The Critical Skill of Risk Management
In stock trading, risk management is not just important—it’s the most critical skill. Contrary to common misconceptions, stock trading isn’t akin to gambling or inherently fraught with extreme risks. The key to distinguishing yourself in the market lies in effective risk management, which primarily involves savvy portfolio management. The nuances of portfolio management include decisions on diversification, response to market news, placement of stop losses, and interpretation of stock charts.
Navigating Market News
The market news often presents a confusing array of flashing signs, signals, and sometimes panicky updates. However, it’s crucial to remember that news channels are typically late in reporting market movements. These updates are already factored into the stock prices. Therefore, making trading decisions based on the news can be misleading. The most reliable source of information is the stock chart itself, following the principle of ‘trend lines over headlines.’
Understanding Diversification
Diversification is a significant aspect of risk management, but it’s often surrounded by misinformation. The goal isn’t to buy stocks merely to offset the risks of others. Instead, understanding what makes up your portfolio and how it performs is key. Like tending a garden, you want to nurture the flourishing plants (profitable stocks) and weed out the non-performers. Diversification is essential because it’s impossible to predict the performance of any public stock accurately, and over-speculating in a single security increases your risk.
Managing Portfolio Sizes and Stop Losses
How much should one diversify? It depends on individual circumstances and the ability to manage the portfolio. More than five stocks can become cumbersome, especially for those with other jobs. Each position should have specific stop losses and profit targets. I recommend buying each position up to 10% of your portfolio’s worth, occasionally extending up to 25% in rare cases. The trade risk per stock should be between 7% to 8%, with stop losses set accordingly. Also, it’s vital to ensure that the risk associated with one position doesn’t exceed 2% of the entire portfolio’s worth.
Adjusting to Market Trends
In volatile market conditions or when there’s no clear uptrend, tightening your stop losses is necessary. Instead of the usual 7% or 8% mark, aim for a maximum of 3% to 5%. Similarly, profit targets should also be adjusted to about 9% to 15% from the buying price. Portfolio stop losses are another critical aspect, often overlooked. I recommend setting a monthly portfolio stop loss, which I’ve adjusted from 6% to 3% to control risk better.
What is a Portfolio Stop Loss? It’s essentially the threshold you set to ensure your portfolio’s value (Net Liq) doesn’t dip below a specified level within a given month. For instance, if your portfolio’s Net Liq starts at $10,000 at the beginning of the month, and you’ve set a 6% minimum threshold (equivalent to $600 in this example), you won’t allow your portfolio to fall below $9,400 (which is $10,000 – $600). When your portfolio’s Net Liq reaches $9,400, you’ll close all your positions, especially the ones incurring losses, and tighten your stop losses. After that, you refrain from taking new positions until the next month.
In the subsequent month, you’ll once again establish the starting Net Liq level and calculate and set your new stop loss based on the Net Liq. Personally, due to past losses, I’ve become risk-averse and currently maintain a tight 3% monthly portfolio stop loss.
Importance of Trend Lines and Moving Averages
Trend lines, moving averages, and chart patterns are crucial for making informed decisions. The 200-day simple moving average (SMA 200), 50-day SMA, and 21-day exponential moving average are key indicators of market trends. I adhere to the rule of not purchasing stocks below the SMA 200, as it usually signals increased market volatility and makes setting stop losses and profit targets challenging.
Moving averages are valuable tools for identifying price trends and frequently serve as reliable support levels. Why is this information useful? Consider the scenario where you’re examining a specific stock, and you observe that it has recently rebounded from its 21-day Exponential Moving Average (EMA 21), a pattern it has displayed previously. This signals a positive indication that the stock’s price is currently in an upward trend. In essence, EMA 21 has functioned as a support line, presenting an opportunity for you to consider purchasing the stock and setting a stop loss just below the EMA 21. Such a strategy inherently reduces the level of risk involved in the trade.
RS Rating and Its Significance
The RS Rating, a part of the CAN SLIM Investing Strategy, is a vital indicator to identify market outperformers. It reflects the percentage by which a stock outperforms others in the Investors Business Daily’s database. For instance, an RS Rating of 86 indicates outperformance of 86% of the market. In my strategy, I focus on stocks with an RS Rating of 85% or more, provided the overall market is in an uptrend.
Incorporating Fundamental Analysis
Fundamental Analysis is an integral part of the CAN SLIM strategy. Key metrics include earnings per share growth (annual and quarterly), sales growth, and return on equity (ROE). These factors drive the market, as a company must have robust sales and a positive net income to generate strong earnings. However, it’s important to recognize that these factors contribute to, but do not solely determine, stock prices. In scenarios where stock prices react negatively to positive earnings or sales growth, prioritizing price action and chart patterns becomes essential for profitability.
Conclusion: Navigating the Complexities of Stock Trading
In conclusion, successful stock trading hinges on more than just understanding market trends and company fundamentals. It is the art of risk management, the discernment in news consumption, and the wisdom in portfolio diversification that truly set apart the proficient trader. Embracing these principles means acknowledging the complex interplay of various factors — from market trends to fundamental analysis — and responding with strategies that are as informed as they are cautious. By prioritizing knowledge over speculation and strategy over impulse, traders can navigate the often volatile waters of the stock market with greater confidence and competence. Remember, in the world of stock trading, it is the well-informed, disciplined decisions that yield sustainable success.
