Step Nine -Trading the Plan

Wednesday 11th July 2001

In the previous eight articles we have discussed and explained a wide range of stock market concepts. We have looked at how the stock market began, how it functions, and how an individual can invest and trade in shares.

In the next two articles we will begin to apply some of the concepts we have discussed in real trading and investment scenarios. This article will focus on short term trading for profit. Next weeks article will follow some longer-term investments for growth and value.

Remember that trading is specifically aimed at making short-term profit from an increase in price. Traders focus on the price performance rather than the business activity of the company. The example below might be different from your own strategy. It is only designed to demonstrate a basic trading plan.

Short-term trading for profit requires several specific skills. Most of these skills can be learned and tested before you commit any money to the market. The one skill that cannot be taught is discipline.

Discipline is required in all investing, but it is of most importance when you are short-term trading. A good trading plan will help you to be disciplined, but the final decision is always up to you. The following examples demonstrate some basic trading strategies and the discipline required protecting your money and securing your profits.

Trade One A New Zealand Tech Company (ABC)

Day One

ABC has been in a sideways trend for several months. One basic trading buy signal has been generated by the price of the share moving well above the current trend.

The price has closed at $2.80. We will buy the next day as soon as the market opens.

We will now plan the trade so that we will be able to remain disciplined and protected.

Trading Plan

We will buy at approximately $2.80. Once we have bought we will set a "stop-loss" level at 10% below the closing price of the previous day.

A stop-loss level is a price level that you are not prepared to see the price drop below. This means that if the price falls to your stop-loss level, you will sell.

There are several ways to decide your stop-loss level. You can set an arbitrary percentage, as in the example above, or you can use more complicated technical indicators to fit a specific stop-loss strategy to a particular share.

We will use a simple 10% stop-loss level below the closing price of the following day. This means that on day one our stop-loss level is $2.52. This is $2.80 minus 28 cents (10% of $2.80). This means we are currently risking 10% of the money that we placed into this share. If we decided that this was too much, we could use a 5% stop-loss level, or if we were prepared to take a greater risk, the percentage could be increased.

One Week Later

We bought the share at $2.80.

The price has increased to $3.50. We will continue to use the 10% stop-loss level as our protection.

Therefore the current stop-loss level is going to be at $3.15.

We are now protecting some profit. If you were a more aggressive trader you could increase your stop-loss level to protect even more.

Two Days Later

The share price has fallen.

The price has decreased to $3.30. Because we are in the business of protecting our profit we will not lower our previous stop-loss level of $3.15.

This means that the price is only 15 cents away from the point where we will have to sell.

It is often tempting to sell at this point. But we will stick to our plan and wait.

Six Days Later

The share price has increased to $4.15

Our stop-loss level is now at $3.75.

We have protected a good profit and now we must stick to our plan and sell if the price falls below our stop-loss level.

Nine Days Later

The share price has been dropping

The price is currently at $3.72.

This is below our stop-loss level of $3.75. Therefore it is time to sell.

We tell our broker to sell the next day as the share opens for trading.

The following day the share was sold at $3.72. We bought the share for $2.80 and sold it for $3.72. The result was a profit of 38% over five weeks.

This is certainly a good result. However it is also an exceptional example. We used a very basic strategy and followed our plan. It is important to understand that many shares that you will trade will not make a profit.

We risked a total of 10% on the trade above. We successfully made 38% but what would happen if the next three shares that we bought actually dropped instantly in value? We might have to sell each at a loss of 10%.

This would mean a loss of 30% over the three bad trades and a profit of 38% on the good trade. The net result would be about 8% profit. We only made money on one out of four trades and still managed to show an overall positive result.

This demonstrates three things:

Firstly, you must have the discipline to make and take profit. It is essential that you use a plan that allows a share to increase without selling too aggressively.
Secondly, you must have the discipline to sell shares even if they do not make a profit. If one of our three bad trades were to lose 20%, we would be in a negative overall position.
Thirdly, you must be consistent.

Trading requires an active daily interest in your investments. You must develop a strategy that suits you and you must then have the discipline to follow that plan through good and bad markets.

Trading can be a rewarding and frustrating investment strategy. The amount of effort that you put in is directly proportional to the amount of reward you receive. If you are interested in learning more about trading and developing a trading plan, then check out the web site of Intelligent Investing by clicking here.

Next week we will look at a real example of investing for value in an undervalued New Zealand company.

This article was written by Nick McCaw from Intelligent Investing.

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