Have you ever bought a seemingly good stock only to have it immediately go down?
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?!
1) Build a Trade-Map
Have you ever driven the airport and got on a random flight without knowing where it was headed? Maybe, if you’re the free-spirited type, but I think it’s safe to say you’ve never gone on a trip without 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 stock purchase you’d like to make before you make it.
Think of it like a recipe for baking a cake. It can be applied to any type of financial investment but is typically used for riskier stuff like growth stocks.
If you’re buying safe investments like GIC’s, bond’s, or some other type of fixed income security, you won’t need to complete a trade map. A trade map is used for stocks on which you wish to speculate, i.e. a stock you think might go up so you buy and hope to make a profit, but you don't foresee holding it for an extended period of time.
For safe stuff like blue-chip stocks or Index ETF's, a trade map isn't necessary since you'll likely keep these investments indefinitely as a core holding in your portfolio.
2) Identify your risk tolerance FIRST
The first thing you MUST ask before ever clicking the buy button is: How much am I willing to lose in the worst case scenario?
Now, you might be 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 average investors make, and it’s the reason you hear so many horror stories about people losing their shirts in the stock market.
For example, after cashing Granny's birthday cheque you now have $1,000 sitting in your account, ready to become a self-made stock market millionaire. Before you buy anything you absolutely must determine exactly how much of that $1,000 you're willing to risk on any single stock trade.
The standard benchmark for most professional investors is between 2% and 5%. Personally, I aim for 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 $1,000 in our portfolio and want to buy a stock – let’s call it stock XYZ, and if things go completely wrong (i.e. the stock price goes to $0) we don’t want to lose more than 3% of our total portfolio value (i.e. $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.
3) Knowing when to sell: set expectations
Now that we’re clear on how much we’ll lose if **** hits the fan, let’s figure out how much profit we want to make.
Just like knowing how much you can lose, you must set a profit target so you know when to sell and cash in. Letting it ride with no idea when to sell is not a winning strategy.
The most important aspect of any stock trade is to have a pre-established 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 incredibly certain that the rewards outweigh the risks by at least three to five times. Personally, I aim for 5x and don’t recommend going any lower than 3x.
Going back to our example, if we are willing to lose $30 of Granny's birthday cash in the worst case scenario, we want to know that we will make at least $150 (5 x $30) if things go well, i.e. risk $30 to make $150.
This is hugely important because we now only have to pick a single good stock out of every five in order to make money and be profitable.
It’s impossible to predict the future, if so I’d be on a yacht sipping champagne with my lottery winnings, but we can stack the odds in our favor by controlling risk and maximizing our wins.
If I only have to be right once for every five stock picks those are odds I'm willing to take!
- Starting Portfolio Value: $1,000.
- Risk Tolerance: $30 (3%)
- Profit Target: $150 (5 x $30)
Worst case scenario we lose $30, best case we make $150.
Time to set up the trade
Now that we've established our risk tolerance and profit target we can pick a stock and prepare to click that exciting little button labeled “BUY”. Let’s continue using stock XYZ for this example:
Imagine stock XYZ currently costs $10 per share. Since we're willing to risk 3% of our total portfolio (i.e. $30) this means we can afford to buy 3 shares of XYZ. Establish your number of shares by dividing your risk tolerance against the current share price (i.e. $30 risk / $10 share price = 3 shares).
Q: What if the stock starts going down right after I buy it?
This happens all too often – you buy a stock, it goes down, but you hang on hoping it’ll come back so you can just sell it, break even, and end the miserable waiting game. Your money gets tied up for months (or even years), costing you even more because you're unable to put that cash to work somewhere else - i.e. opportunity cost. Thankfully, there's a plan for this!
We've established our risk tolerance as 3% of our entire portfolio, and we'll continue using this same risk tolerance 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 (no matter what) we will only lose $0.30 per share if things don’t work out as planned.
Q: 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!
Thankfully there's a little thing called a “sell stop” or “stop order”. Every online brokerage and 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 price goes down past a certain point. With this handy little feature available, once we buy the stock we immediately activate our stop order to sell the stock if it goes down past $9.70.
4) When the trade is on you need to be off – lose the emotion
Having a sell stop in place is especially important because it takes your emotion out of the trade. Emotion is what kills the vast majority of investors, and is easy to fall victim to.
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 lose 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!
If the trade doesn't work take your loss and move on. Period.
If things don’t go our way and we get “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 simply no good. If as soon as the sell order fills the price comes roaring back to $11, so be it, 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. Preserving money is always more important than making it.
In our example, we would have 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.
Thanks to our trade map we still have lots of cash to play with and most importantly it’s not tied up in some lemon stock. We can now begin to look for our next trade opportunity.
If the trade does work, maximize your profit
Let’s rework this scenario assuming the stock price goes up.
- Starting Portfolio Value: $1,000.
- Risk Tolerance: $30 (3%)
- Profit Target: $150 (5 x $30)
Worst case scenario we lose $30, best case we make $150.
Recall stock XYZ initially 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 in case things go wrong:
- Sell Stop on at $9.70
We want a profit 5x greater than our risk tolerance:
- Profit Target: $11.50 (i.e. the stock price goes up by $1.50 per share ($30 x 5)).
Once the trade is on, wait.
Stock trading is often glamorized in the movies with dozens of computer screens covered in blinking charts and crazy stock traders yelling buy and sell. For the majority of investors and traders, however, this is not the case.
As Warren Buffet says, patience is the most powerful investment tool. Wait 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 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 profit target. This is a great tool if you want to put a trade on autopilot before heading out on a vacation, or don’t have time to keep an eye on it.
Alternatively, almost all online brokerages allow you to create free alerts via email or text message if certain price points are reached.
5) To sell or let it ride? Here is the answer
Moving on. Assume 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 be wondering, "What if it keeps going to $12, or even higher? I want to make the MOST money I possibly can!” 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”.
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 we specify, ready to automatically sell the stock and lock-in profits in case the price reverses.
For example, if our stock XYZ reaches $11.50, we could immediately sell it and take a profit, but as we’ve learned we can’t predict the future; just because it's reached our target doesn’t mean it can’t still go higher.
We now must decide how much of our profits we are willing to give back (i.e. risk) in case $11.50 is as high as the stock price ever goes before coming back down.
Let’s use 1% as our profit risk – 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 sell our shares 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 to $11.60 our trailing stop will advance to $11.48. If the stock price goes 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! Furthermore, a trailing stop order only moves in one direct – up, so if the price starts to reverse you don’t have to do anything.
Once again, this is hugely advantageous because it takes our human emotion out of the trade; i.e. no need to constantly monitor the stock price, wondering when to sell. The more we can automate this process the more profitable we will be.
6) Time to Cash In!
Assume we pass our profit target of $11.50, our trailing stop order gets initiated with a $0.12 spread, the price continues up to $12 before pulling back and stopping us 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 need only pick one winning stock out of every six to be profitable (or at least break even without losing money).
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! Over time you’ll become a well-oiled trading 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.
Automate things even further by activating a trailing sell order immediately after buying the stock. However, as the stock price get’s closer to your profit target, tighten the trailing sell order as to lock-in more profit.
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.