Hi, this is your Trader of Stocks. Since I’ve been wearing my trading armor, the stock market hasn’t been able to hurt me in over 8 years of active trading. Learn to greatly reduce the probability of severe trading losses and stick to your hard earned profits by adhering to a multilayered defensive strategy.
As a private stock trader you must strive to mimic the casino and avoid slipping into the role of the gambler ever!
The reason why the casino wins in the long run is solely due to an above average probability of coming out ahead in each and every game they offer.
They achieve this mostly via game design and to a small degree by applying Jedi mind tricks such as the color choice, the cozy atmosphere, free drinks or the maze structure at the venue.
A prominent example of a ‘rigged’ game is roulette. Roulette would have a equal chance of winning and losing, just like coin flipping, if not for the 0 or the ‘house wins’ button. And I guess we don’t have to talk about the slot machines.
So a casino stacks the odds in each game they offer in their favour to ensure that they can’t lose in the long run. Apparently this is very valid business idea as obvious from the charts of stocks such as LVS, WYNN or MGM.
My time tested defensive strategy
The real question is, how can we mimic the casino and stack the odds in our favour as private stock traders?
The answer to this is twofold, and this article will cover only part of it. The defensive strategy I explain here is an important level in the pyramid of stock trading success!
First, a trader can improve or even create a winning edge by being more experienced than most other traders. 95% of all non-mentored self thaught traders hand over all their funds within a year or two before they quit. While some experienced traders challenge this theory, my experience actually supports the believe that this is a higher truth of the stock market which most traders neglect. You stick around long enough and chances are that you will become a net profitable trader eventually.
This works due to the very low skill level and the susceptibility to psychological ‘road’ blocks of the countless casual retail traders out there.
But we don’t want to only talk about the stocks we trade in, we also have to consider the trades we choose not to take.
So the second part of the answer is to make sure that you never participate in high-risk and low-profit trades in the first place.
This can be achieved by adhering to a multi-layered safety mechanism which prevents you from being ambushed from behind hence improving the odds of surviving the steep learning curve during the initial years.
A more detailed explanation of each layer follows below:
Layer One: Always cut your losses short
This one is so simple yet most traders are unable to do it. When your business risk, defined by your stop loss is hit, you exit the trade. You do this when price slowly runs into your stop, you do it when a stock quickly takes you out and you certainly also do it when a stocks gaps down 20% beyond your stop overnight.
Every story of a blown account started with a trader not being able to get out of a losing trade.
Want to trade full-time for a living one day? Well then get out of your trades asap when they hit your stop loss price.
Layer Two: Keep your position sizes in check
Did you ever see a casino with only one big roulette table in the center of the hall? No? Well the casino would be in a bad spot if they had to rely on only one game. One lucky player and the casino would be in trouble.
When you trade in highly correlated growth stocks, you want to hold at least 3 to 4 names in your portfolio to be fully (100%) invested so that a single stock black swan event doesn’t hurt too much. Better hold 6 to 8. More than 10 names will likely have a negative impact on performance, however.
Layer Three: Avoid stocks with a risky business case
In most cases this applies to smaller biotechnology stocks. Such stocks can have huge range expansions when a study show promising results. However, if the study suddenly fails or the FDA decides against a new potential drug or treatment, those names can disintegrate in an instant. This is especially true when their business case is built on only one or two products.
Then there are shady stocks with a hyped business case. I remember MGT which was a new security company. They prominentely got McAfee on board and then quickly hopped onto the crypto mining train in order to fund their security stuff. They exploded higher before imploding and were soon delisted.
In 2020 we experienced the implosion of LK, a fast growing star bucks competitor from China. It turned out that a major chunk of sales only existed on paper. Generally chinese names don’t have to adhere to the high US auditioning standards so they are more prone to fraud. But there is also a lot of opportunity in those names (GSX, VIPS, WB all had been major winners in the past) so you want to balance the profit potential against the risk in each individual case. Be aware that a stock doesn’t implode without giving at least some price and volume clues beforehand! LK was already broken when it dropped 80% overnight. GSX on the other hand is currently faced with open fraud allegations. However the price and volume chart didn’t raise any major red flags yet. In the end it depends on each traders individual risk allowance.
And this brings us to the next layer.
Layer Four: Avoid penny stocks
Penny stocks lure in traders with 100, 200% or sometimes even lager daily moves. You simply avoid junk which can be moved by a single trader or group of traders. More often than not insiders pump up such stocks to suck in weak hands before selling them all their shares. Once liquidity provided by the pumper is gone you can be trapped in such a name thus losing it all.
Some argue that every stock was once a penny stocks. Well, first this is obviously not true and second you are better off waiting until it matures so that the big -less nervous- money starts to trade in the name.
Layer Five: Don’t short buyout candidates
Don’t short small or midcap companies with an innovative or even revolutionary product or service. Chances are high that they are bought by a bigger company when you least expect it. This is especially true when they possess technology which is already used by or which can boost the product or the service of a larger company.
My rule is to never short anything below 70B market cap. However, I violate this general rule on an intraday basis sometimes when I see climax moves in smaller names. So the rule is rather as follows:
This rule includes well known growth stocks such as TSLA, NFLX, LNKD, MBLY and ACIA.
Well, guess why!
ACIA is a recent example and everyone who was short the stock into the merger news (many did due to the “bearish” reversal) now need a 60% win just to compensate their 37% loss. Those traders are now in a very weak position. I can relate because I also once suffered a 40% overnight gap loss. Details follow in Layer 8!
Layer Six: Avoid stocks with small floats
Stocks which only make a small amount of their overall outstanding shares available in the free markets posses certain risks which you must be aware of. First of all, a small float decreases the effective market cap.
What I mean is that a stock with a 400M USD market cap (40M shares outstanding multiplied by 10$ share price) but a low float of only 4M shares behaves like a stock with an effective market cap of only 40M USD (4M shares float multiplied by 10$ share price).
You can use our Stock quality checker to figure out the effective market cap.
Make sure to use this effective market cap in your baseline quality screen. If your screener doesn’t allow to search for it directly you have to calculate it manually.
The second danger with low float stocks is that of secondary offerings. Most companies couldn’t care less about the impact of such an offering on stock price so they often announce it when the stock is battered already. I have zero clue why the management don’t announce it into strength.
Layer Seven: Avoid illiquid stocks
This is a cousin rule to layer 4 (penny stocks) and layer 6 (low float ratio).
Make sure that the trading vehicle you engage with allows you to quickly move in and out. Depending on your account size this means that you simply can’t trade in certain stocks unless you use ineffectively small position sizes.
Illiquid stocks can be identified as follows:
A) A steady and coherent price action is a sign of high liquidity while jagged price action with huge tails is a sign of low liquidity. Liquid names have a much more natural price flow even when volatility is high. Refer to the following two charts. Both stocks show spin-outs and shakeouts while going sideways. However the first one (STEP) is an example of a liquid name while the latter is illiquid and not worth your attention.
When you can spot the difference between the two at a glance you already posses a solid chart eye!
B) When the stock is trading quiet on low volume you can test the liquidity with a small buy or sell order. If you can enter and exit with one or maybe two clicks (orders) everything should be fine. Of course this depends on what you would consider small/large.
Layer Eight: Don’t gamble on earnings
Giving up control in exchange of profit potential is never a good trade. You might disagree with me but the earnings reaction of a stock is a gamble with a 50/50 probabilty just like coin flipping.
Gambling on earnings means that you sit through earnings without any profit cushion so that you hazard the consequences of a -30% overnight gap down on you. Why would anybody do that unless he is a true gambler.
Remember to be the casino and not the gambler!
However if you have a large enough profit cushion you can sit through earnings with a reduced size. Always position size in a way so that a potential 30% earnings reaction against you would not make you blink!
I’d go so far and say that a earnings gambler will never be a net profitable full time trader.
Guess who was a gambler once? LITB gapping down in 2013 with me being long a full position cured me from “gambling” for all times.
Layer Nine: Use preset stop loss orders and have phone line to broker
This one is special because many traders disagree with me on that one.
I always set a stop loss order which my broker can actually see. But I never ever felt that someone was going for my stop. Shakeouts move typically end on a PLL so you simply place your stops in a proper way.
I would never even go to the bathroom without a stop. I experienced a couple flash crashes already in my 10 year career so I know the risk.
The other reason why you should use preset stop loss orders is because the internet can go down or the trading station of your broker can stop working (never happend to me with Interactive Brokers).
In such a case it also comes in handy when you have a direct telephone line to your broker. Most brokers only offer that for clients with larger accounts. But even if you still trade small it doesn’t hurt to simply ask, maybe you are lucky.
Layer Ten: Only trade in quality stocks
Create a quality baseline screening filter to make sure to only watch charts of quality stocks which are also in the focus of large stock market participants. Avoid all the rest and don’t even look at the charts.
A reasonable base-line filter is shown here. I also want to see good fundamentals. I focus on only two growth parameters. Forward EPS growth and/or quarter over quarter sales growth. You can also use our Stock Quality Checker to figure out if a certain stock fulfills our basic quality criteria.
If you want to become sensitive to the little price and volume clues of high potential growth stocks you must make sure to only watch these higher quality stocks. If you watch charts of penny stocks or other junk every liquid stock does look ‘good’ to you I suppose.
I am proud to only engage and trade in my own little stockmarket within the stockmarket.
Layer Eleven: Avoid stocks after a major bearish price & volume clue
A stock rarely shows a major price break without firing some warning shots, in the form of faulty price and volume action, before. Only consider going long stocks which showed some recent bullish clues and regained importand support level to make up for former weakness.
It is a time tested fact that a major price break is not an isolated event. When stocks break hard, a second break is just around the corner. As a matter of fact this rule is the basis of my approach to the short side. Whenever a former leading stock breaks through support on heavy volume I put it on a temporary short sale watchlist with the idea to hit it hard on any future weak rally into resistance. I adopted this approach from William O’Neil and Gil Morales and helps a ton with timing market corrections or the stock market in general.
This makes clear that the odds are not in your favour when you try to fish for a bottom in a former leader after it flashed a nasty price break.
Always apply all layers on top of each other in order to be properly shielded against big losses.
I fully adhere to my ‘safety net’ because I experienced first hand what can happen if I don’t. And if you believe that you need penny stocks and earnings gambling to make money in the stock market you are on the wrong track.
With such a multi layered protection in place you can now focus all your attention on developing an edge over other traders by improving your stock handling and chart reading skill over time.
If you do this you are on the winner cycle already and true stock market success in only a matter of time.