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In this week’s column I want to talk about how to start trading. But first, let’s define trading: it is any transaction the duration of which is expected to be shorter than three years. This is the definition the South African Revenue Service uses, and I concur.
It does not need to include geared products such as foreign exchange (FX), contracts for difference (CFDs) or futures (see sidebar). It is about how long one holds a position and the three-year rule means a lot of people who consider themselves investors are perhaps traders as they hold for less than three years.
The first thing a newbie to trading must truly understand is that you are not going to make money quickly. There is a lot to learn and, like with any other skill, it will take time to master. Generally, my advice to you as a new trader would be to forget about making money for the first year or two, and rather set a goal to break even over this period. Protecting your capital is critical because when it’s gone, well, you’ll have to start from scratch again.
How to use a stop-loss
You protect capital by using one very simple tool: a rigid stop-loss. This is a predetermined level at which you will accept that the trade is not working. Once the stock reaches this level, you will exit the position without hesitation. The problem with a stop-loss is that, far too often, traders ignore it because they either don’t want to take the loss or because of the pain of being mistaken. But that’s going about it all wrong. Any trade you enter is merely about probability and even successful traders will be wrong about half the time. But if your profitable trades make more money than those that lose money, you’re winning.
Taking it a step further, you can’t use profit or loss in any individual trade as your metric for success. Even if you do everything right, this trade may just be one of the 50% that result in a loss. In other words, you could do everything right yet get stopped out at a loss. How can you decide if a trade is bad when you obeyed the rules?
So, a much better way of measuring our success as a trader is to decide what a perfect trade looks like and try to execute one perfect trade after another. This list of what makes a perfect trade would not include profit or loss, but would include questions such as: Did I wait for confirmation? Was the position size correct? Did I have an exit strategy in place before I entered the trade? Did I adhere to that exit strategy? I use a list of seven points and my aim is simple: to get a perfect 7/7 in every trade.
Another important aspect of a stop-loss is, obviously, where you place it. Typically, traders place it far too close to the entry. For example, 3% away from entry on a stock that has an average daily move of almost 2% and an average true range of almost 5%. These two values tell you that your 3% stop-loss will almost hit even as the share is moving in your direction over the duration of the trade. You need to reduce the size of the trade and move a stock stop-loss to around 8% from the entry, giving you more wiggle room.
Trading smaller is also a very important starting point for newbies. You might be tempted to put all your capital into a trade because you’re confident about it, but as I mentioned above, trading is about probability and any trade could be profitable or losing. You need to make sure that you’ll survive those losing trades.
This article originally appeared in the 26 January edition of finweek. Buy and download the magazine here.
