Investing in the Stock Market
Overview of Trading System
(Date posted: October 17, 2010)

Warning – you must take sole responsibility for any losses you suffer in the stock market.

Most ordinary investors in the stock market lose money. However, there is a way to make big profits and avoid big losses (no guarantees, of course). This is article #1 in the series about such a trading system. It provides an overview of the trading system and its underlying principles. (Note: This information is meant only for experienced stock traders or investors.)

Following are the topics for this article:

The overall trading strategy
How to find suitable opportunities
Planning for profits
Watching and trading activities

DISCLAIMER -- Stock trading is not appropriate for everyone. There is a substantial risk of loss associated with trading the stock market. Losses can and will occur. No system or methodology has ever been developed that can guarantee profits or ensure freedom from losses. No representation or implication is being made that using this methodology or system or the information in this article will generate profits or ensure freedom from losses.

The overall trading strategy

Do not be concerned if I give advice that you don't know how to follow. I will explain these matters in later articles. For now, just try to grasp the overall philosophy of this trading system.

The overall goals of this trading strategy are to make big profits and avoid big losses. As you will find out, this usually requires you to avoid constant in-and-out trading. It also means that you should stay in a profitable position as long as the trend continues.

How to make big profits -- Most big profits are made by taking a position early in a long-term bull market, carefully adding to your position on dips, and riding the market up until the final blow-off.

If you have a profitable position in a market that is going into the mania stage, you need to be alert for the inevitable collapse. You want to benefit from the mania, without exposing yourself to the possibility of large losses.

How to avoid big losses -- Regardless of how attractive the profits may appear, it is very dangerous to begin acquiring your position during the mania stage of a particular market. Also, you should never take a position if there is a possibility of being unable to exit your position when you want to.

You should be aware that most important markets are managed or at least influenced by governments or some other powerful special interest. Your goal then is to profit from their expected actions. However, you should be very cautious when doing so. Another way of saying this is to expect the unexpected.

Why ordinary investors usually lose money -- One of the main reasons that people lose money in the stock market is that they allow their emotions and/or crowd behavior to guide their trading. To make money you need to buy low and sell high. However, when prices are low most people get discouraged, so they don’t buy when there is little risk. Instead, they wait until the price has substantially recovered, so they can buy when the crowd is buying. By the time a market is getting ready to enter the blow-off phase, the crowd is euphoric. So instead of selling out at the top, people expect the trend to continue and they hold their positions. They wait for a recovery, which may never come. Finally, in desperation, they sell at the bottom. The result is that people often buy high and sell low. This is not the way to make money.

So how do you avoid the influence of your emotions and/or crowd behavior? For the actual trading, use some type of mechanical trading system that reflects the realities of the market. However, you probably should do some paper trading first. Then you would have confidence in whatever trading system you have chosen.

How to find suitable opportunities

The causes of big market moves -- It can be useful to understand the causes of big market moves. If an advisory recommendation is based on one of these causes, then you are off to a good start in finding a suitable opportunity. In my opinion, the following are the most prevalent causes of big market moves:

* Breakdowns in transportation
* Business cycles
* Changes in the customs or attitudes of consumers
* Changes in the emotions of traders in the market
* Changes in the inventory level of vital commodities
* Crop failures or other shortages
* Currency or economic crises
* Depletions of natural resources
* Embargos, tariffs, or other trade restrictions
* Failures of market to reflect new conditions
* Government interferences in the market
* Growth or decline of companies
* New laws or regulations
* New technologies
* Rumors, propaganda, and publicity
* Special situations (sudden or unexpected events)
* War and other disasters
* Widespread strikes

How to handle investment advice -- There are four basic types of investment advice. Advisors using fundamentals often can alert you to potential long-term bull markets before they start. However, these advisors are often very poor at timing these moves. Advisors using technicals often are good at timing, but may ignore other important considerations. Advisors using special techniques (astrology, etc.) may have certain insights into the markets, but their methods are outside the mainstream of trading. Finally, there is worthless advice. This advice is known as hot tips, and it usually comes from nonprofessionals or even fraudsters.

Don't be confused if different investment advisory services don't agree with each other. No advisor is right all the time. Thus, it can be very useful to hear a contrary opinion. Also, treat forecasts from advisory services as a possibility, not a sure thing. You should use their information mainly to alert you to potential opportunities and to warn you of possible dangers.

How to review the pros and cons -- When deciding whether a potential opportunity is suitable for trading, consider the following factors:

* How long the current trend has been in effect
* The likelihood of the trend reversing or reacting
* The likelihood of the market being controlled by outside parties
* Other apparent risks in trading the opportunity
* The amount of risk capital needed to trade the opportunity
* Whether the affected stock/market has a low-risk entry point
* Whether the affected stock/market has ample trading volume
* Whether taking a position would violate your money management rules
* Whether taking a position would violate restrictions discussed elsewhere

Planning for profits

Determining entry and exit points -- Here are my suggestions about entry and exit points. You would take the initial position upon a price breakout from the prevailing market price. If the market appears to be strong, you might want to take additional positions upon a price reaction, and then a price breakout from the newly prevailing market price.

Protect your positions with appropriate stop orders to close out a position that is losing money.

There is an old rule in stock trading, "Sell down to the sleeping point." Thus, if you aren't comfortable with your current positions, then you need to close out some of them. However, if you follow the above money management rules, you will avoid this problem in the first place.

I believe in three types of stop orders to close out your position. The first stop order is set below your purchase price. Its purpose is to keep you in the market upon small fluctuations in the market price, but to close out your position if the price starts to collapse.

The second stop order is set slightly above your purchase price. Its purpose is to take you out of the market at a breakeven point if the price starts to collapse.

The third stop order will take profits for all or a portion of your position after a minimum profit has been attained. This is a trailing stop that is raised, but never lowered, as the market price continues to climb.

You need to determine the formulas for a price breakout and the three types of stop orders, using the above guidelines. (There will be more details on this matter at a later time.)

Set up your stock trading plan -- After you have verified that a market opportunity appears to suit your needs and resources, you need to determine the market risk, either low or medium. Determine the expected price move per investment advisors and/or past market activity. Determine how much of your available funds to invest in this particular opportunity. Use the restrictions in your money management plan above.

You should make all your decisions and record them before taking any position. By doing this, you have used your common sense, not your emotions or the crowd behavior, to determine how to trade a market.

Watching and trading activities

Take a position only on a breakout -- Take your positions only upon a daily price close above the breakout level per your watching spreadsheet. Ignore what the cheerleaders and the perennial bulls are touting.

Set up your trading spreadsheet -- Once you have taken a position, add it to your trading spreadsheet, and place the initial stop loss order. Use the formulas for the three types of stop orders per your exit points above. Place and monitor appropriate stop orders on all open stock positions. You should revise the stop orders weekly, if needed.

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