Understanding the Profit Potential of a Trade
Stockscores.com Perspectives for the week ending December 2, 2007
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In this week's issue:
If I told you that my stock picks were right 70% of the time and that I only lost money 3 out of 10 times, would you think that I was making money in the market? Most traders would love to have that kind of accuracy and assume that it ensures consistent profitability. But beyond stock picking prowess, there is another factor that is more important to determining long term trading success.
How much you make when you are right and how much you lose when you are wrong is key.
Consider the numbers. A trader that makes an average gain of $1000 when he is right and then loses $7000 a trade when he is wrong has to be right 88% of the time to make money. While it is very difficult to be right that often, it is not hard to have that lopsided of a gain/loss ratio.
The reason is simple. As human beings, we are programmed to let losses grow bigger over time and sell our winners early. If you are a normal human being, you are wired to fail in the stock market.
To be a great trader, you have to think differently about risk.
The best traders I know are those who don't care if they lose money. They don't judge their market performance one trade at a time. They don't let small losses grow in to big losses. They add to their winners. They ride a strong stock until it has shown important signs of topping out.
What do you do?
If you are like 90% of investors, you don't plan your losses and instead hold on to a weak stock way too long with the hope that it will turn around. Hope turns traders in to long term investors. Hope belongs in the bedroom, not in the stock market.
If you are like 90% of investors, you sell your profitable trades at the first sign of weakness. You may even sell them before they show weakness because you love to rejoice in the feeling of making a profit. You worry about your winner turning in to a loser and are afraid of the pain that you feel when this happens.
It all comes down to pleasure and pain. These two words are why most people have trouble beating the stock market. If you want to be a great trader, you have to reverse your mental associations to them. If you do, then making money is easy.
I have met many traders who tell me that they would make money if they only shorted when they bought or bought when they shorted. The truth is, reversing the position is not enough to reverse your fortunes. The reason is simple; it is not the stock pick that determines your success, it is how you react to seeing a loss or a gain. It is what you do after you enter the trade that matters.
Some simple rules:
Never add to a loser
Plan your stop loss points
Execute your exit when the stock hits your stop loss point
Don't take more risk than you are comfortable with
Don't watch the profit/loss figure, watch the chart
Be prepared to ride out short term pullbacks in long term trends
Sell when there is a reversal signal, not when it feels good
Be selective about what you trade
These are simple rules that are hard to follow because of the eight inches between your ears. If you can keep your emotions in check then you can trade well. If not, go to Las Vegas. At least there they give you free drinks.
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You have to adapt to market conditions if you are going to be a successful stock trader. That means that you are not going to apply the same strategy in all market situations; you might apply a short selling strategy one week and a buying strategy the next. The anticipated hold period for one strategy might be a lot longer for one market situation than another.
Over the past month, the stock market has been selling off pretty dramatically and in recent weeks I have been pushing strategies that traded stocks for a bounce off of support from oversold market conditions. Last week, I featured three stocks that were all likely to bounce back this week, and all three did just that. That strategy was appropriate because the overall market was pulling back to support and was also likely to bounce.
The market has been led lower by the Dow, pressured by concerns over the subprime mortgage market and the way that many banks bought that debt in the asset backed bond market. So, when I went searching for stocks that were likely to bounce from support after some weakness, I looked to the New York Stock Exchange. My aim was to find stocks that had sold off dramatically, had come to long term support and were showing lowering price volatility. Here are a few stocks that I think are worth considering here for a bounce.
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1. IOM
$3.50 has stood up as a floor on IOM many times in the last year, and we find the stock at that price point again and perhaps likely to bounce if the market can stabilize. If the stock closes below $3.25 I would consider this trade a mistake and get out.
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2. LMC
LMC has fallen from $14 to $9.50 in seven weeks but has bounced off of that price point twice in the last year where it has gone on to significant gains. I think the emotion may be overdone here and the panic will give way to opportunity. If the stock closes below $9, cut the loss.
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3. ERF
$40 held up as support in January, March and August and now we are at that price floor again after ERF suffered an $8 slide for the month. The stock looks good to bounce back in the near term so long as it can hold on a close above $39.
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References
Get the Stockscore on any of over 20,000 North American stocks.
Background on the theories used by Stockscores.
Strategies that can help you find new opportunities.
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Build a portfolio of stocks and view a slide show of their charts.
See which sectors are leading the market, and their components.
Disclaimer
This is not an investment advisory, and should not be used to make
investment decisions. Information in Stockscores Perspectives is often
opinionated and should be considered for information purposes only. No
stock exchange anywhere has approved or disapproved of the information
contained herein. There is no express or implied solicitation to buy or
sell securities. The writers and editors of Perspectives may have positions
in the stocks discussed above and may trade in the stocks mentioned. Don't
consider buying or selling any stock without conducting your own due diligence.
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