Survival is probably the most important skill in trading. Capital is the lifeblood of your business. If you get wiped out, all other skills are worthless. In this brutal market, whether you wash out as countless others have or live to see another bull market depends on how well you practice survival skills.
1. Diversification
Old but true. The more stocks you carry, the closer you get to the market return, BUT: the farther you get from being crushed in a string of bad trades. It’s not easy to find tenbaggers. We all know the past ones, but try to name the next five or ten that one should be buying now.
Since we don’t know who those new Ciscos or Tasers are going to be, it’s best to buy as many fresh breakouts as possible and let the market do the sorting. Some markets produce dozens of strong breakouts, others – just a handful. If you go with the flow, you will be fully invested (and even on margin) in a good market, and largely in cash in a bad one. Just keep your position sizes constant.
2. Position sizing
Have you ever looked at a tenbagger and said: if I’d just put all my money into this stock, I would have been rich by now! Why didn’t you?
How many tenbaggers can you name? 10? 20? Out of roughly 10,000 stocks, that’s a 1/10 of 1% chance to strike it rich. A 99% chance to lose. With odds like this, you MUST discipline yourself to limit your position size no matter what.
One way is to never risk more than 2% of your capital on any one trade. Another is to determine your maximum dollar loss. If it is, say, $400 per trade, and you cut your losses at 10%, your maximum position size is $4,000.
3. Cutting losses
NEVER lose more than 10% on a trade. Any stock can drop 10% for any reason at any time. You can’t avoid it – comes with the territory – but you can minimize the chances of that happening by buying right. Don’t argue with the market, don’t try to convince yourself that you are right and the market is wrong – just get out, until next time. Remember: you are not the stocks you buy.
4. Averaging down
You can build your position over time by buying in installments. Your first installment is the marker. NEVER average down from it. We all would like to get a better price in a pullback, but don’t confuse a pullback with a selloff. Plus, a sharp pullback may be a sign of weakness – not good. Do this: buy on a pullback, but ONLY when your position is showing you a profit and the pullback price is still above your original purchase price.
5. Staying in cash
We all want to get rich sooner rather than later. But you can’t force profitable trades on a lousy market. If you are showing a string of losses, it’s time to step back and pause. There will be another day – just not today. Let others lay the foundation for new strong bases from which you will buy. The constant allure of easy profits (or desire to make up for past losses ASAP) makes this rule hard to implement. Ignore the constant buzz from financial gurus and talking heads like “doing nothing is not an option,” “stocks outperform other assets over time,” “have a plan and stick with it,” and “how are you going to achieve your goals with 1% return?” Plus 1% is still better than minus 20% in my book, and you can make all your money for the year in just a couple of months if you keep your powder dry and move when it’s time.
Slav Fedorov is a full time stock trader and founder and managing member of TradingZoom, LLC – a provider of timely stock picks in small caps based on proprietary selection methods.
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