STEP-3. Share selection
What instrument to trade? There are various ways to identify high-probability opportunities and they are all good. Whether you use technical or fundamental analysis or follow the advice of a broker. As this section is such a small part of the ingredient to success, but ironically such a wide topic, we will not dwell on all the techniques, suffice to say:
- Indices/ETFs are less risky than individual shares
- Liquid (widely traded) shares are less risky
- Some shares behave better with technical analysis than others
- Buying the dip and breakouts/new highs techniques work equally well
- Patterns (double tops/bottoms, heads & shoulders) raise odds of success
- Trendlines are always helpful
Sharenet also provides a Technical Analysis Newsletter (TAN) that uses pure technical analysis to push trading ideas to subscribers.
STEP-4. Selection of correct stops
This is a huge determinant to success. Many traders lose their shirts because they hold onto losing positions for too long, hoping for a recovery. Its amazing how many traders trade without abort stops.
The purpose of a stop is to select a criterion where we decide to abort the trade as its not going our way. Its NOT a way to lock in profits. It is there to define and quantify your maximum allowable loss or your RISK.
- Without a stop you can’t pick an appropriate EXIT that will offer the required reward/risk ratio for your trade
- Without a stop you cannot determine your appropriate position sizing
There are many ways to select stops, but the method we prefer is using known proven levels of support. You can use trend lines, major bottoms or Donchian lows (lowest low of the last x days).
Whatever level you select, you must be careful that your stop is not too close to your entry, or you will be stopped out too easily or prematurely. Stops less than 1% away from your entry could be too "tight" Think of a stop as the reins of a horse you are riding. If you pull the reins in too tight, the horse can’t move its neck to gallop. If you give the horse "some reins" it can pick up a nice gallop. Your trade needs some reins to run nicely.
Below is a random potential high probability trade setup with suggested stops/targets from JSW-Online. We have elected to use the support level defined by the Donchian 10-day low as our stop (the orange line) as this was the last known major support in the last 10 days, which is 7.5% away from the current price. We have also elected two profit EXITS, which are the last known major resistance levels that are 9.7% and 22% away from current price, but more on those later.
If the "Macro" was favorable, and this is a liquid large cap widely traded share that looks like its making a recovery, and we have some defensible stops and exit targets then there is no reason not to treat this as a "high probability setup".
What we are configuring in this example is that if the share closes below the stop then we are going to ABORT the trade and get the hell out. The reasoning is that the last known major support has failed and who knows how much lower we are going to go, so cut our losses.
A successful trader can lose a lot more trades than he/she wins, but if the losses are small and the wins are always a factor higher than the losses then the trading strategy still has a positive expectancy - the winning trades can swamp the losing trades. So, you need to expect to be wrong at least 40-50% of the time and therefore having a strategy of cutting the losing trades before they do real damage.
The nice thing with the Donchian stop is that it will rise with the rising share price (just as it falls with the share price falling) so will start “locking in” some profits on the way up, which is a good thing.
Again, Donchian stops are not the be-all-and-end-all and is merely a mechanism favored by our systems as we like the concept of using support/resistance to govern stops and profit exits. It doesn’t matter how you pick stops, as long as they make some kind of logical sense and are not random numbers.
Dwaine van Vuuren
RecessionAlert, Sharenet Analytics
Dwaine van Vuuren is a full-time trader, global investor and stock-market researcher. His passion for numbers and keen research & analytic ability has helped grow RecessionALERT.com (US based) and PowerStocks Research (now Sharenet Analytics) into companies used by hundreds of hedge funds, brokerage firms, financial advisers and private investors around the world. An enthusiastic educator, he will have you trading and investing with confidence & discipline.