The whole goal in trading/investing is to make money. Ironically, however, in order to make money, a trader/investor must not focus primarily on the money he/she is about to make. Instead, he or she must generate good, well-researched, ideas that come with level headed analysis. The psychological part is in fact much greater than the money making part. You cannot have the latter without the former.
That said, it is important to have a set of guidelines to guide you along the way and to help you maintain the composure necessary. Below you’ll find some general highlighted “rules” to consider.
Speculative vs. Non-Speculative:
One of the more easily determined trade rules is whether or not a particular trade is speculative or non speculative. On the non-speculative side, these companies are ones with higher quality and less volatility. Speculative on the other hand are quite the opposite. They are in many cases, though not always, lower quality companies.
An example of a non-speculative vs speculative would be a mega cap health stock like JNJ versus a small cap weed stock like CRON.
In short, the primary driver here is risk appetite as summed below.
Non-speculative vs. speculative:
Less risk vs. more risk
Less stock volatility vs. more volatility
The market cap will give you an idea of its size (i.e. mega-cap, large-cap, mid-cap, small-cap, micro-cap or nano-cap) and its average volume, average true range and its beta will tell how much volatility to expect on any given day.
Nano-cap below $50M
A quick check on market cap size, immediately gives you a certain level of expectation for a particular stock’s behavior. For example, when you come across a blue chip company with a $200B market cap you can stand to understand it’s not a tiny company and moves fluidly relative to a biotech with a market cap around $50M.
It’s important to know the size of a company prior to entering a trade as it will tell you a lot about a stock’s personality.
For example, are you entering:
A $50M biotech is not going to trade the same as a $200B company. In the case of the $50M biotech you’ll want to know whether if it is thinly traded, has a high daily trading range, and high beta? If so, you better buckle up and be ready to risk at least 10-20% of your overall capital put into that trade with the idea that you want to see 15-25%, or even 50% or more upside on your trade. You also want to take smaller position sizes in this kind of a trade vs. what you would do in a more normal, non-speculative trade.
Or, are you riding a large-cap play with very high trading volume with a moderate daily trading range? If you are in this kind of stock, you don’t have to keep checking quotes on your iPhone while you are trying to eat your lunch.
Assume you have a $100,000 trading account. In the example of the biotech play with a $50 million market cap, personally I would be taking a position size of around $2,000-5,000.
As for the the large cap play, I would feel comfortable taking a position size that is significantly larger, maybe $10,000-20,000.
These rules are not absolute and definitely don’t apply this to every single situation. They are however general guidelines that will help you adequately size your positions.
Volume is similar to the lifeblood of a particular stock. When you look at volume you have to couple it with a stock chart. The stock chart coupled with volume will give you an idea of the stock’s personality. It’ll show you if it’s a choppy type of stock, gapping up and down in annoying fashion or not. For me, I prefer to find stocks that trade no less than an average trading volume of 200,000 shares. This is an absolute baseline minimum for me. Obviously, however, the more volume that exists, the more liquidity there is.
BETA and ATR
For the purposes of this example we will compare AAPL and ROKU.
Apple (AAPL) has a market cap of $740B, a beta of 1.08X and an ATR of 4.59 (since the stock is currently trading at $156.30/share, that means that the stock has the potential to move as much as 2.9% on any given day)
It's not that surprising to see that ROKU has a higher beta.
ROKU has a market cap of $4.79B, a beta of 1.69X and an ATR of 2.82. Given that ROKU trades at 43.86 that implies that the stock has the potential to move as much as ~7% on any given day.
It is important to note that the overall market has a beta of approximately 1x. With that understanding, we are able to garner that a stock like ROKU trades with a beta of 1.69x the market and can be expected to move 169% the overall market (in general).
When you combine the above, these measures give you a quick picture of a stock’s personality and how much volatility you should expect in a trade at any given day, regardless of whether you are long or short.
Don’t Push the Pot:
I’d like to express that the majority of this write up expresses the trading principles of trading common stock. Though the behaviors of stocks are universal, the mechanism in which you trade stocks and options is not the same. With that, below there will be some guides I follow on how to trade an equity.
First and foremost, and for the most part, do not plan on getting long or short a stock all at once. Obviously, we can do that occasionally without problem but for the most part you want to scale in. An example of going all in at once would be wanting to buy ROKU while it’s at 45.50 with a hard stop at 44.95 or below.
In general, should you want to get long, plan on adding at least a couple of times depending on if the trade is with a higher quality company or not. The goal here is to not attempt to perfectly time when to buy into a stock one time, but rather, develop a system that will help you build a framework of where to buy and how much to risk.
Specifically, let’s say we want to get long ROKU at 45 and we want to scale in. Obviously we will take our initial entry at 45, but won’t plan on adding until the stock has fallen about 5% or more. So, just to keep with the example, if we were to get long with the idea of adding two more times to the position, we would get long at $45/share and then add at around $42.75/share and then again against $40. This would give us an average price of around $42.50-42.75 depending on where our last entry was.
It’s important to note that we will only be adding to our position should the trend remain in tact and no new material information become present that changes our perspective of the company. If the trend were to break and/or new material information presents itself and changes our long thesis, we are not to add any longer.
I’ve found that a majority of people who start trading prefer to play volatility events. Though thrilling, this in fact is the opposite of what you should look for to become successful. Make it a habit to NOT hold a trade into earnings results.
The caveat to that statement being, of course, if you plan on holding the stock for at the very least several months, and at the most several years. This also should only be done with quality companies.
In addition to the above, the single most important thing to remember is this:
A STOCK CAN ALWAYS GO LOWER. AND DURING SELLOFFS, IT ALMOST CERTAINLY WILL
More people lose money in the markets simply by not having or not respecting their stops than any other reason that I’ve come across. Averaging down only works to a limit and you should not fall victim to the fallacy that you should continue to average down should the stock run past your initial exit point.
Lastly, don't make any one stock too large of a percentage of your trading account. Constantly monitor your position weighting in your account and reduce some equity to a comfortable size as the stock’s price appreciates.
Before you jump into a trade, understand the stock’s personality and know the basic metrics. Know what you're getting yourself into and whether or not the trade is going to be speculative or non-speculative. Know it’s market cap, trading volume, ATR, and beta ahead of time.
Size your positions appropriately and know your stops. When your stops hit, respect them with absolute discipline.
For the most part, avoid holding a trade into earnings. Don’t forget, a stock can always go lower (unless it’s already at zero).
Finally, make a habit of taking the right kind of trades more than the speculative (“wrong”) kind of trades. The majority of your trades should be higher quality (non-spec, higher volume, lower ATR and beta). While the minority should consist of lower-quality (spec, lower volume, higher ATR and beta) and account for a much smaller portion of your account.
Though not absolute, these rules are a standard guidepost. There are no guarantees in trading, but, in almost absolute certainty, should you apply (some of) these rules, you will improve your trading significantly.
Disclaimer: Once again, this is for informational purposes only and does not constitute as financial advice. Please speak to a financial professional prior to making any financial decisions.
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