In the article last weekend, I talked about understanding how even a trade that loses can be a good trade. That was intended to reinforce the concept that cutting losses can be critically important to successful trading. This weekend, I want to discuss stock picking a little.

Of all the questions I am asked about trading, the most frequent is probably: "How do you pick a stock." That is what seems to concern most retail traders the most and many spend untold hours trying to find just the right one. I once had a student who had suffered severe losses in the downdraft that began in 2000 and when he came to me he was afraid to make any trade at all. He was consumed with the effort to structure a method by which he could select the perfect stock so he would have no chance of losing. Though there is a strategy that I discuss in "Trade Your Way to Wealth" that protects against loss, I don't think there can ever be a stock that assures success. No matter how hard we try and no matter what fundamental analysis we undergo and no matter what marvelous mathematical formulae we construct to find the perfect stock, there is always the chance that 10 minutes after we buy it there will be some world event or some news announcement by the company that will result in the price dropping.

I believe that one of our jobs as traders is to make things as easy on ourselves as possible. Many retail traders just buy stocks. If that is all they are going to do, they should at least give themselves an edge. Buying stocks in a falling market can be similar to trying to catch a falling torch. It is a good way to get burned. When markets are falling, most stocks are falling with it. Trying to predict when a market (much less an individual stock) will turn is pretty risky business. If all a trader wants to do is buy stock, consider buying when the markets are turning and/or trending up. If the markets are falling, go fishing or play golf. They will turn up again and then our trader can go back to buying.

In my estimation, we need to spend less time hunting for the perfect vehicle and more time in developing a sensible exit strategy. No gain is ultimately realized until we exit the play. Exit, then, becomes a key element in successful trading. If we develop an exit strategy that removes us from a losing position with only a small loss but keeps us in a winning position as long as our gains are increasing, I believe we can be successful traders.

Is there such a strategy? Probably there are many. One example would be the use of a moving average. We could decide, for example, that we would enter a bullish position when a stock price crossed above a moving average. Such an event signals bullishness. The time frame would depend upon our personal business plan, but it could be a 5 day, a 20 day, a 50 day, or whatever the trader chooses. As long as the stock remained above that moving average, we could hold the position, but we would exit if the price fell below the moving average. Now, the stock price movement is making both the entry and exit decision for us. We have found a basic method to remove our emotion (the enemy of traders) from the decision process. In trending markets, this method can be pretty effective though one runs the risk of whipsaws in sideways markets. Some traders choose to use MACD crossovers as entries/exits; others may move stops using candlesticks or exit on breaks through trends. The point is that utilizing an exit strategy that provides the discipline and removes the emotion can help us become more successful traders.

Good Trading!
Bill Kraft

February 16, 2008

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