THE SEVEN GOLDEN RULES OF TRADING

If you have lost money on shares before, it is almost certain you will recognise that some of your actions broke the golden rules of trading.

One of the benefits of our training is that it helps you appreciate why you made the wrong decision and why you almost certainly compounded the mistake by not recognising your error.

  • Golden Rule 1
  • Golden Rule 2
  • Golden Rule 3
  • Golden Rule 4
  • Golden Rule 5
  • Golden Rule 6
  • Golden Rule 7

Golden Rule 1:  Start With A Financial Plan

A Financial Plan is an essential ingredient for all successful businesses. Trading shares should be treated as a business venture — it will require your time, knowledge and money to succeed. Your financial plan represents your roadmap for success. Regardless of whether you rely on your own efforts or consult a professional, your financial plan must deal with important questions.

What Are My Financial Objectives?

What you want to achieve will affect how you trade, and therefore you need to determine what your objectives are before you start.

What Is My Risk Level?

Comfort with different levels of risk will affect the type of investments you make.
Remember, the higher the return you want to achieve, the higher the risk.

Low Risk Level
I am not very comfortable with risk and will invest in fixed interest / capital guaranteed securities (government bonds, bank term deposits).

Medium Risk Level
I can take on a moderate amount of risk (blue chip Industrial and Banking and Finance sector shares).

High Risk Level
I am comfortable with risk. I am seeking a high return and prepared to evaluate companies early in their growth phase (recently listed resource companies

How Do I Fund My Investments?

For most of us, we do not have immediate access to a large pool of ready savings.

Most people venturing into the stock market will have some funds to start investing with. This may be from savings, inheritance, or capital gains, such as from a sale of a property.

Depending on your financial situation you should carefully select investments which can help you meet your objectives. For example you may only which to invests money which you can afford to lose in high risk securities.

In most instances, the problem is not acquiring funds to start a portfolio; it is having the knowledge to invest with confidence.

What Is The Best Ownership Structure To Minimise The Tax Liability?

Various structures include personal ownership, joint ownership, and company structures and trusts. Investors should seek professional advice from a qualified taxation specialist or accountant when deciding which ownership structure best suits their situation.

Personal Ownership
Personal ownership is where you own the shares in your own name. While this is easy to manage, any profits will be added to your personal income and taxed at the top marginal rate. One benefit from personal ownership is where a spouse does not earn an income from working. Shares can be held in that person’s name and they will benefit from a lower tax rate than their working partner.

Joint Ownership
By placing ownership into joint names you may benefit from income splitting.
Instead of the profits from the portfolio being added to the income of the higher wage earner and being taxed at the top marginal rate, the portfolio income is split between the couple. If the spouse earns a smaller income, than at least half of the portfolio profits will be taxed at a lower rate.

Company Structures and Trusts
For individuals on high incomes, earning money through a company can reduce your tax. Companies and trusts can also be an effective way to protect your assets. These structures however involve significant establishment costs and benefits are very much dependent upon personal circumstances. You should seek the advice of a qualified taxation accountant before setting up any such structure and in particular understand the ramifications of capital gains tax.

What Tools Or Knowledge Will I Need?

Once you have capital, you need knowledge to make effective use of these funds. Reading this Manual is certainly a positive step towards building your knowledge, however, you need to keep current by participating in “Refresher” courses from time to time.

Golden Rule 2: Employ Risk Management Strategies

Earlier you were asked the question: “What is my risk profile?” With any investment - share trading, real estate, or business - it is important to your success that you understand what risk is and how to minimise your exposure to risk.

This process is known as ‘Risk Management’.

As a customer of Stratos Technology you will benefit from expert coaching from one of our Consultants who will teach you in detail how to implement an effective Risk Management strategy.

Minimising Risk

Look at the following Risk Profile bar.

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At one end of the investment spectrum you have Government Bonds. This is a safe investment with a low return. At the other end of the spectrum is speculation, such as a mining exploration venture. The probability of striking a rich deposit is low, but the investment return will be high if successful.

Our objective is to adopt strategies that limit risk while maximising the return.

The Three Elements Of Risk Management

To minimise risk you need to apply the three elements of Risk Management.

1. Spread Your Risk: Don’t Put All Your Eggs In One Basket

Spreading your risk is as simple as not putting all your eggs in the one basket. This is called diversifying your portfolio.

Spread your capital so there is never more than 20% is in a single stock.

Don’t however take this to extremes and over-diversify by investing in too many stocks at once.

Warren Buffet (renowned as the world most successful investor) warns against such diversity as the “Noah’s Ark” approach:

“Buy two of everything and end up with a zoo instead of a portfolio.”

You cannot expect to outperform the market if your portfolio closely matches the market. A rule of thumb is to limit your portfolio to between 5 and 10 stocks at any one time.

2. Plan Your Exit: Know When You Need To Leave The Party Early

Set your Early Exit point at the time of entering a trade.

Let’s say that you plan to buy 3,000 shares at 100p a share. From your trading plan you decide that if it breaks below 95p you are no longer prepared to hold the stock, so you set 95p as your exit point.

If later the share starts to increase, you can always buy back. If it keeps going down you are not letting a small loss turn into a large loss.

To illustrate this, look at the following chart for Barclays Plc (BARC)

  • The entry price for this investor was 307.157 a share.
  • After buying the share it falls to the point where the investor had set as his early exit price (297.799)
  • An investor who is conscious of Risk Management immediately sells at this point, even though there is a possibility that the share price might increase again.

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BARC dropped to £2.61 on our chart but because our investor remained objective and sold following a break below support, he avoided the decline and a significant loss.

Note: The market or a share is described as bearish when the share price is falling and further falls are expected.

Failure to sell on at the pre-set Early Exit price is caused by two things:

  • hope that the stock will turn around and save you from a loss (even though it is a relatively small loss); and
  • fear that it will go back up again and you will miss out on the return by selling.

The solution to this fear is simply to buy the stock back again if the price starts to rise.

After selling a stock at the Early Exit price (95p), set a new potential entry price at or slightly above your previous exit price (say 105p). If the share recovers to this price then you can buy it back. The margin between your previous Early Exit point and the re-entry point is simply referred to as your ‘insurance premium’.

‘Support’ and ‘resistance’, are two critical concepts we need to understand to maximise our benefits from share trading. We will cover these in much greater detail in Invest Like a Pro Part II.

As a customer of Stratos Market Analyst, you will be taught how to identify ‘Support’ and ‘Resistance’ levels and effectively use them in your investment process.

3. Floating Stop Loss: Don’t Drive Without A Seatbelt

The Floating Stop Loss tracks the highest price reached by the share since purchase. If the share falls by more than 10% from this price, it is time to sell. We suggest 10% - you can change this depending on your trading style. Too small a percentage and it will get you out too early. Make the percentage too large and you give back more of your profits before exiting. Start with a 10% fall and see what you feel comfortable with.

Let’s return to our example of 3,000 shares purchased at 100 each. We set the Early Exit price at 95 in case the price fell. Our analysis proved sound as the price rose to 150.

So, at what point do we sell? It never makes sense to sell when the price is rising, as this would limit the potential profit. How would you feel if you sold this share at 110 only to watch it rise to 150 a few weeks later?

The best time to sell is when the price starts to fall. Once the price has fallen from its peak of 150 and falls by 10% to 135, there is a high probability the price will continue to fall.

When selling at a Floating Stop Loss of 135 we lock in a 35% profit on this trade.

Rounded Rectangle:  	Our share rises from 100 to 150.     10% of 150 is15.    “Sell” when the share falls to 135 and lock in the profits. 

Golden Rule 3: Always Trade With The Trend

Trends are the cornerstone of trading.

To profit from trading we must trade with the trend. If a share price is rising, we can make money by buying that share. If the share price is falling, we look for other opportunities. It does not make sense to buy a falling share.

Our aim is always simple – find a share in an uptrend and take a large chunk from the middle of the trend.

Overall Market Strength

Buying a share that is rising in value is common sense. But are there any methods we can use to increase our chances of making a profitable trade?

The first step is to look at what the overall market is doing. If the market is rising, then we increase our chances of making money. For this, we can use a chart for the FTSE 100

The FTSE 100 Index is a weighted sum of the prices of the top 100 shares listed on the LSE. From this the performance of the share market can be gauged. If the FTSE 100 goes up, it is because shares in the top 100 have risen.

Open up a chart of the FTSE 100 for the last one or two years. What is the market doing – is it going up, sideways for down?

An example of a chart of the FTSE 100 is shown below (January 2005 to December 2007).

What direction is the chart pointing?

This is an example of a strong market. During these two years, the FTSE 100 increased by 40%! Investing in a strong market increases your chances of success.

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OK, The Market Is Strong But How Do You Decide Which Stocks To Invest In?

As at 31 July 2010, the London Stock Exchange listed 2,713 companies. To examine each one individually would take a great deal of time. Instead, the next step in trading with the trend is to find the strong sectors in the market.

Stratos Market Analyst provides you with a daily break down of performance by sector and indices as shown in the following chart.

The following chart measures sector performance over a 3 month period.


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The Key is to concentrate your investments in those sectors that are doing well. For example the above chart shows that companies in the Beverages sector have been the best performing in the past three months. Therefore it’s probably a good idea to look at companies like, SABMiller Diageo, Nichols, AG Barr, Britvic, and other companies in this sector.

Golden Rule 4: Don’t Buy and Hold

The London Stock Exchange is one of the strongest markets in the world. While the market tends to always recover from falls, the same cannot be said for individual companies. Even during a booming market, as we have experienced over the last 2 years, strong companies can suffer significant losses.

The credit crises saw many financial institutions share prices plummet as a result of some banks being over exposed to toxic assets. Although the British banking sector was rescued by government intervention, many banks still suffered enormous losses. It is likely to take many years before these companies see their share prices recover back to the highs of 2007.

These public company failures can cost investors large losses which they hold on to for years. Buy and hold is considered a good strategy by investors who have not educated themselves with the basic rules of trading.

Trade only on an uptrend and sell the poor performers and it will be impossible to experience a large loss. This is the secret to outperforming the market and achieving a consistently superior return.

Golden Rule 5: Have A Share Selection Strategy

The question on every share market investor’s lips is: “What is the next ‘hot share’ to buy?”

While learning to sell a share is actually more important to your success, the question of share selection dominates the thinking of the novice investor.

So How Do You Select Shares?

There are a few methods available. The novice will react to news and rumour. The professional trader has a proven share selection strategy.

With news, it is a question of time. When something positive happens to a company, for example a resource company makes a new oil or gold discovery, professional investors who have thoroughly researched the company react quickly. Other traders are attracted to this change in market sentiment and immediately follow suit.

Rounded Rectangle:  	An increase in demand pushes the price up and this information is reported in the financial press. Frequently the market is well informed prior to official announcements, and even though a company may issue what is a seemingly positive announcement, the share may fall after the announcement. The reason is the market over anticipated the extent of good news.     Trading on rumour rather than fact can be even more damage in. Rumour can be started by interests who are simply trying to create a false market so they can off load their interest to those less informed. Rumours that materialise into fact are rare.     

Trading on rumour is speculation and is dominated by greed. The professional trader controls this emotion and instead focuses on strategies that minimise risk and have a high probability of success.

A share selection strategy can be as simple as:

  1. Only invest in a strong market.
  2. Search for stocks in strong sectors.
  3. Search for stocks that are trending up.

Golden Rule 6: Trade Only Liquid Shares

To be able to buy and sell the share at the time and price you want to trade at, there must be sufficient turnover each day to accommodate your demand.

The next time you find a company that interests you, have a look at the number (or volume) of shares traded for the last few days. Multiply this volume by the closing price to give you an idea how ‘liquid’ the share is. The higher the value of trade in a share, the more liquid it is. For example, if a company has traded 100,000 shares today and the closing price was 242, we can estimate that £242,000 worth of shares changed hands today.

Before buying a share, you want to make sure there is adequate turnover to accommodate your potential sell order.

For example:

You own £10,000 worth of Company X and you want to sell. Company X is however only trading an average £3,000 of shares each day. If you enter your sell order on the market, you will inject 3 days’ worth of turnover onto the market and there will not be enough buyers for you to immediately sell the stock at your chosen exit price.

To ensure you invest in liquid shares, only trade those where daily turnover is at least ten times what you are planning to invest. If you are investing £10,000 in a single share, look for an average daily turnover minimum of £100,000.

Golden Rule 7: Develop Your Own Trading Plan

The purpose of a Trading Plan is to establish a clear set of guidelines for what and when to trade.

The Plan will set out criteria a share must meet to qualify as a potential buy and then specify the performance required for entry. Once included in your portfolio, the Plan will set strict guidelines for exit. Quitting a stock is critical to ensure any loss is kept at a small loss, and the Trading Plan also requires flexibility for re-entry if the stock recommences an upward trend.

Consider the process of a novice trader — John — starting without the benefit of sound trading rules:

John buys a stock after receiving advice or a tip, and his plan is ‘to hope it goes up’.
If the stock falls in price, then John ‘holds’ and hopes it recovers.

He is not prepared for losses. He changes his approach from trade to trade. His inconsistency means he sells early on winning trades as he attempts to recover past losses.

Eventually John quits trading, convinced it is only for those “in the know”.

How to develop a Trading Plan

Traders who consistently make profits plan their trade and trade their plan.

As a customer of Stratos Technology, your customer service representative will teach how to formulate your trading plan in detail.

However at this stage we set out the basics for the structure of a trading plan.

Before deciding what to buy, first establish if the market is in a positive phase. If the market as measured by the FTSE 100 Index is negative over recent weeks (or longer) do not enter the market. The majority of stocks are going down or sideways and the probability of you buying a share that is going to rise in the immediate future is slim.

Having waited till the market is in a growth phase; determine if there are any sectors showing strong growth over recent weeks. These are the sectors that have shares performing well and increasing in price.

Examine shares in these strong sectors and determine those that are on an uptrend. Before concerning yourself with the definition of an uptrend, simply look at the chart for a share and determine if the price has been going up for at least the last 3 months.

These stocks will qualify as having potential for ongoing growth as they are generating positive market sentiment. Providing they have adequate liquidity you could add any of these to your portfolio safe in the knowledge that you could exit quickly at any stage should you desire.

Having selected shares to include in your portfolio you must then have an exit strategy in the event any of these shares show signs of reversing. This requires you to set an Early Exit price to ensure any share you buy never generates a significant loss.