Anatomy of a Online Trading Plan
It must be one of the most often repeated sayings in the online trading world –
“if you fail to plan you plan to fail”.
Of course no one wants to fail, particularly in trading and investing when your own money is at stake. Everyone wants to make money, but they don’t have a clear idea of how to go about investing and trading.
Most of the time it boils down to it – a trading plan – or the lack of it that will separate those who make money and those who don’t.
At its most basic a trading plan is a guide on the why, what and how of trading. Depending on your personality and preference, you could make your plan as high level (with a few details) or as detailed (with a step-by-step procedure) as you like.
Before you get seriously active in trading, make sure that you have a trading plan – your map and guide that will help you keep on track and focused on your trading goals.
Three (basic) elements of a trading plan
Why? It may sound simple and easy. But most of the time it is not. Many people, when asked why they trade, would say because they want to make money. While it is helpful to have a goal – to make money – it is much better to have a more definitive objective.
What is your the reason to make money? Do you need additional income? Do you want to save up for a big holiday? Do you want to build your investment capital? The answers to these questions could be critical once you get trading. If you have a strong and important WHY – the reason for your trading – the more determined and focused you will be in achieving your goals.
What? Once you have a clear idea of why do you (want) trade, you have to find the WHAT of your trading plan. This refers to the instrument – e.g. shares, ETFs, warrants or currencies – that you want to trade to achieve your trading objectives.
While there are many instruments and markets to trade, you will be better off trading what you know and what you’re comfortable with. Some of the most successful traders focus on specific instruments and they become profitable experts in those particular areas. If you are fascinated with health or medicine, you may be interested in trading biotech or healthcare stocks. If you have a strong inclination towards mining and natural resources, it may pay well to trade mining stocks.
How? This is the segment of the online trading plan that calls for the most detail. Ideally you would have a step-by-step process that will keep you on track. This part of your trading plan could be broken down into:
The different levels of an online trading plan
Entry Level – Whether you’re using fundamental or technical analysis, you should identify your entry level for each and every trade. And once this level is reached, that is the time to open up a position. Not before or after.
Profit target – While no one can definitively tell where or how far a share price can move, it is important to have a pre-set target when it comes to profit taking. Once your profit target is hit, then you can either add to your existing position or take some money away to protect your capital. You may or may not always achieve your profit objective, but if you are working towards a target it will keep you focused and on track.
Exit Level – This could be one of the most important elements of your trading plan. Why? Because your exit level can determine whether you will make money or not. For example, you got into a trade and it went your way. It was instantly profitable and you decided to hold on thinking that it would still run further the next few days. The next day the share price went down five percent. You’re still holding on thinking that it would come back the next day. It did not. It lost another three percent and because you did not have an exit level, you didn’t know at what point to cut the losing position. A pre-determined exit level will help you make the decision to get out of a trade when it goes against you. Without a clear exit strategy, you could be holding on to a loser.
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3 ways to diversify your portfolio
We’ve been told about it not just once but many times over. It is one of the tenets of investment and wealth creation – “do not put all your eggs in one basket”. But that sounds a bit negative. To make it more positive and action oriented, we can say – diversify your investment. In practical terms, what does diversification mean? And how can you diversify if you are just starting to invest or in the early stage of your wealth creation?
There are many different ways to diversify. Let’s start with the big picture.
Ideally, your investment portfolio should have different asset classes. This means allocating some money in cash, in shares, some in fixed interest and later on maybe in property.
The idea behind this is that each asset class has its own growth potential and rate of return. And when taken together or made to work in combination, these assets will work in different ways like:
- Capturing growth in specific markets or assets
- Lessening the impact of any low/slow returns
- Providing passive but ongoing income
In the book The Elements of Investing (John Wiley & Sons), the authors encourage people to diversify across securities, across asset classes, across markets and even across time.
We will tackle all these (in another article in this series), but for now let’s focus on diversification across securities or shares.
It is no secret that Australia has one of the highest levels of share ownership in the world. At last count, there are approximately 6.68 million Australians directly or indirectly invested in shares. Australians just love to own, invest in and trade shares.
And how do you diversify your share portfolio? Here are three ways to do it:
Invest in different sectors
Some people invest only in mining shares, others prefer to put their money on retail companies while others like investing in the finance sector. Different sectors go through different cycles of growth and contraction. So, if all your investments are all in one sector, your portfolio could suffer if that sector contracts.
Of course the reverse is also true – if you’re invested in a sector that is booming, then it could be happy days. The only problem is when the boom is over, the bust will surely follow. And you don’t want these huge roller coaster dips in your investment portfolio.
A better situation is to invest in at least two or three sectors. This means that even if one of them suffers a slowdown while the other two are growing fast, you can still capture good returns on those two sectors.
Invest directly and indirectly
We all like to say that we have our own share portfolio. And we like to think that we can do better than the fund manager or financial adviser. But realistically, if you have a day job that requires a lot of your time, focus and energy, when would you find time to manage and grow your portfolio of shares.
While it is best to be in total control of your own portfolio, there are also advantages in putting some money in a managed fund or a similar indirect investment vehicle. Because the last thing you don’t want is for your investment to lag or to decline just because you don’t have the time and energy to manage or to grow it.
Invest with other people’s money
Did you say you’re just starting in your wealth creation and you don’t have enough money to invest in shares? Well, the good thing is – as a mature investment market, Australia provides many opportunities and investment vehicles for savvy investors and would-be investors.
One of these is margin loan – a popular and accessible form of accessing capital to grow your investment.
If you look at it closely almost everyone is doing it. Professional investors, businesses and companies alike, use other people’s money to invest and to grow their businesses. They may not call it margin loan, but they borrow money just the same.
The idea behind margin loan is to borrow money (with a low interest payment) and invest it in shares or managed funds (that will generate a higher return than the interest payment on the loan). So, technically, you are not forking out your own money. Instead, you are using other people’s funds to start or to grow your investment.
As you can see, these are just a few ways to diversify your investment. We will tackle the other ways and levels of diversification, but in the meantime, think of the different baskets you can put your investment in.
Remember: don’t put them all in one basket.
Fundamental vs Technical – do they really work?
People buy stocks for different reasons. Some want the long-term capital gains while others are after the dividend returns.
Still others want to capture the sometimes quick and sharp rise in price and instant profit.
No matter what your reason is for buying stocks, the first question that needs to be asked is: How do you know which stock to buy? With over 2,000 companies listed in the Australian Stock Exchange, how do you decide which ones to buy? How do you determine which stock will deliver the growth and the gains you’re after? How will you know if the stock you buy today will have a stellar rise and not drop like a rock tomorrow?
If you are like Warren Buffett (or if you think you are like him), then you will most likely use what is called Fundamental Analysis to sift through thousands of shares. This method looks at a company’s balance sheet, cash flow, income and profitability to determine its intrinsic value. And if the share price comes below the intrinsic value, then it is considered a good investment (with the view that the price will rise to the level or higher than the intrinsic value).
Is there another option?
Be like Marty Schwartz – one of the world’s most successful traders and author of the book “Pit Bull Trader”, then you will be pulling up charts and looking at price movements, support and resistance levels, moving averages, volume of trades and other patterns or trends to see which stocks will be moving higher or lower. This method is called Technical Analysis which relies purely on price movements which are then reflected on charts.
Using the Warren Buffett and Marty Schwartz examples, we can say that both Fundamental and Technical Analyses work. And they can help in choosing which stocks to buy or to avoid. But looking closely at these two successful money makers, we can see the difference in their styles and how they use fundamental and technical analyses to fit their money making strategies. There are three major differences between fundamental and technical analysis. Knowing these differences will serve you well as you try to analyse the markets and stocks you want to buy. Let’s look closely at these differences.
Are you an investor or a trader?
It may seem and sound obvious, but the big difference between Warren Buffett and Marty Schwartz is that one is an investor and the other is a trader.
Mr Buffett, also known as the Sage of Omaha, is well-known for his value investing method which tries to identify companies that are undervalued. Mind you, Mr Buffett is not the typical investor who allocates a few thousand dollars to a few shares.
What he does with his investment is buy into companies – whole companies, not just shares in companies. He is not concerned about the rise and fall of a stock price. He is more interested in a company’s earning capacity. Warren Buffett is a long-term investor who is on the hunt for undervalued companies that have the potential to consistently make lots of money.
The Marty Schwarth way
Marty Schwartz, known as the Pit Bull Trader, is famous for making $600,000 during his first year as a private trader and doubling to $1.2 million in the second year. Mr Schwartz is a very active short-term trader. He usually holds positions only for a few hours or a couple of days. As a trader he is only interested in pure price movements – whether up or down – and usually relies on charts to see if the position is going his way or against him.
After spending several years studying companies using fundamental analysis, Mr Schwartz turned to technical analysis when he started trading his own money. In his own words, he said: “I used fundamentals for nine years and got rich as a technician.”
Time in the market or timing the market?
You must have heard and read this a million times. Fundamental analysts say what is important is the time you spend in the market. This means you need to have a long-term view and be ready to hold on to your stocks for a long period of time.
For technical analysts it is all about timing the market. You don’t have to hold your position for months or even years. But you have to be ready to capture the short, sharp and sometimes lightning quick moves in price.
While investors who use fundamental analysis are ready to wait and spend a long period of time until their investment appreciates, traders who use technical analysis are in for quick and sometimes instant jump in rise of their positions.
Charts or company reports?
Fundamental analysts spend hours, days and even months reading through company reports, calculating sales and revenue forecast in a bid to find if there’s real value or growth potential in a company before investing in a stock.
On the other hand, technical analysts pour over charts to determine support and resistance levels or to see whether there are more buyers than sellers or if a stock is overbought or oversold.
Can you use both?
Depending on your preference and inclination, you can use fundamental or technical analysis to identify stocks (and other instruments) for your investment and online trading. While each school of thought will always have their share of followers and critics, what is important is to identify which one suits your money making style and strategy.
You don’t even have to favour one over the other. You can mix and match and use features from each (fundamental and technical) that will help with your online trading and investment. For example, you can use fundamental analysis to identify which stock has the potential for long-term growth. Then apply technical analysis to time your entry in that stock.