How I Trade Stocks

The obvious way to make money in the stock market is to have all of your money in an equity that is increasing in value. The problem is that it is impossible to know in advance which way the stock market is going to go. For this reason many people think of it as gambling. And you certainly can gamble in the stock market.

But what if you could tilt the odds in your favor? What if you could minimize your downside risk and maximize your upside exposure? Would it still be gambling?

Here is what I do. First of all I do not trade in stocks at all. I trade in Exchange Traded Funds (ETFs). One advantage over a stock is that with an ETF there is no insider information. I am trading the broad market economy, and so to get an opinion about which way they are going to go, I just have to read the general financial news.

Another advantage of an ETF is that they can be leveraged. For example I like Direxion Large Cap Bull 3X Shares (BGU). These ETFs will move the same as the Russell 1000 Stock index, but are designed to amplify the movement by 3 times. That gives you plenty of big movements to make money.

Lastly ETFs are market direction neutral. For example, if I think the market is going down I just trade the opposide ETF which is Direxion Large Cap Bear 3X Shares (BGZ)

Now with a margin account you can trade for up to twice the amount of money that you have in your account. For example, if you have $25K you can buy securities worth up to $50K and hold them overnight. However, if you are just daytrading and not holding them overnight (which is considered riskier) you can buy up to $100K worth of securities for only $25K.

So you can see that if you buy $100K woth of a 3X ETF you have plenty of upside bang for your $25K, but unfortunately you also have a lot of downside bang, too. Is there any way to limit that risk so that the odds are in your favor?

There are two main ways to do this. The first is with the STOP LOSS order. This is a type of order that you can place that if the stock drops to that level it will automatically sell it for you. There is no charge to do this unless the security actually sells. So for example, if I buy a security that is going up for $100 dollars, I can immediately follow that up with a STOP LOSS order at $99. So I would have infinite upside exposure and only 1% downside exposure. Now I can go to the bathroom and if the market starts to slide I will be kicked out of it before my losses become substantial.

Also, the STOP LOSS order is adjustable. For example if that stock I bought at $100 goes up to $101 (because I bought it on an uptrend remember) I can adjust my STOP LOSS order to $100. Now I have little or no downside exposure and infinite upside exposure. Do you see the odds adjusting in my favor now?

But still those bouncy crazy stocks can be tricky. If you lose 1% often enough it adds up. How can you limit that first exposure? The trick is to pyramid up, not pyramid down.

Investors often pyramid down. For example, if you buy Apple Computer Stock (AAPL) at say $100 and then it drops to $90, and investor will buy more, because if it was a good deal at $100, it is an even better deal at $90! Traders never do this, they do the opposite.

For example, say I can buy up to $100K in securities. I will split it up into 4 $25K blocks and when a trade looks good to me I do not spend all $100K. Instead I only buy $25K worth and I immediately also place a STOP LOSS order. Now if I am wrong I will get booted out of the market with a small loss, but with almost all of my money intact to try again another time. But if I am right it will go up and I move my STOP LOSS to what I bought it for. Now I am safe from loss. If it goes up more then I move my STOP LOSS up to secure a profit. Now here is the important point: now that I have a profit I can safely commit more capital. I can pyramid another $25K in and if the market turns against me, I will only have risked the profit that I just earned. I will not have lost any money. Then I do the same thing again two more times moving my STOP LOSS order up as I go. In this way I can deploy $100K into the market at the risk of only 1% of $25K. Further, if I can successfully do this I will also have validated my belief in the market direction. If I am wrong about the direction it will have already kicked me out.

There are few things as exciting as being all in safely into a market that is moving in your direction.

Note: You can not do this at any time. You have to be patient and wait for the right time. It does not work if the market is moving sideways. Fortunatly, lately the market has been bouncing up and down like a ping pong ball.

Also, I am fortunate to work weekends and so I can devote my time during market hours to only trading. I would not try this if I was at work for example. Anyone who would face distractions during market hours are better off investing rather than trading. It does take concentration.