Before investing or trading, it is important to
develop a strategy or game plan that is consistent with your goals and style.
The ultimate goal is to make money (win), but there are many different methods
to go about it.
As with many aspects of trading, many sports offer a good analogy. A football
team with goals geared towards ball control and low-scoring games might adapt a
conservative style that focuses on the run. Teams that want to score often and
score quickly are more likely to pursue an aggressive style geared towards
passing. Teams are usually aware of their goal and style before they develop a
game plan. Investors and traders can also benefit by keeping in mind their goals
and style when developing a strategy.
Goals
First and foremost are goals. The first set of
questions regarding goals should center on risk and return. One cannot consider
return without weighing risk. It is akin to counting your chickens before they
are hatched. Risk and return are highly correlated. The higher the potential
return, the higher the potential risk. At one end of the spectrum are US
Treasury bonds, which offer the lowest risk (so-called risk free rate) and a
guaranteed return. For stocks, the highest potential returns (and risk) center
around growth industries with stock prices that exhibit high volatility and high
price multiples (PE, Price/Sales, Price/Hope). The lowest potential returns (and
risk) come from stocks in mature industries with stock prices that exhibit
relatively low volatility and low price multiples.
Style
After your goals have been established, it is
time to develop or choose a style that is consistent with achieving those goals.
The expected return and desired risk will affect your trading or investing
style. If your goal is income and safety, buying or selling at extreme levels
(overbought/oversold) is an unlikely style. If your goals center on quick
profits, high returns and high risk, then bottom picking strategies and gap
trading may be your style.
Styles range from aggressive day traders looking to scalp 1/4-1/2 point gains to
investors looking to capitalize on long-term macro economic trends. In between,
there are a whole host of possible combinations including swing traders,
position traders, aggressive growth investors, value investors and contrarians.
Swing traders might look for 1-5 day trades, position traders for 1-8 week
trades and value investors for 1-2 year trades.
Not only will your style depend on your goals, but also on your level of
commitment. Day traders are likely to pursue an aggressive style with high
activity levels. The goals would be focused on quick trades, small profits and
very tight stop-loss levels. Intraday charts would be used to provide timely
entry and exit points. A high level of commitment, focus and energy would be
required.
On the other hand, position traders are likely to use daily end-of-day charts
and pursue 1-8 week price movements. The goal would be focused on short to
intermediate price movements and the level of commitment, while still
substantial, would be less than a day trader. Make sure your level of commitment
jibes with your trading style. The more trading involved, the higher the level
of commitment.
Strategy
Once the goals have been set and preferred style
adopted, it is time to develop a strategy. This strategy would be based on your
return/risk preferences, trading/investing style and commitment level. Because
there are many potential trading and investing strategies, I am going to focus
on one hypothetical strategy as an example.
GOAL: First, the goal would be a 20-30% annual return. This is quite high and
would involve a correspondingly high level of risk. Because of the associated
risk, I would only allot a small percentage (5-10%) of my portfolio to this
strategy. The remaining portion would go towards a more conservative approach.
STYLE:
Although I like to follow the market throughout the day, I cannot make the
commitment to day trading and use of intraday charts. I would pursue a position
trading style and look for 1-8 week price movements based on end-of-day charts.
Indicators will be limited to three with price action (candlesticks) and chart
patterns will carry the most influence.
Part of this style would involve a strict money management scheme that would
limit losses by imposing a stop-loss immediately after a trade is initiated. An
exit strategy must be in place before the trade is initiated. Should the trade
become a winner, the exit strategy would be revised to lock in gains. The
maximum allowed per trade would be 5% of my total trading capital. If my total
portfolio were 300,000, then I might allocate 21,000 (7%) to the trading
portfolio. Of this 21,000, the maximum allowed per trade would be 1050 (21,000 *
5%).
STRATEGY:
The trading strategy is to go long stocks that are near support levels and short
stocks near resistance levels. To maintain prudence, I would only seek long
positions in stocks with weekly (long-term) bull trends and short positions in
stocks with weekly (long-term) bear trends. In addition, I would look for stocks
that are starting to show positive (or negative) divergences in key momentum
indicators as well as signs of accumulation (or distribution). My indicator
arsenal would consist of two momentum indicators (PPO and Slow Stochastic
Oscillator) and one volume indicator (Accumulation/Distribution Line). Even
though the PPO and the Slow Stochastic Oscillator are momentum oscillators, one
is geared towards the direction of momentum (PPO) and the other towards
identifying overbought and oversold levels (Slow Stochastic Oscillator). As
triggers, I would use key candlestick patterns, price reversals and gaps to
enter a trade.
This is just one hypothetical strategy that combines goals with style and
commitment. Some people have different portfolios that represent different
goals, styles and strategies. While this can become confusing and quite time
consuming, separate portfolios ensure that investment activities pursue a
different strategy than trading activities. For instance, you may pursue an
aggressive (high-risk) strategy for trading with a small portion of your
portfolio and a relatively conservative (capital preservation) strategy for
investing with the bulk of your portfolio. If a small percentage (~5-10%) is
earmarked for trading and the bulk (~90-95%) for investing, the equity swings
should be lower and the emotional strains less. However, if too much of a
portfolio (~50-60%) is at risk through aggressive trading, the equity swings and
the emotional strain could be large.
