Have you ever bought a seemingly good stock only to have it start going down?
It’s like there’s some conspiracy out there against you and as soon as you buy the damn thing starts going the other way!
I’ve been there. I’ve felt your pain. But don’t worry, there isn’t a worldwide government conspiracy against you. There’s an incredibly simple tactic you can use to quadruple your success rate in the markets - the pros know it, so why shouldn’t you?!
Build a Trade-Map
It's called trade mapping. Have you ever driven to the airport and got on a random flight without knowing where it was headed? Well, maybe you have if you’re the free-spirited type, but I think it’s safe to say you’ve never gone on a trip without first planning things out beforehand.
When are we leaving? Where are we going? How much will it cost? When are we coming home?
These are all questions you answer before heading to the airport, so why should investing your hard-earned money be any different?
In a nutshell, a trade map outlines every aspect of a specific stock purchase you’d like to make. Think of it like following a recipe for baking a cake. It can be applied to any type of financial investment, but it’s typically used for the more risky stuff like that penny stock your cousin Bill told you about at the family picnic.
If you’re buying something safe life GIC’s, bond’s, or some other type of fixed income investment you won’t need to complete a trade map. A trade map is used for stocks you want to speculate on, i.e. a stock you think might go up so you want to buy it and make a profit, but it's not something you see yourself holding for a long period of time.
For the safer stuff like Blue Chip stocks or an Index ETF, don't worry about preparing a trade map since you'll likely hold these investments for a much longer period of time.
Identify your risk tolerance FIRST
The first thing you want to ask before you ever click the “buy” button is: How much am I willing to lose in the worst case scenario?
Now, you’re probably thinking, “what do you mean, lose? If it goes down I’ll just hold onto it until it comes back up. Right?" Wrong! This is one of the biggest and most common mistakes the average investor makes and it’s the reason you hear so many horror stories about people losing their shirts in the stock market.
Example: Let’s say Granny gave you some birthday cash and you now have $1,000 sitting in your account, ready to become a self-made stock market millionaire. Before you buy anything you need to know exactly how much of that $1,000 you are willing to risk on any single stock trade.
The standard benchmark for most professional investors is between 2% - 5%. Personally, I stick to 2% unless I’m incredibly certain a stock is going to do what I think it’s going to do. If you go over 5% you’re just asking for trouble. Let’s use 3% for this example.
Recap, we have a $1,000 portfolio and we want to buy a stock - let’s call it stock XYZ, and if things go completely wrong and the stock price goes to $0 we don’t want to lose any more than 3% of our total portfolio value ($30). We’ve now established our risk tolerance.
Remember, it not about how much you can make, it’s about how much you can lose. This is the single-most important difference between successful professional investors and those who’ve lost their kid's tuition money betting on penny stocks. Focus on risk first and the profits will naturally flow.
How do I know when to sell?
Next step: now that we’re clear on how much we’ll lose if **** hits the fan, let’s figure out how much we want to make.
Just like knowing how much we can lose, you have to set a profit target so you know when to sell the stock and cash in on your investment. 'Letting it ride' with no idea when to sell it isn’t a winning strategy. The most important part is to have a game plan, otherwise, you’re just gambling and are better off trying your luck at the craps tables.
Some of the most successful investors ever to walk this earth will tell you they'll never buy a stock unless they feel strongly that the rewards (if things go their way) are 3 to 5 times greater than the amount they are willing to risk. Personally, I aim for 5x, but I don’t recommend going lower than 3x.
What does this mean and why is it important?
Going back to Granny’s $1,000 birthday present, if we are willing to lose $30 in the worst case scenario, we want to know that we will make at least $150 (5 x $30) if things go well.
To summarize: we are risking $30 in order to make $150.
This is hugely important because now we only have to pick 1 good stock out of every 5 in order to make money.
As you know, it’s impossible to predict the future, if so I’d be on a yacht sipping champagne with my lottery winnings, but we can certainly stack the odds in our favor with regards to controlling our risk and maximizing our wins. If I only have to be right once out of every five stocks I pick, those are odds I'm willing to take!
I’m a visual learner, what does this look like in bullet form?
- Starting Portfolio Value: $1,000.
- Risk Tolerance: $30 (3%)
- Profit Target: $150 (5 x $30)
Meaning: Worst case scenario we lose $30, best case we make $150.
Let’s set up the trade
Now that we have these two key targets identified we can decide on a stock and prepare to click that exciting little button labeled “BUY”. Let’s continue using stock XYZ for this example:
Pretend stock XYZ currently costs $10 per share. Since we are willing to risk 3% of our total portfolio (i.e. $30) this means we can afford to buy 3 shares of XYZ. Calculate this by dividing your risk tolerance by the current share price ($30 risk / $10 share price = 3 shares)
What if as soon as we buy the stock it starts going down?
It happens all too often - you buy something, it goes down, but you hang onto to it hoping it’ll come back so you can finally just sell it and break even to end this miserable waiting game. Your money gets tied up for months or even years, costing you even more money because now you can’t put that cash to work somewhere else - this is called opportunity cost. Not to worry, we have a plan for this!
We know our risk tolerance is 3% of our entire portfolio, so let’s use that same risk tolerance factor for each individual trade. For example, we buy stock XYZ at $10 per share with a clear game plan that if it goes down more than 3% from where we bought it (i.e. down to $9.70) we sell the stock and cut our loses. This way, before we even buy the stock we know that no matter what we will only lose $0.30 per share if things don’t work out as planned.
But I don’t have time to sit at my computer all day watching the stock price, waiting to sell if it goes below $9.70!
Yes, sitting there all day would suck. Thankfully there's a little thing called a “sell stop” or “stop order”. Every online brokerage or stock trading account has this feature. Essentially, once you buy a stock, you can set a rule that will automatically sell the stock if the stock price goes down past a certain point. With this handy little feature available, once we buy the stock we right away activate our stop order to sell the stock in case it goes down past $9.70.
Lose the emotion
Having a sell stop in place is especially important because it now takes your emotion out of the trade. Emotion is what kills the vast majority of investors and it's easy to fall victim to it.
For example, letting the price come down to $9.70 but not selling and hoping it’ll come back. Then it goes to $9.50, then $9.20, and before you know it the stock price is $7.25. You think, “I can’t sell now, I’ll loose too much! I’ll just wait it out”. Sure your prayers may get answered, but realistically you’re now locked into this lemon stock indefinitely. You should have stuck to the game plan!
Take your loss and move on. Period.
Let’s pretend things don’t go our way and we got “stopped out” at $9.70. We take our loss of $0.90 (3 shares x $0.30) and move on. It’s that simple. Don’t get caught up in "what could’ve been". The trade was no good, and if as soon as you get stopped out the stock price comes roaring back and goes to $11, so be it. Them's be the breaks. No one ever said the market was kind.
The key to remember is that you can’t predict the future so don’t beat yourself up about it. Just move on. Period!
So we lost $0.90 from our $1,000 portfolio, which works out to a loss of only 0.09% from our overall portfolio. Not bad! Consider it the price of admission. We still have lots of cash to play with and most importantly it’s not tied up in some losing stock. We can now begin to look for our next trade opportunity.
What if things DO go our way?
Let’s rework this scenario, but this time let’s pretend the stock goes up.
- Starting Portfolio Value: $1,000.
- Risk Tolerance: $30 (3%)
- Profit Target: $150 (5 x $30)
Meaning: Worst case scenario we lose $30, best case we make $150.
Recall stock XYZ currently costs $10 per share. If our risk tolerance is $30 that means we can afford to buy 3 shares.
- Current Share Price: $10
- # of Shares to Buy: 3
- Total Cost of Trade: $30
As soon as we buy our shares we activate our stop order to cover our butt in case things go wrong:
- Sell Stop on at $9.70
We know we want to make 5 times the value of what we are willing to lose:
- Profit Target: $11.50 (i.e. the stock price goes up by $1.50 per share ($30 x 5)).
Now we wait!
Stock trading is often glamorized in the movies with loads of screens covered in blinking charts with crazy traders buying and selling every three seconds. For the majority of investors and traders, however, this is not the case.
As Warren Buffet says, the most powerful tool in investing is time, i.e. waiting for favorable conditions to develop. Investing should be boring. Don’t expect to become a work-from-home day trader. Believe me, I’ve been there, done that, and it’s not as easy as the movies make it look!
As soon as you buy your shares you can even activate a “sell trigger” which means it will automatically sell the stock for you if it reaches a specified price. This is a great tool if you want to put on a trade before you go on vacation, or don’t have the time to keep an eye on it.
Alternatively, pretty much all online brokerages allow you to create alerts via email or text message if certain price points are reached. These are great free features and are what I personally use when monitoring a stock price.
We’re in the money! Should I sell or let it ride?
Ok, so our stock has been doing well these past few weeks and the price is now closing in on our sell target of $11.50. You might ask, "But what if it keeps going to $12, or even higher? I want to make the most money I possibly can!” Not to worry, once again we have a solution, and it’s all a part of our pre-determined trade map.
Just like stop orders and sell triggers every online brokerage has a feature called a “trailing stop order”. Essentially, once a stock hits our target price we can activate a trailing stop that will automatically follow the stock price higher and higher, trailing behind it at whatever distance you specify, ready to automatically sell the stock and lock in your profits in case the stock price reverses.
For example, let’s say our stock XYZ reaches $11.50. Yes, we could sell it right now and take our profits and there would be nothing wrong with that. But as we’ve learned, we can’t predict the future, so just because it has reached our target doesn’t mean it can’t go any higher.
We now need to decide how much of our profits we are willing to give back (i.e. risk) incase $11.50 is as high as the stock price ever goes before it starts coming back down.
Let’s use 1% as our value - our stock has worked hard making us money so we’d hate to give any of it back!
1% of $11.50 is $0.12, so we set our trailing stop order at $0.12 (or, $11.39). This means that if the stock price begins to come down, no matter what, we will automatically be sold out at $11.39, locking in $1.39 in profit. For every penny the stock price increase beyond $11.50, our trailing stop order will follow behind by $0.12.
For example, if the stock price continues rising up to $11.60 our trailing stop will advance to $11.48. If the stock price goes up to $12 our trailing stop order moves up to $11.88, and so on. This feature is so great because it lets us take advantage of a rising stock price without ever having to worry about predicting the future! If the price starts to come back down you don’t have to worry, a trailing stop order only moves in one direction - up, never down.
Once again, this is hugely advantageous because it takes our human emotion out of the equation. We don’t have to sit there watching the stock price continuing to go up and not knowing if we should sell or not. The more we can automate this process the more profitable we will be.
Time to Cash In!
Ok, let’s pretend the stock price continued past $11.50, we have our trailing stop set at $0.12 behind the stock price, it keeps going up to $12, then starts pulling back and we are automatically sold out at $11.88. This is great! We’ve made $1.88 per share which is a 19% return on our initial investment! Give yourself a huge pat on the back. Not bad seeing as we only risked 3%. That’s a risk/reward ratio of more than 1 to 6! The investment gods would be proud. With that type of ratio, we only need to pick a winning stock once out of every six times and we'll still make money (or at least break-even).
Key takeaway: Human emotion is the number one killer of money in the stock market. Don’t get caught up with all the nagging decisions that come along with buying and selling stocks. Build a trade map and establish a solid game plan that tells you exactly what to do in every scenario, leaving nothing to chance or “gut feelings”. It’ll take some time and practice to completely remove your emotional tendencies from your stock trading - after all, we are human! But over time you’ll become a well-oiled investing machine, capable of handling whatever the market throws at you!
Here’s an example of a trade map you can use!
- Stock: Twitter (TWTR)
- Risk: 3% of portfolio (risking $1,000)
- Current Share Price: $17.80
- Sell Stop: $17.26
- Profit Target: $19.93
- Risk/Reward ratio: 1:4 (risking $0.53 to make $2.13)
- # of shares to buy: 50
- (risk divided by share price = $1,000/$17.80, rounded down to the nearest tenth).
- Trailing sell order if profit target is reached: 1% ($0.19)
Game plan: buy 50 shares of TWTR at a price of $17.80 per share. Sell stop on at $17.26. Activate email/text alert if the share price goes above $19.93. If the stock price reaches $19.93, activate a trailing sell order of $0.19 @ $19.74.
One last note!
If you want to automate things even further you can activate the trailing sell order immediately after buying the stock. Simply make it the same price as your established 'sell stop' price and it will follow the stock price up (assuming it goes up). However, as the stock price get’s closer to your profit target you’ll want to tighten the trailing sell order so that it's closer to the actual share price, therefore giving back less profit if the stock price comes down before reaching your profit target.
Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions.
Before you invest be sure to download your free copy of Building a Bulletproof Portfolio, the complete guide on how I built a winning portfolio that sailed through the 2008 stock market crash without losing a dime.