Successful trading isn’t just about picking the “right” stocks; it’s also about carefully plotting out your strategy and sticking to it. Even so, we often find that’s easier said than done. So we asked our Schwab trading experts what they think makes a successful strategy, how they go about implementing it, and how to avoid the most common pitfalls.
Q: How do I know which stock to buy?
Randy Frederick: Start with a rating system and use it to weed out stocks that don’t fit your parameters. With Schwab Equity Ratings®—our proprietary stock rating system that uses a simple A–F scale—you can take a universe of a few thousand stocks and whittle them down to a couple hundred just by ruling out anything less than a B rating. You can then use fundamental analysis (research gathered from a company's financial statements) or technical analysis (research drawn from examining chart patterns) to narrow the list further. Once you have identified a good stock, consider using technical analysis to decide when to get in and what price you’d like to pay for it.
Lee Bohl: I like to buy stocks that are highly rated by Schwab Equity Ratings with positive technical signs. For example, I look for up-trending stocks that are trading above both their 20-day and 50-day simple moving averages. In my view, it’s also a good indicator when the near-term volume (5-day average volume) is greater than the longer-term volume (20-day average volume or 6-month average volume, depending on trade time frame) because it may indicate that the trend will continue.
Q: How should I use a stop order?
Kevin Horner: A stop order is an order to buy or sell a security when it reaches a set price. It helps traders control their emotions and stay in control of the trade. When I don’t use them, I end up holding positions much longer than I should. It’s important to set a stop order at the beginning of every trade. The first step is to look at a security’s support and resistance levels, where historically the price of the security has tended to stop and reverse direction. You can place your buy order based on that information. Once the order has been filled, you can enter your stop order. Always keep in mind, however, that there’s no guarantee that a stop order will be executed at or near the stop price.
Lou Mercer: Schwab.com and StreetSmart Edge® have a tool called Recognia that suggests where to place your stop order. You can indicate whether you want to set a tight, moderate or loose stop. It uses an algorithm that takes volatility into account.
RF: Stop orders tend to work well during market hours. After hours, you want to be careful. For example, when a company reports its earnings after market hours, you might see a considerable gap in price when the market opens (the opening price is significantly lower than the prior day’s closing price). As a result, your order could be filled at a price that is substantially lower than your stop order price.
Q: How do I keep from selling a stock too soon?
LM: The best way to try to avoid this is to know exactly why you bought the stock and what you want to get out of it. When people don’t establish those parameters ahead of time, they tend to let their nerves get the best of them.
KH: A trailing stop orders is the best tool available to help sell at the most opportune time. It sets the stop order at a specified amount below the market price. To reduce the likelihood of being stopped out early and selling too soon, review the stock’s average true range (ATR) for a time frame that is consistent with the trade you have in place. For example, if a stock’s 15-day ATR is $1, that means it’s averaged a $1-a-share spread for the prior 15 trading days. In that case, I want 1.5 to 2 times that amount as my trail to limit my chances of being stopped out.
RF: I often sell half of my position when I think I’m getting close to the top of a trade. If you sell half and the stock goes higher, you still have some of your position. If you sell half and it goes lower, you’ve pared back your position. It’s a simple discipline but it has worked for me.
Q: When market volatility heats up, how do you recommend traders respond?
RF: I like to make smaller trades when volatility flares up, because volatility can increase risks. While smaller trades will mean decreased profit opportunities, there’s also a lower risk of losses.
KH: Volatile markets require even more discipline. I think it’s important to pay attention to what the stock is telling you; wider swings could mean more risk. Yes, volatility can work in my favor, but volatility can also leave me in an uncomfortable position rather quickly.
Q: What should I include in my trade plan?
LB: I believe that the most important component of the plan is your exit criteria for a trade—both when the trade is going for you and when it’s going against you. In addition, you should establish your time frame for the trade and whether you’re going to rely on fundamental analysis or technical analysis to help make buy or sell decisions.
LM: Your trade plan needs to address whether you’re buying something as a short-term trading idea or a long-term investing idea. All too often, traders buy a stock as a trading opportunity and then let it transition into a long-term investment when it goes against them. In addition to an exit strategy, your plan should set a risk/reward ratio. This puts you in control of the trade by defining both how much you expect to make on a trade and how much you are willing to lose. For example, I look for a risk/reward ratio of roughly 1:3. This means that I’m comfortable risking $1 to potentially make $3.
Q: What is the biggest mistake that you see traders make?
LB: People don’t like taking losses. That often leads them to hold a position for too long, or add to a position that’s not working just because they can buy it at a lower price. Loss aversion is a powerful force—the best way to fight it is to have a trade plan and stick to it.
RF: Some people will trade a product or strategy that they don’t understand. They will put real money on the line and then do the research to find out how they lost it. My advice is to do the research up front.
KH: Sometimes I see investors make trades based on the news or a market event. Instead, keep notes about your exit strategy the day you make a trade, and then follow that strategy. This allows you to make decisions based on chart analysis rather than rely on your emotions.
Q: What are the habits of successful traders?
LB: First and foremost, stick to your trade plan. On top of that, maintain a trade journal and review your trades. Jesse Livermore, who traded during the early 20th century, was one of the greatest stock speculators of all time. At the end of each year, he would go down to his bank and lock himself in the vault and review all of his trades from the prior year. Fortunately, modern traders have tools at their disposal to make this process a lot easier. StreetSmart Edge enables you to take pictures of charts and take notes. Make use of them whenever you get into or out of a trade and revisit your notes later to understand why something did or didn’t work.
LM: Successful traders don’t gamble. In order to trade for the long term you need to understand what’s at stake and have a method for managing risk. Having a disciplined risk management strategy is what will keep you trading for many years to come.
Randy Frederick Managing Director of Trading and Derivatives
Lou Mercer Trading Solutions Regional Manager for Northern California
Kevin Horner Senior Specialist, Trading Services Education
Lee Bohl Market Manager, Chartered Market Technician