Three Steps for Effectively Managing Trades
Stock selection is a good start for traders, but good trade management is key to success
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The vast majority of stock market advice is focused on stock selection. Stories about a great stock and why it is so great are a staple of financial journalism. Everyone wants the next great stock that they can buy and hold forever, just like Warren Buffett has been known to do.
A few such great stocks come along occasionally, but 98% of the stocks that investors buy require some effort and action to keep losses small and maximize gains. The easiest way to produce subpar results is to ignore stocks that are acting poorly because you don’t want to admit that you may have made a mistake by selecting them.
Trade management sounds very simple in theory: Cut your losers quickly and let your winners run. But the devil is in the detail. At what point do we declare that a stock is a loser? When does a winner stop being a winner?
The reality is that most investors don’t put much thought, if any, into what they will do after they buy a new stock. There is a plan to hold it for some unknown period of time, and there is not much thought about if and when they might sell it.
Formulating a trade plan is extremely difficult because so many different things can happen. For example, maybe it really is a great stock, but it doesn’t go up as hoped because of poor market conditions. Maybe it is a lousy pick, but a strong market supplies a tailwind of momentum. Maybe it’s the wrong sector at the wrong time.
There are a million different things that can happen, and it is impossible to plan for all of them. Rather than try to forecast the future, the better approach may be to be in a position to react to changing circumstances rather than to try to forecast them.
In general, my view is that trying to predict the future is a losing game. No one can do it consistently and with great accuracy. It is a distraction more than anything. Rather than trying to guess what the future may hold for a stock, the better approach is to manage the trade as it develops. Instead of anticipating a long list of potential outcomes, react quickly to what actually does occur.
Here is my three-step approach to trade management:
1. Be clear about your investing style. The easiest way to mess up a trade is to not be clear about what you are hoping to accomplish. Are you buying this stock for a quick flip, or are you looking to make it a core, long-term holding? Far too often, a lousy trade turns into a long-term investment because there is no clarity of intent. You can always change your mind if the stock doesn’t do what you hope, but be sure you are clear about what you are trying to accomplish.
2. Don’t rush to buy a full position immediately. When you take a partial position, it forces you to develop a plan for what you will do next. You either buy more at some point or decide that it was a mistake and dump it. If you happen to take the most common course of action and just ignore it and hope it works out, it won’t do too much damage.
Partial buys allow you time to develop a better feel for the stock and more fully understand the fundamentals. It also gives you time to consider shifting market conditions and other factors that will impact how you will trade the stock. Emotions are often your worst enemy, but they are far less of a problem when you make incremental decisions instead of jumping in with both feet immediately.
3. Use more than one time frame. The best way to reduce risk is to trade the same stock in many time frames. This is sometimes referred to as "trading around a core position." Adjusting the size of your position in response to market conditions, technical patterns, news flow, earnings reports, and other factors allows you to press when the time is right and pull back when the risk becomes too great.
That is it: clarity of intent, incremental entry, and multiple time frames. There are many other considerations as well, but if you do those three things, you will have a foundation in place for a trade management system that will help you enhance your returns.
At the time of publication, DePorre had no position in any security mentioned.
