Trading Lesson #1

Tuesday, April 22, 2008

When buying and selling stocks, one of the most difficult things investors must deal with is human emotion.  If one does not learn to deal with the major emotions at play in the market such as fear, greed, hope, and envy, these emotions will wreak havoc with your portfolio. 

There are two things that can help you improve the way you handle your emotions while you are trading.  The first thing you must do is conduct your trades using a sound system based on time-tested rules.  Here at The Gilmo Report we use a system based on rules established by some of the greatest traders of all time such as Jesse Livermore, Nicolas Darvas, Richard Wyckoff and William O’Neil.  When we offer you an Actionable Stock Idea, it is because we see a situation where we feel, based on these rules that we follow, that the chances for success are good.  You should only trade when you feel that the odds are in your favor.  The market should not be a random walk, not if you are trading with a proven system with established rules.  Often a recommendation will be made because a stock is very near a breakout point or about to hit a level of previous support, such as a major moving average.

The second thing that you can do to help overcome emotion is to “Plan Your Trade”.  Unfortunately, if you ask most traders what their plan is before and after they buy a stock, most would answer “I hope that after I buy it the stock goes up!”  This is not a plan, this is hope, and hope is very dangerous because it tends to feed on your emotions.  Whenever possible, you should know your target entry point and the type of volume that you want to see on each trade, and have your plan for purchasing that stock when it hits your target.  You should also plan the amount of stock you will purchase (that portion of your portfolio you want this stock to represent). 

Next, you should have an exit strategy. In this exit strategy you should take into account a number of possible outcomes.  You first should have a plan to protect yourself should the trade go against you.  When The Gilmo Report offers a recommendation with a target buy point, we will often tell you where you should sell the stock if it fails.  With higher probability trades, such as breakouts from sound “base patterns” on high volume under strong market conditions, you should always limit your losses to no more than 5%-7% from your initial purchase price. 

When the probability of the trade is not quite as high, perhaps because of the target price or market conditions (something that The Gilmo Report will help you to understand within each report), you should consider taking a smaller position and cutting your loss at 3%-4% from your initial buy point.  Also, you need to have a plan if things go horribly wrong.  The more you stick to the very best stocks with the very best fundamentals that have target prices with higher probabilities for success, the better your chance becomes to avoid that disastrous gap down. 

But anyone who has traded the market for any amount of time can tell you that even the best-looking stocks can have a major event or announcement that sends the stock into a downward spiral or even gap the price down with no chance to get out before significant damage has been done to the price.  The question is:  What do you do when the price falls significantly below 5% or 7% from your initial purchase price?  This is, unfortunately, where most people freeze up and become the proverbial “deer in the headlights.” But this is the time for quick action.  You must have a plan for this situation as well, and that plan should be to get out of trouble as quickly as you can and protect your capital. 

Take a look at CROX late in 2007.  This stock had tremendous fundamentals and had been a true market leader.  After a huge stock price run of well over 300% there were great expectations for the stock as it reported earnings at the very end of October 2007.  The stock had a disappointing earnings report and gapped down from roughly $75 to $53 – quite a serious haircut.  This is where many investors got caught staring into the headlights, hoping this “leading stock” would bounce.  After all “it must be oversold…surely it would recover.”   But the real move here would have been to cut your losses, and fast!  In fact, CROX over the next few months not only DID NOT recover, as many of the TV pundits predicted, it followed up that decline of roughly 30% with a slow painful decline of another 66% from $53 to around $10.

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Finally, it is imperative to also have a plan for success. Again, it is fine to hope your stock will rise, but what you do with your profit is just as essential as cutting your losses. Otherwise, to paraphrase Wyckoff, those profits will only be “borrowed money,” or as others would say, paper profits. Unless you feel you have a true market “monster” (and mind you those are few and far between) most stock gains should be locked in at a 20%-25% profit. If you continue to buy high probability stocks, cut your losses short, and lock in your profits at 20-25%, you are truly creating a winning formula.

The key elements here are:

1. Have a system for selecting the very best stocks based on sound time-tested rules.

2. Know how to understand when the odds are in your favor.

3. Understand where your entry point is and what your position size will be.

4. Establish your exit strategy for all situations – good, bad, or awful.

5. Execute according to your plan.

To summarize: Plan Your Trade, And Then Trade Your Plan. This will help manage your emotions and allow you to more safely traverse the ups and downs of the stock market.

Chart courtesy Qcharts.