When considering best trading practices, it’s easy to discard the idea as too general and simplistic, or to default to the industry’s well-worn cliches. However, for both new and experienced traders, there are several rules that constitute a sound approach to trading.
Although it takes time, effort and money, lessons are more lasting when dealt by the uncompromising hand of experience. In one trading venture, I made so many mistakes that the only steps I didn’t take represent a solid summary of what you should do.
After quitting a safe job at a major U.K. firm for a considerably more risky role with a startup, your humble correspondent came across an untested personal opinion that an unproven U.S.-based software company, Select Software Tools, had strong growth prospects. That was all the research this would-be trader needed to justify a significant financial investment.
Let’s go through the process step-by-step as this trade was established and evolved to see what should have been done instead.
1: Trade for the right reason
I was going to make a killing. I was excited not only about the financial rewards sure to come, but the prospect of playing in the overseas financial markets. The bulk of my research? Finding out how to open a brokerage account and looking up the stock symbol.
Trade for one reason only: to make money. If you’re in this for excitement, to prove you’re right, because you’re bored, or because a colleague talks up the next Microsoft, you’re doomed
to fail.
2: Match broker to your needs
After an extensive search, I decided on E*Trade UK as my brokerage firm (it was the first broker listed alphabetically in the phone book that had direct access to U.S. equity markets). I opened an account and deposited the £4,000 that I had decided would be enough to make this activity profitable. I somehow determined this without knowing the actual price of the stock. While waiting on the paperwork, I looked a bit more into Select Software Tools and even learned the ticker symbol: SLCTY.
Evaluate brokers based on your specific requirements for execution venues, speed, accuracy, customer service, fees and financial soundness. Also, make sure your broker is aware of your needs as a trader. For example, if you are opening an account to make your first trade, tell them. If you plan to trade anything out of the ordinary (such as non-domestic stocks), let them know. If you don’t, you might not get the type of service you need.
3: Understand the risks of a position
After my check cleared and I knew the stock symbol, I simply phoned up E*Trade UK customer services and asked to speak to someone to place a trade.
“What company do you want to buy?” the customer service rep asked.
“Select Software Tools, S-L-C-T-Y,” I responded, proud that I knew the symbol.
“I can’t find a listing for that firm,” he said. “Does it trade on the London Stock Exchange?”
“I’ve got no idea. It’s an American company, if that helps.” I said.
“Oh, your account doesn’t have permission to trade on American exchanges. That requires another set of forms. We’ll send them to you,” he said.
I was frustrated. I was surely missing out on huge profits and hoped the price wouldn’t go up significantly before I got the right forms. That’s when it struck me that I should take this opportunity to actually look up the price so I could determine how many shares I’d get with my four grand.
In addition to your personal analysis of the market, always have a clear idea of past price history for any market you are considering. Know the historical highs and lows, as well as significant areas such as past support and resistance. Go beyond price, however. Also know the volatility. Know what qualifies as a big day. School yourself on the logistical minutia and by all means, for anything not priced in your base currency, know the currency risk!
4: Select entries carefully
After some research, I figured out that I was dealing with a Nasdaq stock because my company had a five letter symbol. With that, I was able to find out that SLCTY was trading around $5 per share.
I was smart enough to know what I didn’t know, in this case, namely that I wasn’t sure whether $5 was good or bad because I had no reference point. Historical data would have been helpful, but considering I didn’t know what to do with it, it probably didn’t matter that I couldn’t find any.
From the price, I was able to apply my sophisticated risk-management strategy: 4,000 divided by 5 = 800 shares.
I eagerly filled out the forms and sent them back, full of pride that I’d sound like a real genius when it came time to call the broker back.
Have clearly defined rules for when to enter a trade. Choose something that makes sense for both your trading method and the market you are trading. Your entry trigger should view current price and recent price action relative to accurate historical technical and fundamental data. One look at “Time to buy” (below) might have given even a new trader pause about buying the company in question.
Understand how the risk on a particular trade fits into your overall portfolio risk. Don’t take too much or too little risk on any one position. Size positions with respect to relative volatility, not just how much money you have to invest. And, if your trade is denominated in a foreign currency, don’t forget about both currency conversion and risk.
5: Mechanics trump everything
I called the trade desk as soon as the final forms cleared, only to be told that a) I need to call the U.S. trading desk, and b) that it’s 5 a.m. in the United States and I need to call back at 2:30 p.m. GMT. I passed the time by looking up the price of SLCTY again. Yep, still $5. (It didn’t cross my mind that Nasdaq hadn’t opened for trading yet.)
At 2:30 p.m. sharp, I was on the phone and gave them my order.
“Eight hundred shares of SLCTY please.”
“Well, you can’t buy U.S. equities with a sterling-denominated account. Should we initiate a currency transfer?”
Dreading another delay, I asked if that required more paperwork.
“No, as cleared funds, we can do it right now,” I was told. “You have $6,858 in your account. How many shares was it you wanted to buy?”
That’s when I realized yet another screw up: I made my calculations in pounds, not dollars.
“I don’t know. I’ll call you back,” I said before hastily hanging up.
The process of grabbing the calculator and playing with the new number did get me thinking, however. I decided that it might not be a good idea to use the whole amount on one trade. Instead, I would buy 350 shares with $1,750. Risk management at its finest.
I phoned back.
“OK, 350 shares of SLCTY please.”
“Right, that’ll be $1867.50, if you’re filled at the current ask of $5-1/4,” a new rep informed me.
“Wait a minute,” I said. “Why isn’t that $1,750? Where did the extra $117.50 come from?”
“Well, the current price is $5-1/4 and you have $30 in commission to execute the trade,” he said.
Not only did it not occur to me that the price I’d have to pay would be different from the last trade price, but I forgot about the commission too. I asked the rep if there was any way I could say what price I’d pay for the shares.
“Yes you can,” he said. “It’s called a limit order.”
“OK, I want 330 at $5-3/16 please,” I said, feeling really smart. I knew prices were in sixteenths for this equity and at that price, with the $30 commission, 330 shares would come in under the $1,750 I wanted to pay.
He repeated my order: “That’s a limit order for 330 shares at $5-3/16 in SLCTY. Good for the day or until
cancelled?”
I wasn’t expecting that new question.
“Uh, until cancelled, I suppose,” I responded.
“Your ticket number is 1436752,” he said after a few seconds.
I waited, expecting something to
happen.
“Are you still there, Mr. King?”
“Did I buy the shares?” I asked.
There was a long pause.
“Er, no. This stock doesn’t trade actively, and the market price is $5-1/4, which is above your limit price,” he said slowly and clearly.
“OK, I’ll call back later,” I said and hung up before he could expose any further ignorance on my part.
You need to understand the nuts and bolts of the market you are trading, including market terminology. Do not make assumptions. Understand what order types are available and effectively use them to your advantage.
To use various order types effectively, you must understand the market environment and have clear goals. Don’t miss a trade for the sake of a tiny price improvement at the start.
This might seem overly elementary; however, in an era when new markets are coming online constantly — e-forex, exchange-traded funds, single stock futures, binary options, narrow-based indexes, etc. — we can’t assume that our tried and true procedures are valid across the board.
6: Have a plan
The next day, I was told that I had bought 68 shares at $5-3/16 and the rest of the order was not filled. I had been charged $30 in commission anyway. They asked what they should do with the rest of the order. I didn’t know, really, so I told them to leave it.
The important thing, though, was I was filled, and at what I now considered a really good price. I hoped the rest of the order could get filled there, too. I waited. Nothing happened. I phoned back, no fill. The brokerage statement came at the end of the month and it said I had 68 shares and the sum total of my profit on the entire position was a whopping $3. Not enough to cover the $30 commission, but something.
Then, the market started to move. The price went up to $6, leaving my standing limit order in the dust. I couldn’t believe it. I missed out on a whole $1 move by trying to save a measly sixteenth. I didn’t want to miss out on any more profit. I phoned up and entered a market order to buy 332 shares at the market. This would give me a nice round 400 shares. I got filled at $6-1/4. I owned 400 shares at a total cost of $2,482 for an average per-share price of around $6.21 including commissions.
A complete position management plan is a critical element to trading on any level. You need to have rules for how and when will you scale-in (add), scale out (reduce) or completely exit a position. You need to define how you will make adjustments for changes in volatility and for an increase or decrease in your account size. You also need to focus on the seemingly small stuff, such as how you will handle non-filled portions of a previous order.
7: Have a well-defined exit strategy
The price bounced up and down for awhile. Then it moved back down to $5. The next unexpected development was when my statement came at the end of the month, I learned that I owned 662 shares. There was an extra order on my statement for 262 shares at $5-3/16.
I phoned up E*Trade. “That was your limit order at $5-3/16 for 330 shares. You got 68 shares on the 9th and then the remainder on the 23rd when the price dropped to $4.50,” the rep said.
Obviously, I’d forgotten to cancel the limit order when I placed the market order. I now owned 662 shares with an average cost of $5.86. The market price was $4.50, 23% below my average cost.
Exit rules need to be established based on reason, not emotions or sloppiness. Avoid getting excited when you’re up and depressed when you’re down. Pre-define the maximum loss you will allow yourself to sustain. Never, ever add to a losing trade.
8: Don’t put all your equity in one trade
The price was $4 in a few months. For me, this was a great buying opportunity, particularly with an earnings announcement coming soon. I did what seemed to be the most logical thing: I bought another 768 shares at $4 with the remaining $3,072 dollars in my account. The average price was $4.79 for the 1,430 shares I owned.
What happened next made me feel like a genius. The price went up to $8. I was up 67%. I would make at least 1,000% if things carried on like this. Then the price went flat. Things were quiet as I waited on the earnings announcement. The price started to go up again just before the announcement day, but then it dropped quickly. Maybe earnings weren’t that good after all. The price was back to $4. I was under water, and I felt like I was drowning. I couldn’t bear to check prices and I couldn’t stop checking them.
The price went to $3, then $2, then $1. I was so clueless. I wondered if a buy order above the current price would make it move up a bit. The stock was de-listed. Still I held on. The price went below $1, then pennies. I didn’t even have enough equity in the account to cover the commission to exit the position. Somehow, I had lost more than 100% of my original capital without using margin – now that’s what I call a proper losing trade.
No trade is worth your entire stake in the markets. Do that, and “It all ends in tears” could represent your investment success, as well. That’s because no trade is a sure thing, and nobody can predict the future with absolute certainty. If you have reason to believe that next earnings announcement will exceed the expectations of the street, great. Bet on it. But understand that, to some degree, it’s exactly that, a bet. You can’t remove all elements of randomness or uncertainty out of a forecast and actually knowing what the market expects is not as simple as researching what one or two analysts say.
Don’t let the fact that there is no way you would make all the mistakes listed here give you a false sense of security. Chances are you are still making some of them, and any one could lead to disaster. The most important practice is to have a plan so you know precisely what you will do in numerous scenarios before you are faced with them. Trading without a detailed plan is a big mistake. If you do, you’re going to lose money.
Paul King is author of the book “The Complete Guide to Building a Successful Trading Business.” His firm, PMKing Trading LLC www.pmkingtrading.com , helps international clients build and launch U.S.-based hedge funds. Reach him at futures@pmkingtrading.com
