The 4 Keys You Need To Know Before Buying A Stock

The 4 Keys You Need To Know Before Buying A Stock

The Beginner Trader

4 Keys You Need To Know Before Buying A Stock

A lot of information goes into deciding whether or not to take a position in a stock. Traders may use volume bar, moving averages, chart patterns, news, and any number of other indicators available to use on most charts.We won’t get into all that in this post as a lot of that depends on your strategy. 

What I will cover in this post is the 4 things to remember, regardless of strategy when trading a stock. 

  1. Set reward/risk ratio in your head
  2. Finding an entry price
  3. Finding your profit target
  4. Knowing your stop loss

1: Reward/Risk Ratio

In my short experience as a trader I have stuck with a reward/risk ratio of 2:1. What does that mean? Simply put, when I enter a trade I figure out what my target profit is, let’s say it’s $1/share. If that is the case, then my risk should be 0.50 cents/share.

I am risking 50 cents to make 1 dollar. Why? Believe it or not, if you have a 2:1 reward to risk ratio, you only need to be correct on 33% of your trades in order to be profitable. Think about that for second. You can make 3 trades, and be stopped out (sell at your loss point) on two of them, and still walk away profitable. 

Many new traders or folks who have apprehension about trading think that they need to be geniuses and make the right decision most of the time to make money. That adds stress and pressure for some, and it may even stop them from invessting at all. Would you feel better knowing you only needed to be right 33% of the time?

See the chart below to see what I mean. 

Break Even Chart

Let’s break down what we are seeing in this image. The green bar is telling us that if we are correct on 66% of our picks, we break even, even if we lose twice as much as we make on trades. Not ideal, and starting out you likely won’t be hitting on 66% of picks anyway. 

The blue bar is telling is that we will break even if our winning trades make as much money, as our losing trade lose money. If your risk:reward is 1:1, then you have to be right half the time. 

Now, the orange bar is telling us that if we manage our reward to risk ratio to be 2:1, we only need to be correct 33% of the time to break even. 

In a perfect world you hit on 50-70% of your stock picks and stay close to that 2:1 ratio, thus almost ensuring you are profitable. 

So how do we ensure we are using the ratio correctly? As you learn more, and start to become comfortable with predicting possible price targets, you can start to set where you will sell if a stock goes up, and where you will bail if a stock goes down. If you determine that there is a good chance stock XYZ is going to go up $2 a share, and you think it’s worth jumping on now, then in your head (or by setting alerts) you need to know to sell if the stock drops $1 from where you entered. This happens more than you think, and when you bring in the psychology of trading, you won’t believe how hard it is to actually sell at a loss. Most people just say – “Well, I lost money already. Let’s just hang on to see if it turns around.” – and in some cases it might. In others though, the stock will continue to drop, and a 5% loss turns into a 20%, 30%, 40% loss, and then you will really regret not staying disciplined. Trust me…I know from experience. If I am being 100% honest I have 1 stock right now that I should have sold weeks ago, but got into that “It might come back” mentality, and now I am stubbornly waiting for a turn around. *sigh* so dumb. 

Likewise, you would set an alert if the stock gets close to your $2 profit target. If you get to your target and you think the stock still looks strong, you may consider letting it ride longer, or selling half your position. Take some profits, and let the rest continue to rise. If you do that then you can move your stop loss up to the original price you bought in at, and even if it does drop all the way back to where you bought it, that remaining half of the trade would break even. If that was confusing, read it again. 

2-4. Finding An Entry Price / Price Targets / Stop Losses

Let’s say you do some research and scan for stocks that fit your criteria. You see a few that match what you’re looking for, and just jump in, right? Probably not. What will most likely happen is you find stocks that fit your criteria, then you wait for a point of entry. So, how do we do that?

Well, again, that will depend on your strategy and your time frames for holding the stock. In general however you will want to base your entry on a signal or signals you get from your chart analysis. It is important you become familiar with the tools available on charts, and most importantly, finding patterns in the charts. 

Chart patterns when combined with certain indicators will give you the best possible chance of your trade being successful. It’s also important to understand that there is no 100%, full proof, silver bullet, magic formula, absolute, indicator, pattern, news reports, or earning call that will always make a stock go up when you buy.

The reason certain patterns work most of the time, but not others, is that other traders are looking at the same pattern as you. As a collective group looking for a signal, if you all spot that signal and “buy” at the same time, that will cause the stock price to go up. In other words, it’s a self fulfilling prophecy. Which is a good reason to avoid obscure stocks that no one is looking at with very little volume. If you can master finding even one pattern, and consistently invest using your reward to risk ratio, you will be profitable most of the time (above 50%) which is what we want. 

In future posts I will break down exactly how to come up with a price target based on patterns. Stop losses are simply where you will stop out of the stock if the price drops below a certain price of indicator. We will also cover the difference between stop losses, and trailing stop losses. 

Have a question? Let me know in the comment section below, or on Twitter or Facebook

 

Investing Q&A of the Day: Bull vs. Bears?

Investing Q&A of the Day: Bull vs. Bears?

The Beginner Trader

Bulls vs Bears

Even if you’ve never invested a penny in your life, you have likely heard the term “bullish” being used in regards to not only stocks, but any number of other subjects. For example, you may be bullish about your favorite team’s chances of winning a championship. Meaning, you think the chances are good. Being “bearish” mean the exact opposite. 

If you’ve never heard the term and are unclear about how it applies to the stock market, continue reading for a quick overview. 

Bull Market vs. Bear Market

One of the factors to take into consideration when looking for a trade is determine whether we are currently in a bull or bear market. Simply put, is the stock market going up, or going down. If the stock market is generally trending up for an extended period of time, we may be in a bull market. The exact opposite if true of a bear market.

This could be taken into account as a daily status, “are stocks generally  up, or down today?” to help you decide how much risk is involved in a particular trade. It’s true definition however would be if the stock market is trading above or below its 200 day moving average. 

You can look this up easily using your favorite charting software. If you don’t have charting software you like to use or have not used any before, you can use the free versions at www.StockCharts.com or www.Tradingview.com. 

Chart Bear Market

Bear Market Signal

In these images I will use a very recent, real world example. When Covid 19 began to wreak havoc on the economy we saw the stock market take a dive. Near the end of February 2020, the S&P 500 index closed below it’s 200 day moving average, the red line. This is a confirmation that the stock market is in decline. Further confirmed when the blue line (50 day moving average) also crossed below the 200ma. That is know as a “death cross” and people start to panic, and selling intensifies. You can see that play out in the larger red candle in mid-March. 

You will also hear folks on CNBC and twitter say that a bear market has begun when stocks fall 20% from recent highs. That can also be a signal to proceed with caution.

 

Chart - Bull Market

Bull Market Signal

Two months after the signal of the start of the bear market, we got the opposite signal. The first candle to reclaim the 200MA happened on April 18, 2020. It did slip slightly below it on the next day, but stocks continued to rise after that. The 50MA then crossed the 200MA in June, and stocks have generally continued in an uptrend since. 

Why does it matter to us?

If we are in a bear market that doesn’t mean we can’t buy stocks. In fact, just the opposite may be true. It may be a good time to find value stocks, or in the case of Covid, look for stocks that are likely to have a turn around once we find a vaccine. It does mean however, that we have to be cautious. Maybe be more patient, wait for opportunities, and try to scale in to a position rather than dump all your money into a stock at once. Bear markets can also be great for people that are comfortable with shorting stocks. Shorting stocks isn’t for everyone, or the faint of heart as they can be much more risky than just going long on a stock. That is a lesson for another day though. 

A saying you will hear a lot when it comes to investing will be “Bulls make money. Bears make money. Pigs get slaughtered.” Don’t be a pig. In other words, you can make money no matter which direction the stock market is going, but only if you know what you’re doing. Understanding the direction of the market is often the first step in entering a trade, but not the only one. 

Have anything to add to the discussion? Follow me on Twitter, @cchapeton, or find my Facebook page.

Investing Q&A of the Day: Bull vs. Bears?

Investing Q&A of the Day: Float

The Beginner Trader

What is a stock’s “float”?

A stock’s float refers to the amount of outstanding shares that are available for trade (buy/sell). To determine the amount of outstanding shares a company has, you can do a quick search on Yahoo Finance. THIS LINK will take you the Yahoo Finance “Statistics” page for the Coca Cola Company, stock symbol $KO. If you scroll down to the “Share Statistics” you will find the float. I have highlighted for you in the image below. 

 

Highlighting where to find a stock's float.

The “floating” stock is calculated by subtracting closely-held shares (insiders, major shareholders, employees) and restricted stock that may arise from an IPO.

Why does float matter?

Depending on your trading strategy, you will want to narrow your searching by float. In my day trading strategy I look for companies with less than 30-50 million shares. While that sounds like a lot of shares, that would be considered a low float stock. You can see in the example above that $KO has almost 4 billion shares of float, which is very high.

In my day trading strategy I am looking for stocks that are moving quickly in one direction or another. A stock with less shares will be more volatile than a stock with lots of shares. This is simply due to the dynamic of supply and demand. If a low share, low cost stock has good news in the morning, lots of traders will pour into that stock, and since there isn’t as many outstanding shares, the price of the stock will fluctuate wildy in the first hour of the morning. Riding that volatility is where you can make (or lose) money in a short amount of time. 

If you’re looking at a stock as more of a long term investment, float may not matter as much in your calculations. You would be looking at other fundamentals like ROIC, PE Ratios, ROA, etc. 

To learn more about stocks and investing be sure to follow me on twitter @cchapeton.