Friday, 21 September, 2007

Plan your Trade - How to Trade Stocks after all?

Buying a stock is one of the easiest things one can do. However, buying is just a tiny part of the big equation. There is lot more to Stock Trading than just buying a stock. Without a proper plan a business goes down the drain. Stock Trading is NO different. Stock trading too requires proper plan and most importantly execution of the plan. Researching a stock and then buying it is one part of the story. The other part being How to plan a trade?

How to plan a trade?

Most important thing one must consider before planning a trade is figuring out the Risk/Reward ratio your trade offers and the exit strategy, namely Stop loss. Everyone is intrigued by the question of How to calculate a stop loss and how to place one. There are many ways one can come to a figure as it purely depends on one’s own trading style, capital invested, risk appetite and much more. We will try to gauge a reasonable way to planning your trade.

Risk - Reward Ratio

Every investment must have some Profit expectations. For example, you may want 10% or 20% or even 50% or more profit from your investment. And this applies not just to Stocks, but to any type of investment you make. You decide ahead of time what you are looking for.

Expected profits can be based on your own prior experience. Ok, i have always traded for 15% profit, so i will go with it.
Expected profits could be based on the underlying trend of the stock. Ok, this stock has always given profits of 20% or more at these levels so i will consider something around that range.
Expected profits could also be un-determined. Ok, i do not really know how much profit i want. I like this stock and will just hold for as long as i can and will sell when something changes in the company or some other factor triggers me to sell.
Once you have decided on your Profit expectation, you need to plan your trade.

Plan your Trade

First step to planning your trade would be to calculate Risk/Reward ratio. Ok, what exactly is a Risk/Reward ratio? Simply put, it is the ratio that says how much money are you willing to loose to gain X amount of profit. Let us take an example.
I invest Rs.100,000 in a stock. I expect a return of Rs.25000, which is 25% profit. However, i intend to sell the stock if my investment goes below Rs.80,000. That would mean, i want 25% profit and am ready to take at the most 20% loss.
Hence your risk reward ratio would be 25/20=1.25. This is your Risk/Reward Ratio. This is extremely low and you will never be able to make real money using this Ratio.

For an ideal trade, one must have at least 2, even better would be 3. Which means, you should expect at least 40% profit with 20% loss potential as a minimum. However, if you can have 60% profit expectation with a 20% loss per trade, that will take your Risk/Reward ratio to 3. An Excellent one. However, this all depends entirely on a trade by trade basis. For some stocks 2 is great, for others 3 may be a good option.

Once you have decided on the profit/loss expectations, the next step in this direction is the exit strategy. Just because you have decided that you want say 50% profit does not mean that you will eventually have it. What if the stock moves upto say 40% and then goes down south again? What will you do? One of the key aspects of trading is preserving your Profits. And this is achieved by something called a Trailing Stop Loss. A stop loss is the one that you place on a definite stock price or a %age. Trailing stop loss is much better than a Stop loss because it Trails the price. We will cover TSL (Trailing stop loss) in another article.

Ideally speaking, your loss exposure should be used as a trailing stop loss from where you stand. And such stop loss should be placed as soon as you enter a stock. This way, you are not caught off-guard when the stock reaches 40% and then trails back. You will be able to book reasonably good profits even in that state.
Conclusion being what i narrated above may not be a 100% fool proof way to trade stocks, but it sure is a good starting point and i personally have successfully followed this for years.