By, Dale Brethauer
This is part 2 in my 3 part course on developing your trading business plan. One of the number one reasons why small businesses fail is they don’t have a plan. They might have an excellent idea, but when it comes to bringing that to their market if they don’t have a plan, the probability of failure is much higher. This course was first presented by me at Trader’s Expo in Las Vegas in November of 2009 and I’ve added to it since then for clarity and implementation.
Trading Business Plan: Part I Summary
I want to go back to this slide that we looked at earlier, where I’ve got a list on the left-hand side of the reasons people lose in the markets. They don’t have a goal. We talked about that with goals and affirmations in Part I. They have unrealistic expectations. They expect that they are going to be millionaires overnight, and that’s just is not going to happen. The market is very fickle. It’ll take away as easy as it giveth. You need to have a strategy on how you’re going to attack the market. You need to have trading rules, and you need to develop that and test it over time. You need to back test it. You need to paper trade it. Then you need to start out small with your investment to make sure you’ve got it under control. You need to be looking for realistic expectations which we’ll talk about in the last part. It’s very important.
In part II, I’m going to guide you through some principled trading strategies, rules (structure for success), and calculating proper trade size.
Why are these principles Important?
Most people who start investing in the stock market expose themselves to too much risk. They put too much money on any given trade. That causes them to jump out of the trade prematurely, to be too quick to take profits, and let their losses run. I will talk about a solution to that problem. We also want to establish trading rules that tell us when to get out, and when to get in. We want to look at trading strategies. A lot of people just trade on indicators, and there are so many indicators out there today. They’ve got their charts just loaded with these indicators, and one’s telling them one thing to do and the other is telling them the other thing to do and they’re confused. They don’t have a strategy, and they just go into the market and they get slaughtered. The market can do that. OK?
Now, some of these are examples are the strategies and the rules I use. You don’t have to follow me. You need a trading business plan and you need to make it your own. I’m just giving you these as an example. What you’re doing is you’re teaching your gray matter how you are going to be a success. How are you going to accomplish your goals? How are you going to trade the market? There are myriads of different strategies, and systems, and indicators. What I’ve found is, find something that works, keep it simple, follow a very small market basket of stocks and just execute the trades.
Let’s say for your trading strategies you really like credit spreads. You found out that it’s very difficult to pick the direction of a stock, and you’ve been losing lately. You like options but you could be correct on the direction, but if it doesn’t move by a certain amount in a certain given period of time, you’re going to lose everything.
One of the nice things about credit spreads is you’re going out of the money and you’re selling. We’re a seller of options. All the options have premium associated with them, they have extrinsic and intrinsic value. Out of the money just has intrinsic value, which is time value, and that time value erodes very quickly. I like to be a seller of options. I like to use credit spreads because I don’t want to sell naked. When I put on a trade, I sell at a certain strike point, and then I buy at a certain strike point a little further out of the money for protection.
Technical Analysis: Regression Channel & Macro MACD
I’m going to base this on the trend, and I’m going to use the regression channel. If you don’t know about the regression channel, I’ll be giving a webinar on that in future dates, but you can go to Wikipedia and type in “regression channel”. It is a great source for giving you a quick explanation. The regression channel basically shows the potential movement plus or minus one or two standard deviations. I use that to determine whether a stock is overbought or oversold.
Then I have my own custom indicator, which is the Macro MACD. It’s the weekly MACD, based on the daily version. I wait for three things: I wait for a change of color, then I wait for a higher high or a lower low. I use this strategy to trade sticks greater than $500 per share. This is one of the two trading strategies that I use.
Vertical Option Spreads
The other strategy I like is to place vertical spreads, which are credit spreads, when the SPX is overbought or oversold, once again based on the regression channel, either plus or minus one or two. Plus or minus one, 66 percent of all prices are contained within that, and plus or minus two, 95 percent of all prices are contained within that channel.
Now, occasionally you do get outliers, but 95 percent of the time it’s going to stay within the +/- 2 standard deviation. That’s a great place to put on a trade when you think the SPX is going to revert back to the mean. Those are two examples of trading strategies. Yours could be anything. It could be completely different, and that’s OK, but you need to write down what it is. What it is that you’re doing, and make sure that it ties in with the reality of your goal and your affirmations?
2. Trading Rules
The next thing, you have to have trading rules. I like to keep things simple. I keep these posted in front of me right along with the affirmations. I enter when trade is overbought or oversold. I look at measured moves.
Measured moves to the upside are you have a move to the upside, a pullback where you have a higher low and then you have a higher high confirming the move. Measured move to the down side is you have a move to the down and then it comes back up, but it makes a lower high, and then it makes a lower low and confirms the move to the down side. Then, I watch the weekly MACD.
I get out using Fibonacci Extensions so I already have my profit targets set before I enter the trade . I never use hard stops because I’ve gotten stopped out before. I know that the floor traders know exactly where there’s a group of stops, and they will go down and capture those and the stock moves right back up. I put in a mental stop. The regression channel, the measured moves, the weekly MACD, and the Fibonacci extensions will all be subjects for future webinars, so stay tuned for that.
3. Proper Trade Size
For your portfolio size what should your trade size be? Money management is critical to your continued success in the stock market. I put together this little chart a long time ago, and I use it religiously. I never risk more than one percent per trade.
You can use these equations for any portfolio you have, let’s assume you have a $50,000 portfolio. You will want to risk one percent per trade. One percent of $50,000 is only $500. However, I know in the long run, my average loss on any trade is 25 percent of the trade. If I divide the 500 by 25 percent, that gives me $2,000, and that is my trade amount.
In step three I say, “Well, if I’ve got a portfolio of 20 stocks”, which indeed I do, I keep it relatively small. There are over 7,500 publicly traded corporations. I’ve boiled it down to 20 that I believe are financially strong and they will move more than the market, but they will retrace more than the market. They’re active stocks and they allow me to get in and get out - to trade options. They’re my favorite, and it’s a small market basket. At any given time, I could tell you exactly what that stock price, what the chart looks like. I am so familiar with those stocks, and that’s what you want to do. You want to be very familiar with what you’re trading.
Capital Allocation per Trade for Different Size accounts
Now, let’s say I have 20 stocks in the portfolio and I’m putting $2,000 per trade that gives me $40,000 capital allocation if I am fully invested, which is below my portfolio. I’m good with that. Equations one and two tell me how much I can put on a trade. $2,000 per option buys me four to six contracts, and that’s all I want to buy with a $50,000 portfolio. Now, let’s take a look at this, “Well, I only have $5,000 Dale, and I want it to grow.” One of the things you could do with a small account is say, “You know, I want to build it up and I’m willing to risk more than one percent per trade.” Let’s say I’m willing to risk five percent, five percent per trade. I’ve only got $5,000. Five percent of $5,000 is $250. Divide it by 25 percent is a $1,000. The $1,000 is going to buy me two - three contracts of options. A $5,000 portfolio, you’re probably not worried about buying stock at that point in time, but this formula will always help you out to not overtrade. Don’t put too much money on any given trade. You might have lost five in a row, and with this trading size, you’re going to still be in the game. If you’ve lost five in a row, what are the statistics that you will win on the sixth? It’s the same statistics for the whole strategy. Just because you’re on a losing streak, don’t buy more than you can realistically put on, and this trade size will keep you out of trouble.
I hope you all enjoyed Part II of establishing your trading business plan. In Part III, we’re going to talk about what are your realistic expectations given a certain strategy. What, as your portfolio grows, what should your portfolio allocation look like? Then lastly, we’re going to be looking at the learning curve which will help you to determine what length of time it is that you’re willing to get to your goal. You can actually where you are, how you’re doing on your learning curve and make any adjustments that are necessary. That’s Part II of your trading business plan. I look forward to continuing and finalize this very important topic.
Part 3: Prelude
In Part III what we’re going to talk about is what are realistic expectations, how you can look at that and develop a rock-solid strategy. What your portfolio ought to look like as it gets larger. Then the learning curve as you go up, how long is it going to take you to get to your goals, and so forth. Today, in Part II, let’s focus on trading strategies, trading rules, and what’s a proper trade size for your portfolio size.
If you have any questions please go to the website, click on contact in the upper right hand corner, and send us a message.