Every trader knows that we should have a plan when we enter a trade. It is an obvious piece of advice but probably one of the most ignored. Most traders really don't think much beyond 'I hope this works.' They may have some vague idea of taking profits after a big gain, but usually there isn't much consideration of what to do if the trade doesn't work.
Part of the problem with designing a plan for a trade is that there are so many potential issues to consider that it can become overwhelming. Positions size, time frames, surprise news, overall market conditions, and a host of other factors all impact how a trade develops. It isn't possible to consider everything. What we need to focus on are the things that we can control. Primarily the only thing we can really control is our response to price movement.
The first step in any trade plan is to assume that things won't go as hoped. If the stock goes straight up after we buy it, then there isn't too much to worry about, but it's the ones that don't work like we hope that require the most attention. Usually, when a trade doesn't work, the natural inclination is to ignore it and hope it improves. We end up doing nothing until we eventually just sell it out of disgust.
Most trades won't work as we want, and that means we better have some idea how we'll handle them.
It can be quite helpful to assume that the minute we buy a stock that it is going to drop like a rock. If we consider that possibility in advance, then we can make a plan for it when it does happen. The obvious way to deal with this situation is to either buy more and lower the cost basis or take a quick stop and try again.
As I've discussed often, I am a big fan of making multiple partial buys when entering a trade. This allows us to take advantage of less than perfect initial entry points. Rather than be disgusted when a stock immediately drops, we can be pleased that we have an opportunity to improve our entry point. It not only changes our positioning but it has a positive impact on our psychology.
Let's take the common situation of trying to catch a trade in a stock that is falling sharply. The conventional advice is 'don't try to catch a falling knife.' That is usually good advice because most people have not developed any sort of plan or strategy for dealing with this situation effectively. Most of the planning in this sort of situation is nothing more than 'I think this stock has dropped too much and will bounce back.' When the timing proves to be off, these trades can be some of the most painful.
Recently the SPAC sector has offered a number of these trades. Because of the peculiarity of the SPAC structure, there can be intense selling pressure when restrictions on certain shares are lifted and allow them to be sold. Recently IonQ (IONQ) saw this situation, and in the past week, Cipher Mining (CIFR) also faced this situation. Both stocks dropped like a falling safe, and trying to catch them was a very tough thing to time. It isn't just possible to do it with great precision.
When I look at these situations, this is the sort of plan I put in place:
1. What sort of money do I want to commit to this trade, and what sort of time frame do I have in mind? You don't have to have precise numbers, but having some parameters in mind will help you to implement your strategy.
2. When the selling appears to be 'extreme,' I make an initial buy. Of course, judging what is extreme is just a wild guess. It is constantly amazing how much a stock can drop when you believe it has already fallen too much. The first step is to commit to the trade and make the first buy.
3. Assume it will drop more. Be ready to immediately lose money. Don't start thinking that your timing will be perfect and it will go straight back up the moment you buy. Just be confident that you will have a chance to buy more at a lower price.
4. Make a second, third, or fourth buy. Since it is impossible to accurately time when the stock might do what we would like it to, the best way to build a position is to average into it. Hopefully if we spread out four or five buys over the course of a few days, we end up with a decent entry. However, if our timing is bad and the miserable stock keeps dropping, then we need to take action.
5. If you have already reached your maximum position size and the loss keeps building, then you make a sale and take some partial losses. The important issue here is that you do not let the dollar amount of the loss continue to expand. You don't just keep buying more and more. You take a fast loss and reduce the position.
6. If the stock keeps dropping or doesn't do what you want, then sell more but stay prepared to add back.
7. I will often make numerous buys initially and then be forced to make a number of sales if my timing is off. I then start to rebuy again and try to time it better. I keep working on my entry points while keeping the position size and the unrealized loss at a comfortable point.
8. If the bounce does occur as it did in IONQ, then I try to scale up when the strength builds and reduce as I lock in some short-term gains.
9. Maybe the trade turns out to be a dud, and the stock never produces a decent bounce. At some point, we need to admit the failure and move on.
With both IONQ and CIPH, I averaged into the positions too early. They kept dropping, so I reduced the position size, but then I bought even more at lower prices, and when the bounce started to build, I became more aggressive and started averaging up. There is a constant series of buys and sells. The position size expands and contracts as I try to time the action. The goal isn't to nail the exact bottom. The goal is to have the biggest position possible when there is sustained upside movement.
Every trade you enter should have some form of strategy like that I outlined above. My trades often anticipate some future news event or better market conditions. What is more important than anything is constantly adjusting position size as conditions shift. Simply making one buy and one sale can work but to really be effective as a trader, you need to have a more complex strategy that deals with the inevitable volatility of the stock market.