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Recently I had lunch with another stock trader. We met at the Vegas VectorVest Users Group and he asked to spend some time with me to help his stock trading success. What we discussed might be useful for other traders so I am sharing what we discussed.

George has been stock trading as a hobby for about five years and recently started full time trading. Like many stock traders and investors, he lost about half of his portfolio in 2008. He trades stocks and options, and has read many books and taken many courses. The first question I asked George was if he had a trading plan. He did, but after more questions on this it seemed to me it was not strategically aligned with his needs. See How to Create a Stock Trading Plan and Sample Trading Plan Using VectorVest for details on trading plans.

The first step in writing a trading plan is understanding yourself and what your trading objectives are, how trading fits into your life. How much money are you trying to generate per year? How much time are you willing to put into trading? How well are you able to take the emotions of trading: fear and greed? How does this trading plan fit into your overall financial plan? We explored these in more detail.

George said he wanted to make a lot of money, maybe 100% per year. That led to a discussion of how reward relates to risk. How he resolves the conflict between greed (high returns) and fear (low draw down) is key to determining what kind of trading he is emotionally able to do. He mentioned that even though he had a trading plan, he often did not follow it once he was in a trade. This is typical for many traders. Getting into a trade is easy. Little emotions are involved. Once you have real money on the line, fear and greed often take over.

I described how I use asset allocation to determine the size of each portfolio, and how I use position sizing to manage risk. For example, I allocate no more than 25% of my net worth to stock-related assets, and each trade is sized so I can only lose a pre-determined amount of money. My maximum loss never exceeds more than 5% of net worth, and often is less. Most traders use 1-3% of net worth to size positions. George has not allocated his assets into different classes, but concentrates on stock and options.

He also focuses more on stop management than position sizing to manage risk. I explained how I sometimes raise stops in trend-following trades, but also use scaling out to manage risk. Scaling out is when you keep the amount you have at risk (including profits) below a preset level, reducing the position size as profits grow.

The books and courses he has been learning from are based on techniques of trading. I suggested he get the one book I recommend to every trader: Trade Your Way to Financial Freedomby Dr. Van Tharp. This covers many of the topics we discussed. If I could have only one trading book, this would be it.

George likes to win. We all do. But with trading, losing trades are inevitable. However getting a high winning percent of trades is not the only way to get profits. What is important is the amount of profit compared to the amount of losses. A system with 10% winners can be profitable as long as the profit from winning trades is higher than the losses of the losing trades. He hadn’t really thought about that before.

George is willing to put a lot of time into trading but when we explored this, he would rather spend less time trading and more time playing golf, etc. I mentioned how I generally use other people’s trading systems (autotrading them) instead of building trading systems. This allows me to spend more time on my other interests.

We also discussed different asset classes and why I am diversified amongst them. I hold working interests in oil and gas wells, raw land, rental property, foreign currency, precious metals and collectibles. This is key to why I have never had a year where my overall portfolio has decreased more than 10%. George saw the value in that and decided to explore other asset classes, reducing his exposure to stocks.

During our two hour lunch, George was able to better understand himself as a stock trader and investor, to decide how to better manage risk, and to investigate different trading systems that he can trade with less time and that fit his trading personality better. I hope some of this helps you too to improve as an investor and trader.

Please leave your questions and comments.

Position sizing determines how much money is spent on each position. Beginner traders often ignore position sizing and think stop management is how to manage risk. Expert traders understand that position sizing is key to managing risk.

The simplest and most common position sizing method is to allocate equal amounts of the portfolio to each position. For example, a $100,000 portfolio would put $20,000 into each five stock positions. This is what the High Performing System does: equally sized positions with 100% invested.

Effective position sizing depends on the level of risk the trader wants to take and the reliability of the trading system. Dr. Van Tharp explains the many choices of position sizing and how to develop your own method in his excellent book called Definitive Guide to Position Sizing.

Here is one way you can use position sizing to change the risk of a trading system. For example, if a system has a 30% drawdown and you would prefer only half of the drawdown, you could put on half-sized positions. In the $100,000 example, you would put $10,000 into each position instead of $20,000. Of course, the returns would be reduced too.

Another position sizing method–one of my favorites–is scaling out of a trade. This means that as profits are made, some of the position is closed to realize those profits. I use this method to keep the amount I have at risk in each trade around my target, instead of letting the at-risk amount grow as profits grow. Dr. Tharp explains this in detail in his book. Scaling out smoothes the equity curve by
lowering drawdown. However, sometimes it does not make as much profit as would have been made if scaling out was not done.

Please leave your questions and comments on position sizing by leaving a comment.

You place stop loss orders with your broker to automatically close a position if its price gets to a certain level (the “stop”). Sometimes news related to a stock can cause its price to change a lot during a day. Stop loss orders keeps these positions from having catastrophic losses. Closing positions is where many beginner stock traders fail. Proper stop management is key to success!

I never hold a stock position without a good-till-canceled stop order. Otherwise all the money I have in the position is at risk: it could go to $0! There are many ways to determine where to put your stop.

The simplest stop is to place it a percent below (long position) or above (short position) your cost per share. Another is to use a trailing stop. This stop automatically adjusts to be a percent of the highest high (long) or lowest low (short). Beginner stock traders overuse this technique, often using tight trailing stops like 5%. Using stops that are too close to the opening price will not give enough room for the stock to move into profit. Many stocks are volatile and need room to move without getting stopped out. Generally I only use trailing stops if I decide to close a position but think it might keep making profit. In that case I will use a tight (2-3%) trailing stop.

Chart readers often set stops near support (long) or resistance (short). Determining support and resistance is more an art than a science. Several trading systems I used were based on support and resistance. I prefer to put these kind of stops just beyond support or resistance, since I assume many other stock traders are using support/resistance. This keeps me from getting stopped out when the market makers “run the stops.”

You can also use mental stops. These are stops you do not place orders with your broker. Instead you check the stock price yourself and compare it to your stop. I often use mental stops with closing prices, while also having wider stops placed with my broker.

An advanced technique which I also use is adaptive stops. Instead of keeping the stop price fixed during the entire trade, it is adjusted during the trade based on how the stock price moves and how long the trade has been on.  This tends to prevent winners from turning into losers, replaces positions that have gone nowhere, locks in profits and reduces the amount at risk. See When to Close a Stock Trade for more information on this.

I also avoid placing stops that end in 0. For example, I avoid stops at 2.00, 1.50, 10.10. Why? Because many people round their stops and I don’t want my stop to be where many others have theirs.

The recommended stops given in the High Performing System I use have been optimized to reduce risk without significantly lowering returns. However, broker-placed stop losses are not used in the hypothetical back test results. All trading decisions in the simulation are based only on closing prices.

Please ask your questions or share your experiences with stops by leaving a comment.

Stock traders like to talk about their winners, their successes. This makes the trader feel good and impresses others with their prowess. More important than winners are stock trading losers. Why? You can learn much more from your losers than your winners. Losing stock trades are expected. No stock trading system is perfect. Carefully analyzing losing trades, though painful, often reveals areas of improvement so you can be a better trader.

I have spent tens of thousands of dollars on stock trading courses, books and other educational material. Yet, I learned much more from my losing stock trades than from all those. Losing trades are the real tuition of a stock trader. So here is my confession and what I learned from it. Hopefully you can learn from it too.

By mid-February 2009 my stock portfolio was up almost 20%. I was feeling good, probably over confident. As part of my market neutral trading plan, I put on a large March Iron condor index option spread. Iron condors are profitable when the index stays within a range (between the short strikes). Soon after I put on the position, the index started rapidly dropping.

Recently I have been developing a way to hedge against such moves to offset the potential Iron condor losses (I put on Iron condors every month). In October 2008, hedging turned a 25% losing Iron condor into a 25% winner. So I felt like I knew what I was doing. I developed my hedging approach through training and experimentation. I had the rules in my head: a mental trading plan.

Following my mental trading plan, I started hedging my March Iron condor in early March. Soon after I hedged the market turned upward. I sold the hedge at a loss. Within a week the market had moved high enough to put the Iron condor at risk again, so I hedged again. The market reversed for two days and my hedge lost money again. By the time I closed the March Iron condor it had a 30% profit, even though it was threatening to be a big loser twice during the month! My hedge losses erased all the Iron condor gains and all my year-to-date profits.

Painful as this was, I objectively evaluated what went wrong (after a few days to get over the shock). I made several mistakes:

1. I did not have a written trading plan. It was all in my head. This caused my emotions to affect my trading. I always follow my written trading plans. But with a mental one, it was easy to second guess myself.
2. I started to hedge too soon. My rule is to hedge only if the Iron condor is threatened within two weeks of options expiration. Almost all of my Iron condors expire on the third Friday of the month. This one used quarterly options, which expire at the end of the quarter, much later than regular monthly options. I forgot about this in the heat of the moment and hedged this position as if it expired on the third Friday. This resulted in me hedging too soon. I would not have hedged the first time if I remembered this was a quarterly option. Not having my trading rules written down was a major factor in this mistake.
3. My rules to manage my hedge are vague, based somewhat on gut instincts. My instincts failed me that month. This is a trading system failure. I need to clearly determine how I will manage the hedge and write that in the trading plan.

Bottom line: I need to update my market neutral trading plan to include hedging with precise rules on how to manage the hedge. This was a very costly error that I still have not financially recovered from.

Jim Tebay just sent me an update to his stock trading plan. I replaced the old version on this site. Please find details and a link to get the trading plan at Sample Trading Plan Using VectorVest.

Today’s post is on stock trading plans by our first guest author, Stuart McPhee. I hope to have more experts like Stuart contribute to this blog, helping you be more successful with your stock trading. Stuart McPhee is a former full time Army Officer, who now trades full time and speaks at trading events around the world. At his

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