you are lucky enough to invest at the “right new low”. If not… you can see in the above chart that there are many new lows before the trend actually reversed.
Obviously, there is much more to that strategy than meets the eye. I strongly oversimplified it (on purpose).
You can design indicators that help to determine if a trend is about to reverse; that improves your chances of being right about your trade (or hunch).
And it is also proven that investors are most optimistic just before the crash, and they are most depressed just before a major market recovery.
Still, it’s a difficult strategy that needs a lot of work and careful risk management to be profitable – I do not recommend it for beginners.
With band trading, we assume that the price of a stock bounces up and down between 2 limits, or “bands”.
The chart below shows how that might look like.
The upper price band is called resistance, the lower one support (in this case).
Bands exist if investor sentiments are in a fight: one part of the traders believe that prices will not go higher than the current resistance price level – so they sell their stocks, causing prices to drop.
Near the support price level, other (or the same) traders believe that the price is now a bargain – so they buy, causing prices to rise with increased demand.
These bands do not exist forever, but while this scenario is ongoing, you can make money by buying and selling between the two price levels.
It’s a relatively high maintenance strategy, which is why I do not use it often.
One problem I have with it is that you need to sell at a certain price level (the resistance level) without knowing if the price does not go higher. Because if it does, you would leave a lot of profits on the table.
I consider it an advanced strategy at that point, but it’s absolutely possible to make it work. It needs a lot more time and dedication to trading than a trend following strategy though.
Which strategy should you start with?
Fair question 🙂
If you have no capital to start with, i.e. if your financial constraint is that you invest on a monthly basis, then I suggest a buy-and-hold strategy with a low-fee index fund.
If you have sufficient capital to trade multiple stocks at the same time, then for beginners the trend following strategy is best. It’s low maintenance and easy to implement.
The two other strategies I do not suggest for beginner traders – but feel free to use a small amount of your capital to experiment.
I mentioned already that my favorite strategy is the trend following strategy.
More than 80% of my trades are based on that strategy. And what about the other 20%? Well, sometimes I use buy-and-hold – for companies where I strongly believe in their future potential.
It’s a risk because there is no stop price to protect me from large price dips – but that’s why it’s only a small portion of my portfolio.
So, make your decision! And write it down in the worksheet for later.
What about constraints?
Constraints act like boundaries for your strategy.
Constraints are everywhere and we already discussed a lot about them – lifestyle, time management, financials, emotion, you name it.
How can constraints be integrated into your trading system? By rephrasing them into rules that are easy to understand and follow. Let’s see how that works!
As an example, imagine you are in the following situation:
You have no trading experience yet; but you have $50,000 available to start investing and you can add $1,000 a month from your salary to grow your cash in your portfolio.
You are married and you have children; your job needs you to travel sometimes, but not more often than once a month for a few days each trip. You often work long hours in your workplace.
Weekends are dedicated to friends and family with almost no exceptions. You feel reasonable secure in your job, and your spouse is also making a good additional income.
What trading strategy could you adapt, and what are the constraints (that need to be rephrased into trading system rules)?
- Trading Strategy: Trend Following (low maintenance, financially feasible)
- Starting Capital: $50,000
- Monthly additional funding: $1,000
- Withdrawals planned: none
- How often available for trading: 2-3 times per week, max. 30 minutes each
- Available for trading on weekends: No
- How long should the system run itself reliably: 2-4 weeks if needed
So far so obvious. Now let’s add some additional rules:
- When emotionally unbalanced: stop trading for 3 days
- If a trade hits its stop price: sell automatically
- Frequency of portfolio reviews: once per month
- Install trading app on smartphone: No
- Before vacation or trips: adjust stop prices
Do you see how that works?
I will not go over each rule in detail; some will be explained in later lessons in great depth. The important thing is to be as precise as possible when making these rules.
Why? So that it is easy to notice if you are breaking them!
And you will break them – sooner or later. Everybody does. Which is OK, it’s part of the learning process. But let’s agree on ONE rule that you should NEVER break (please make an honest effort on that single one):
If you break a rule of your trading system: record it!
We will talk about record keeping in Lesson 8; for now, just take it in. We all learn from our mistakes, but only if we understand that we made a mistake in the first place.
In stock trading that works beautifully.
Every trade has a financial result; collecting this result as well as other information allows us to analyze and learn from the outcomes.
We could, for example, compare performance between trades where you broke a rule and trades where you followed the rules.
Chances are that trades, where you broke the rules, performed worse in the long run.
And once you see which rule breaking costs you the most… you will learn fast to change your habits.
But don’t let that stop you experimenting and tweaking your system! There is always room for improvement – and sometimes it is necessary to test the existing boundaries, as they might change over time.
‘Nuff said. Use the trading rules worksheet and write down your first trading system rules.
Over the following lessons, there will be more to add to them. At the end of the course, you will have your complete set of rules that make up your trading system.
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Get the Lesson 2 downloads:
- Strategies Cheat Sheet (PDF file)
- Worksheet: Build your Trading Rules (PDF file)
Click on the images or links below to get the files.