by Amanda Harvey
Stock trading strategy involves deciding which stock to trade, identifying the optimal time at which to enter the trade, deciding on a target profit, deciding whether to apply a stop limit and/or stop loss, and exiting the trade at the best possible point. Strategy also includes deciding on how much to invest in a trade, the size of the position to be taken, and what its relationship should be to other trades in the trader’s portfolio.
Strategy encompasses the trader’s general style of trading, tolerance for risk, and risk management approach. It also covers aspects of trading such as determining when to run with a winner, and when to cut losses. It incorporates using strategies such as hedging to protect an investment that is facing a possible loss, and increasing positions to either maximize profit or scale down loss.
Selecting Stocks to Trade
The first aspect of stock trading strategy to consider is the selection of stocks which present a viable trading opportunity. The two primary methods used in picking stocks to trade fall into the broad categories of fundamental analysis and technical analysis.
Fundamental analysis examines the inherent value of the company in which the stocks are offered. Using this method of picking stocks is well suited to investors who wish to buy and hold investments over a medium to long-term period. Stocks in companies whose inherent value is strong will usually reflect this value over time.
Technical analysis studies the movement of prices, and bases decisions on strong indications of probable price movement. Technical analysis uses charts and indicators as tools to provide insight into the anticipated future price action. This type of stock picking strategy works best for shorter-term investing, as studying price movement is unlikely to provide any significant indication of what the stock will be doing years later.
Once an investor has selected stocks in which they wish to invest, the next stage of stock trading strategy is to identify the most favorable time in which to enter the trade. Whichever form of analysis has been applied to picking stocks, when it comes to pinpointing the best moment to enter a trade, technical analysis tools can be very effective. Indicators can assist a trader in recognizing the point at which a price is likely to experience a breakout, retracement or reversal, and then, depending on the trader’s style, they can take the action that they feel best fits their approach.
Stock Trading Strategy – Position Sizing
Deciding how much to invest in any one trade is a vital part of trading strategy. One way of deciding this is to allocate a certain percent of available investment capital to each trade. This is a strategy employed by Stock Options Made Easy in our Armchair Trader Membership strategy. This means that if any one options trade is unsuccessful, the trader’s overall success is not impacted unduly, as the winning trades outweigh the losing ones in both numbers and percentage of profit or loss.
Deciding when to exit a trade is an important, and sometimes difficult, aspect of stock trading strategy. Using stop limit orders to secure profit when the price reaches a target level - often a percentage increase determined by the trader – eliminates both the indecision and the need to constantly monitor prices. A stop loss order can help protect against a loss greater than a predetermined percentage of the investment, and helps to make the cutting of losses more clear-cut.
Other Aspects of Stock Trading Strategy
There are times that a trader needs to take measures in order to reduce loss, or to maximize profit. Hedging is one such strategy, and this often involves taking an options position as insurance against the loss which may be incurred by a stock position. If a stock price is dropping, a trader may buy a put option on that stock, which generally increases in value along with the falling stock price. The gain realized from this option trade helps to offset the loss experienced by the stock.
Other strategies that may be employed include pyramid trading, which involves increasing a position in order to run with a winner, or averaging down, by buying a further amount of shares at a lower price than was originally paid to lower the average paid for each share.
The stock market presents a myriad of profitable opportunities for the investor or trader who is well informed, and understands and implements the components required for a complete stock trading strategy. Knowing which stocks to trade, how much to invest, when to buy, and when to sell are all a part of a winning trading strategy.