Finding an outstanding stock to buy makes trading and investing much easier, but it is just the first step. Ultimately, your level of success will be determined by how effective you are at trading it. The most common problems that traders experience are that they either find a good stock and then fail to fully profit from it, or the stock turns out to be a bad choice, and they allow a significant loss to occur.
Both problems are a function of not having an effective trading plan in place. After the initial buy, it is very common for inertia to set in. Rather than being proactive in managing the trade, we just sit there and hope that it works out.
The key to trade management is to identify potential catalysts in advance. What is going to move this stock? There are several things to consider. The first is overall market conditions. A great stock in a bad market is not likely to perform in the manner that you want. Trading with the overall market trend greatly enhances your chances of success, but you have to appreciate the big picture and how it is developing to formulate an effective trading plan. In a poor market, as we have now, it is extremely important that we find ways to take advantage of the weakness rather than try to fight it.
I am often asked why this great stock is acting so poorly. Typically the problem is that overall market conditions are poor, and there isn't any news to attract interest. In bad markets, liquidity dries up, and many people sell a stock for reasons that have nothing to do with its individual merits. If you are aware of that, then you will view the mispricing as an opportunity rather than a problem.
What market conditions are likely to come into play in the near term? Is there significant economic news due or a Fed decision coming up? Is there a strong uptrend, or is this just a counter-trend bounce in a bear market? Those things will determine more about the movement of a stock than anything else, and you have to consider how tolerant you will be of volatility as the overall market gyrates.
The second catalyst to consider is stock specific. Is this stock in a sector that the market favors right now? Is there earnings news coming? Is there likely to be contract news or an FDA decision? What news is on the horizon that will create interest and cause this stock to move?
Oftentimes anticipation of news creates very favorable conditions for a stock to move, so it is extremely important to know what is on the agenda. It is also important to recognize that risk increases when you hold into major news events. If you are able to catch a run-up into news, then the risk of a 'sell the news' reaction will come into play.
Once you recognize the various catalysts that can come into play, you can start crafting a plan. I'll make an initial buy at this point, but overall, market conditions are poor, and there is a higher risk of a downside, so I'll be ready to average in at a lower price. Or maybe an earnings report is coming up, and I want to limit exposure in front of that news but then be ready to buy aggressively on the report.
Currently, I'm looking at some stocks that I believe will have significant contract news in the next few months. My trading plan is to add to positions in weak market conditions and then trade around a core position while building a longer-term position. I will also vary my position size based on overall market conditions.
Once you recognize all the different catalysts that can impact a trade, the important issue is to shift position size as the level of risk shifts. Next week in Part Two I will discuss some specific examples of this and how I develop my trading plans.