The Beginner Trader
4 Keys You Need To Know Before Buying A Stock
A lot of information goes into deciding whether or not to take a position in a stock. Traders may use volume bar, moving averages, chart patterns, news, and any number of other indicators available to use on most charts.We won’t get into all that in this post as a lot of that depends on your strategy.
What I will cover in this post is the 4 things to remember, regardless of strategy when trading a stock.
- Set reward/risk ratio in your head
- Finding an entry price
- Finding your profit target
- Knowing your stop loss
1: Reward/Risk Ratio
In my short experience as a trader I have stuck with a reward/risk ratio of 2:1. What does that mean? Simply put, when I enter a trade I figure out what my target profit is, let’s say it’s $1/share. If that is the case, then my risk should be 0.50 cents/share.
I am risking 50 cents to make 1 dollar. Why? Believe it or not, if you have a 2:1 reward to risk ratio, you only need to be correct on 33% of your trades in order to be profitable. Think about that for second. You can make 3 trades, and be stopped out (sell at your loss point) on two of them, and still walk away profitable.
Many new traders or folks who have apprehension about trading think that they need to be geniuses and make the right decision most of the time to make money. That adds stress and pressure for some, and it may even stop them from invessting at all. Would you feel better knowing you only needed to be right 33% of the time?
See the chart below to see what I mean.
Let’s break down what we are seeing in this image. The green bar is telling us that if we are correct on 66% of our picks, we break even, even if we lose twice as much as we make on trades. Not ideal, and starting out you likely won’t be hitting on 66% of picks anyway.
The blue bar is telling is that we will break even if our winning trades make as much money, as our losing trade lose money. If your risk:reward is 1:1, then you have to be right half the time.
Now, the orange bar is telling us that if we manage our reward to risk ratio to be 2:1, we only need to be correct 33% of the time to break even.
In a perfect world you hit on 50-70% of your stock picks and stay close to that 2:1 ratio, thus almost ensuring you are profitable.
So how do we ensure we are using the ratio correctly? As you learn more, and start to become comfortable with predicting possible price targets, you can start to set where you will sell if a stock goes up, and where you will bail if a stock goes down. If you determine that there is a good chance stock XYZ is going to go up $2 a share, and you think it’s worth jumping on now, then in your head (or by setting alerts) you need to know to sell if the stock drops $1 from where you entered. This happens more than you think, and when you bring in the psychology of trading, you won’t believe how hard it is to actually sell at a loss. Most people just say – “Well, I lost money already. Let’s just hang on to see if it turns around.” – and in some cases it might. In others though, the stock will continue to drop, and a 5% loss turns into a 20%, 30%, 40% loss, and then you will really regret not staying disciplined. Trust me…I know from experience. If I am being 100% honest I have 1 stock right now that I should have sold weeks ago, but got into that “It might come back” mentality, and now I am stubbornly waiting for a turn around. *sigh* so dumb.
Likewise, you would set an alert if the stock gets close to your $2 profit target. If you get to your target and you think the stock still looks strong, you may consider letting it ride longer, or selling half your position. Take some profits, and let the rest continue to rise. If you do that then you can move your stop loss up to the original price you bought in at, and even if it does drop all the way back to where you bought it, that remaining half of the trade would break even. If that was confusing, read it again.
2-4. Finding An Entry Price / Price Targets / Stop Losses
Let’s say you do some research and scan for stocks that fit your criteria. You see a few that match what you’re looking for, and just jump in, right? Probably not. What will most likely happen is you find stocks that fit your criteria, then you wait for a point of entry. So, how do we do that?
Well, again, that will depend on your strategy and your time frames for holding the stock. In general however you will want to base your entry on a signal or signals you get from your chart analysis. It is important you become familiar with the tools available on charts, and most importantly, finding patterns in the charts.
Chart patterns when combined with certain indicators will give you the best possible chance of your trade being successful. It’s also important to understand that there is no 100%, full proof, silver bullet, magic formula, absolute, indicator, pattern, news reports, or earning call that will always make a stock go up when you buy.
The reason certain patterns work most of the time, but not others, is that other traders are looking at the same pattern as you. As a collective group looking for a signal, if you all spot that signal and “buy” at the same time, that will cause the stock price to go up. In other words, it’s a self fulfilling prophecy. Which is a good reason to avoid obscure stocks that no one is looking at with very little volume. If you can master finding even one pattern, and consistently invest using your reward to risk ratio, you will be profitable most of the time (above 50%) which is what we want.
In future posts I will break down exactly how to come up with a price target based on patterns. Stop losses are simply where you will stop out of the stock if the price drops below a certain price of indicator. We will also cover the difference between stop losses, and trailing stop losses.