How to Invest in Stocks | Trading System Part 1

Before I delve into the the intricacies of how to invest in stocks, I must first talk about the importance of a system. Investing in stocks in not simply a matter of throwing a dart at the stock list and buying the 'selected' stock. In order to win consistently in the stock market, you need to have a system .

This system tells you when to invest, how much to buy (position sizing) and when to sell (either at a profit or as a stop loss).

So why is a system so important? Let's talk about the various components of a system.

WHEN TO BUY

You need a CONSISTENT set of rules that help you decide when to invest in a particular stock. These rules should be based on empirical data and extensive research. For instance, if you are a trend follower, you must have a set of rules that when combined, tells you that a new trend has started. Based on your study of past stock charts, You may decide on the following rules:

Invest When:

1. 200 Day Moving average crosses-over the 50 Day Moving Average
2. ADX exceeds 30
3. Volume for the current month shows a 50% increase over the previous month

You then invest in the stock only when it satisfies ALL the criteria above, NO EXCEPTIONS.

Why is it so important?

When you have a set of rules that clearly tells you when to buy, you do not invest in a stock based on emotions. Emotion is often cited as one of the biggest flaws of individual investors. Investors can easily be tempted by greed to invest in a stock that appears to be rising fast, fearful of missing the boat. More often than not, they end up being the last person to the party, buying the stock at its highest price.

POSITION SIZING

Position sizing tells you how much or how big of a position to take. Some common models of position sizing are listed in Dr. Van K. Tharp's book “Trade Your Way to Financial Freedom”:

One Unit Per Fixed Amount of Money:
Buying 1 unit for every $X in your account. For instance, you may decide to buy 1 unit for every $10,000 in your account. That means, if you have $50,000 in your account, you can buy 5 units of stocks.

Equal Units Model:
Spending the same amount of cash for each of the stocks you want to buy. For instance, if you have a total of $50,000 to invest and you are interested in 5 stocks, you can choose to evenly distribute your money among the 5 stocks(i.e. spending $10,000 for each stock). If stock A costs $40, you will invest in $10000/40 = 250 shares of stock A.

Percent Risk Model:
First decide on the percentage of money you are willing to risk on a stock. Then, decide on your stop loss for that stock (more on that later). Divide the amount you are willing to risk by the stop loss amount.

For instance, you may have a $100,000 account and are willing to risk 3% or $3000 on a stock. If you buy the stock at $40 and decides that you would get out if it falls to $38 (loss of $2/share), then you can invest in $3000/$2 = 1500 shares of that stock.

Percent Volatility Model:
Volatility refers to the amount of daily price movement of the stock over a certain time period. A common indicator of volatility is the ATR (average true range) which gives the average trading range of a stock over a given time period.

Here's how the percent volatility model works -

Suppose you have $100,000 in your account and you want to invest in stock A that costs $40 per share. You decide that you are willing to risk 3% or $3000 on stock A that has a ATR of $1.50 for the past 20 days. To determine the number of shares you can invest in, divide $3000 by $1.50, which gives 2000 shares. The difference between this model and the Percent Risk Model is that you divide the amount you are willing to risk by the ATR of the stock, instead of by your stop loss amount.

Why is it so important?

Dr. Van did an experiment which shows the importance of position sizing. He tested the models on the SAME trading system, with the only difference being the position sizing model used. He found that for the system he tested, the first model has the lowest return of 5.75% while the last model boasts a return of 22.93%. This should leave no doubt that the model you use to decide how big of a position to take can have a direct and important impact of the performance of your trading system.

Note: Even though the Percent Volatility model appears superior here, it should not be taken to mean that your system must use this model. Which model to choose depends on your trading style and personality.


That's all for today.... To learn more about how to invest, stay tuned for Trading System Part II :)