For anyone wishing to learn how to trade stocks in the stock market, it is essential to become familiar with basic methods of risk management that can protect against excessive loss and enable the capture of profits if they arise.
Let’s take an example of what might happen
Without going into details of how a stock is analyzed and chosen as a trading prospect, and for that there are a whole set of criteria, let us assume that, after suitable due diligence, or for whatever reason, a particular stock issue has been chosen as a good candidate to trade. The objective is, obviously, to make a profit by selling the acquired stock some time in the future at a better price than was paid for it.
But beyond that objective, too many people venture into the stock market without a clear idea of what to do next, other than wait for the stock price to go higher.
So what happens next?
From the time of purchase, the stock can go up, as hoped for, or it can go down, or it can trade sideways, and any of those actions will take place over a yet undetermined time period during which it is subject to many influences, not all of which may be directly related to the individual stock.
For instance, in recent times almost everyone has witnessed episodes of turmoil in the stock markets where all stock issues, good and bad, were significantly depressed when the market “crashed”, as they say, because of unforeseen global economic circumstances. Unforeseen that is, by many investors.
Such catastrophic events may not be avoidable and are less likely to happen. But other day-to-day negative situations can and do occur often and that will usually result in the loss of money, situations that can be avoided to some degree, incurring a minimized loss through the adoption of some risk management practices.
Not every stock purchase will be profitable but as long as there are enough winning trade surpluses, the trader can be very successful. But it takes discipline and management.
Let us take another general example to illustrate
In a well-known stock, the pattern of trading for several years is that it almost always drops in price when the company’s quarterly earnings are announced, and then within a month or two it surges to a much higher price. In a case like this, and there are a lot of them, many traders will buy the stock on the fall in price after earning are announced, knowing the odds are good that it will repeat previous actions and soon again rise in price as it has done ten times before.
Needed, a plan at the very beginning
So what will be the plan to cope with whatever happens — whether the situation works out as usual or instead, does not and the price falls drastically. That also happens often with stocks.
1. Set Stops – There is a trading device called a Stop Loss that, as its name suggests, will automatically initiate a sell order, preventing further losses if the stock price declines by a specified amount without making any worthwhile gains. Suggested setting: 8% below purchase price.
Set a Trailing Stop to protect any gains that may be made before the inevitable correction back to a lower price. In other words, don’t stay around and watch the full decline from the high. To learn more about Stop Losses see: Exit Price and the Stop Loss over at “How To Trade Stocks Guide.”
2. Establish a selling price based on a target profit point that may be obtainable according to the reasons for entering into the stock purchase. If things go better than expected and that point is reached while still rising in price, either stay with the holding and watch very closely or sell part of the holding to recover the investment and let the balance be allowed to continue the upward move.
In any of the above events or for the following eventuality, always have a Stop Loss Order from the first day. Set the Stop Loss at about 8% to sell by that amount if the stock falls without making any gains
3. Establish a selling price to be invoked if the stock drops from the purchase price. The frequently adopted rule is if an 8 percent loss occurs it must be sold without any period of procrastination while it may fall further creating a much larger loss than necessary. See above, the Stop Price described will protect you if that happens.
4. Establish a length of time to hold a position – If the stock continues to trade sideways for too long a time, thus tying up working capital that could be put to use in other trades, it should be sold.
Those are just a few basic risk management rules that will help make a better trader. There is a great deal more to be learned in trading, for some help toward that check out this site: How To Trade Stocks Guide, its worth a visit.
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