Stock Trading Conversation

Recently I had lunch with another stock trader. We met at the Vegas VectorVest Users Group and he asked to spend some time with me to help his stock trading success. What we discussed might be useful for other traders so I am sharing what we discussed.

George has been stock trading as a hobby for about five years and recently started full time trading. Like many stock traders and investors, he lost about half of his portfolio in 2008. He trades stocks and options, and has read many books and taken many courses. The first question I asked George was if he had a trading plan. He did, but after more questions on this it seemed to me it was not strategically aligned with his needs. See How to Create a Stock Trading Plan and Sample Trading Plan Using VectorVest for details on trading plans.

The first step in writing a trading plan is understanding yourself and what your trading objectives are, how trading fits into your life. How much money are you trying to generate per year? How much time are you willing to put into trading? How well are you able to take the emotions of trading: fear and greed? How does this trading plan fit into your overall financial plan? We explored these in more detail.

George said he wanted to make a lot of money, maybe 100% per year. That led to a discussion of how reward relates to risk. How he resolves the conflict between greed (high returns) and fear (low draw down) is key to determining what kind of trading he is emotionally able to do. He mentioned that even though he had a trading plan, he often did not follow it once he was in a trade. This is typical for many traders. Getting into a trade is easy. Little emotions are involved. Once you have real money on the line, fear and greed often take over.

I described how I use asset allocation to determine the size of each portfolio, and how I use position sizing to manage risk. For example, I allocate no more than 25% of my net worth to stock-related assets, and each trade is sized so I can only lose a pre-determined amount of money. My maximum loss never exceeds more than 5% of net worth, and often is less. Most traders use 1-3% of net worth to size positions. George has not allocated his assets into different classes, but concentrates on stock and options.

He also focuses more on stop management than position sizing to manage risk. I explained how I sometimes raise stops in trend-following trades, but also use scaling out to manage risk. Scaling out is when you keep the amount you have at risk (including profits) below a preset level, reducing the position size as profits grow.

The books and courses he has been learning from are based on techniques of trading. I suggested he get the one book I recommend to every trader: Trade Your Way to Financial Freedomby Dr. Van Tharp. This covers many of the topics we discussed. If I could have only one trading book, this would be it.

George likes to win. We all do. But with trading, losing trades are inevitable. However getting a high winning percent of trades is not the only way to get profits. What is important is the amount of profit compared to the amount of losses. A system with 10% winners can be profitable as long as the profit from winning trades is higher than the losses of the losing trades. He hadn’t really thought about that before.

George is willing to put a lot of time into trading but when we explored this, he would rather spend less time trading and more time playing golf, etc. I mentioned how I generally use other people’s trading systems (autotrading them) instead of building trading systems. This allows me to spend more time on my other interests.

We also discussed different asset classes and why I am diversified amongst them. I hold working interests in oil and gas wells, raw land, rental property, foreign currency, precious metals and collectibles. This is key to why I have never had a year where my overall portfolio has decreased more than 10%. George saw the value in that and decided to explore other asset classes, reducing his exposure to stocks.

During our two hour lunch, George was able to better understand himself as a stock trader and investor, to decide how to better manage risk, and to investigate different trading systems that he can trade with less time and that fit his trading personality better. I hope some of this helps you too to improve as an investor and trader.

Please leave your questions and comments.

Tags: beginner traders, position sizing, stock trading system, trader psychology, trading plans, trading resources

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