Stock Trading

Stock Trading Basics – The Framework

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There are three things that are crucial to financial independence and early retirement: making money, saving money, and managing investments.  Yet if there is one method of making money that is scorned and rarely talked about in the FIRE community it is stock trading.  Many people pore over different stock investment strategies, i.e. maximizing 401ks and IRAs, snowballing with dividend stocks, or using a diversified ETF portfolio, but few discuss strategies for buying low and selling high or selling high and buying low beyond some cursory explanation of price-to-equity (PE) ratios.  This is a mistake because even a cursory knowledge of how to value stocks and find the correct time to buy can help everyone make more money, regardless if they are long-term investors or short and intermediate-term traders.* After all, if you aim to make money over the course of several years, you can easily add another 10% to your profit if you can recognize the dips and buy at that point and not simply whenever you first think a stock is a keeper. This knowledge has certainly helped me make tens of thousands of dollars over the years, and can help you too.**

The first thing that a wannabe stock trader should have before they start risking their money on the market is a trading/strategic framework.  If you don’t have a framework, all the information that your receive will be nothing but a confused jumble.  What information is important? What information is pointless? If you study stock trading websites and all their valuable tips and tricks, how can you integrate everything together? Many people do not use any framework whatsoever and enter the market completely blind. As a result, their positions seem to quickly lose value for no clear reason and they have no idea when or if thing’s will turn around.  They ask themselves questions like “I shorted the stock because I thought it would crash. Why didn’t it go down?”,  or “The stock was valued at $40 five years ago, why isn’t it going up to the old high?”   Without some understanding of how to approach the market, it will rob you in a moment’s notice. I know that if I had one back when I first started out years ago I’d be a millionaire by now (or would have at least avoided heartburn and pain).

With that said, a good starter framework is:

  • When is a stock a good value?
  • What is the trigger to buy/sell?
  • How long do you hold it for?
  • What is your risk management strategy?
When is a stock a good value?

Determining value is the most fundamental skill in stock trading and life in general, yet it is one of the hardest to learn as an amateur. If you are a long-term value investor like Warren Buffet and his ilk, then you study price-to-equity (PE) ratios and income statements for a variety of companies and pick the one that is undervalued on the stock market based on the future income it is likely to earn. If you are a technical trader however, there are other methods. Three in particular are: (1) price support and resistance levels, (2) price channels, and (3) price in relation to other value indicators.***

Note: I state up front that I am not a Certified Market Technician and that there are other resources out there that can help you really dig into the details behind these methods. I strongly suggest consulting them, i.e The Chart School at StockCharts.com. This is only to give you a framework to put all these wonderful ideas in so that you can find your way out of the thicket.

Price Support and Resistance

The most famous method of determining value is to simply use resistance lines (when people tend to sell) and support lines (when people tend to buy) to guide your buying and selling strategy.To do this, you go to the far right of a chart and drag a line back to the left, hitting as many low points as possible for the support line or high points for the resistance lines. Do not worry about hitting the top or bottom. If there are moments where price goes above these lines, that just illustrates how extreme the situation is and that it is an opportunity to make your move. You generally don’t want to trade in between these lines if you can help it because you will never know which direction the price might go in, and it would limit your profits since you have less ground to cover before hitting the turning points.

Note: this is a good strategy to use when a stock is moving sideways in price, neither trending higher or lower.

Price Channels

Another method to use is called price channels, which are useful in situations where stocks are trending up (or down).  Like with support and resistance lines, you start at the right side and draw a line to the left hitting as many tops or bottoms as you can.  The more that you can reasonably hit, the stronger the trend.

It is important to note when using this method that you should always trade with the trend.  If a stock is going up, you should try to buy low as the odds are higher that the trade will move your way.  If you a shorting (i.e. selling stocks at a higher price and then buying them back later at a cheaper price and pocketing the difference) in an upward trending situation, the odds are much higher that you will get burned.  The reverse is also true. If a stock is trending down, you should short at the high points and avoid buying if possible, as the odds are good that the bottom may fall out of the barrel and punish your wallet.

Value Indicators

If you play around with basic charting software (in this case, StockCharts.com) you’ll find hundreds of indicators that can tell you when a stock is appropriately valued. I won’t dive into all of them, but one example involves analyzing the relationship of price to moving average lines. A moving average line denotes the average price for X amount of days – in this case the blue line is the moving average for 50 days, and the red line is the moving average for 200 days. Another way to think of this is short-term value vs. long-term value.  If price is at an extreme where it is higher than both short and long-term value, then this indicates that a stock is overpriced and should be sold. Similarly, if price is beneath both the short and long-term moving averages, this indicates a buying opportunity. As is commonly described in the investment literature, price is like a rubber band. It stretches but will eventually return to its usual form.

Again though, these are three possible methods for determining the value of a stock and there are literally hundreds if not thousands of them.  You should pick one or two that you feel comfortable with and become skilled at interpreting them with a large variety of stocks, and in a large variety of situations.

What is the trigger to buy/sell?

It is not enough, however, to know that a stock is a good value. It could be undervalued for weeks, months, or years for all you know and if enough time passes the low price may become the new normal, i.e. it is no longer under-valued but average. You need to know when a stock has a good chance of reversing course or continuing a trend in the direction you want. Two of the most common indicators that you can find anywhere are called RSI (or Relative Strength Index) and MACD (Moving Average Convergence/Divergence). The former depicts when a stock is over-bought and oversold, and can tell you when its a good time to buy or sell. There are usually two lines that stretched across this indicator to tell you when the indicator is particularly extreme, and those are the signals you would ideally work with.

The latter indicator identifies when a trend is losing or gaining momentum, informing you when a new trend is about to start so you can jump on the bandwagon. Many traders also use the crossing of the lines as a signal to buy or sell, though numerous statistical analyses out there have shown that it does not guarantee success by itself. Like everything with reading and trading the market, indicators work best when used together to give context.  For example, a submarine can use its periscope to get a line of sight of what’s on the horizon. At the same time, no submarine would only rely on a periscope because it tells you nothing of what else is in the water with you – like an enemy submarine.  You need to use both instruments together to get the clearest understanding of the situation.****

How long do you hold your position for?

You must also determine in advance how long you are going to hold a position (e.g. going long on 100 shares), particularly if the stock does not seem to be moving at all or turns against you.  In the latter situation, you must force yourself to acknowledge that your trading idea sucked and that it’s time to give up hope. Money lost can be earned back, but time can never be earned back. Don’t waste it in a losing or stagnant position.  You’ll be regretting it for months or years to come.  My strategy is for an idea to prove itself within one to two weeks.  If the stock doesn’t move like I expect in that time frame, I get out.  Others operate on weekly or even monthly charts and give stocks more time to work themselves out.

What is your risk management strategy?

When it comes to stock trading, the second most important skill to master after determining value is understanding and evaluating risk.  It is so important that it deserves an article all by itself, so I won’t dive too deeply into it here, but its an issue that impacts every trader.  If traders are terrified of risking money, they will only trade small positions, which may not make enough money in the long run to compensate for their losses.  If traders aren’t scared enough (a far more common issue), then they’ll risk too much on a single trade. They can make a lot of money quickly…or get killed if a position turns against them and they’re too pig-headed to cut their losses. Some go further and borrow money from a bank or use margin from a brokerage to buy more shares, which increases the risk even more. I am 100% guilty of trading too large a position size, and will freely attest that putting all of your money in one stock and seeing it lose half of its value in a month will give you horrible heartburn (at the very least)

Conclusion

As you can see, if you approach stock trading with this framework in mind it will be easier to understand what is going on in the market and avoid being side-swiped unknowingly.  After all, you’ve already bought stocks at the right price, at the right moment, at the right position (risk) size and know exactly how long you’ll hold it for. You’re not whipping a dart at a dartboard blindly; you’ve stepped forward five feet, took off the blindfold, locked your arm in a straight position, and know to aim slightly high.  You won’t get a bulls-eye every time, but your odds are certainly better than 50/50!

*When I say short-term, I mean it as being several days or weeks.  I strong discourage anyone tempted to make money by day trading.  The most dangerous thing to a stock trader is not remaining calm and getting wrapped up in your own emotions and the minute-by-minute mental tug of war of day trading completely defeats. The majority of people who try it fail utterly.  If you’re that desperate to lose money, take out your wallet and throw it in a bonfire. At least you’ll get some warmth out of it.

**My current trading record so far is: lost $200 in 2015, gained $30,000 in 2016, and its looking like $40,000+ in 2017.  I know a little bit about what I’m talking about 🙂

***Those interested in learning more about price reading and using support and resistance lines and price channels would benefit from studying the Wyckoff method. It’s an old technique, but solid and dependable.

****That said, while you should never base a stock trade on any one indicator or idea, you can have too many.  A popular rule of thumb is to limit yourself to five. If you can’t identify a good trade with five indicators, or are too scared to operate unless you consult everything, then you should avoid trading altogether.

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