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This article appeared in the July 2011 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Master the basics first: educate, plan, execute.

Photo of Louise Bedford By Louise Bedford, Author

Suppose you were planning to buy a business that had the potential to create an unsurpassed lifestyle for you and your family. Would you spend some time discovering the critical components necessary for success? Of course you would. You would also work hard to develop a business plan that would set you up for the future.

One of the key similarities with successful people from all professions is that they start with the end result in mind. If they want to make a million dollars out of their business, they set up a business that is capable of earning that amount of profit. This sounds such a simple concept, but many traders, when they begin, seem to short-change their new venture and strangle their own potential results.

Let’s look at some aspects you need to consider to trade the sharemarket successfully.

You need support

Do not make the mistake of thinking you can do all of this yourself without help. Sharemarket trading can be lonely, even when everything is going your way. Find someone who cares about your success and a group of traders who have already stepped through the minefield. Educate yourself, or you will suffer the consequences.

To really learn the ropes about trading, invest in some quality books and perhaps attend some seminars. This will speed up your progression from beginner to experienced trader. Trading mistakes are expensive, so it makes good sense to learn how to avoid them.

For a basic set of books, CDs and DVDs be prepared to invest around $2000 to $3000. Courses range from $200 for a day, up to around $90,000 for personal tuition, depending on who you go to, their record and reputation. Paying more does not necessarily mean you get better value. Do your homework.

(Editor’s note: ASX offers a range of free online courses for investors and traders. Consider these courses first before progressing to dearer paid courses.).

Choice of brokers

There are two basic levels of brokers in the trading community: full service and discount brokers.

A full-service broker tends to provide all the bells and whistles you would expect, especially given the amount of brokerage (up to 2 per cent of the value of every transaction).

Discount brokers fall into two categories – the ‘human’ variety or online brokers. ‘Human’ discount brokers will talk to clients over the phone and offer very cheap rates. However, they will not provide advice or send flashy newsletters, and often clients will not be able to deal with the same person every time they make a transaction. Fees of around $50 or more per small transaction are common.

Online brokers often charge a flat fee per transaction (for example, $19.99) up to a certain value of shares traded (say, $50,000). If you know how to trade and are not afraid of technology, online trading is a great way to minimise brokerage costs.

Suitable software

Sharemarket software uses shares-related data to produce charts and other forms of analysis. Expect a fee of $600 to $2000 for good software. You should consider:

  • Can you search the market easily for opportunities?
  • What technical support is available if you run into difficulties?
  • Are there training courses you can attend to help learn about the software?
  • How user-friendly is the manual and help files?
  • Can the software handle a variety of data formats from different data providers, or will you be required to buy your data through only one source?

The software needs data to be able to produce the charts or figures you will use to make trading decisions. Technical analysts rely on data such as volume traded and share price action. Fundamental analysts require company profit, loss and balance sheet figures. It is your choice as to which type of analysis you prefer.

You will also need to invest in a relatively up-to-date computer if you do not already have one, at a cost of around $1500.

Trading plan

The best traders approach the market with a trading plan, which is their blueprint for success.

Your plan must cover some basic issues such as your trading goals and objectives, an accounting structure from which to trade, and how you will handle your positions when you go on holidays. A trading plan must also cover three essential areas:

  • Entry
  • Exit
  • Position sizing

Entry

Develop a scientific process for analysing signals, and do not let your emotions dictate your trading habits. You need to define your signals in words in a clear fashion, so another trader unfamiliar with your technique could duplicate your strategy.

Exit

The golden rule of trading is “Keep your losses small and let your profits run”. Stop-losses provide a sign that it is time to exit your position, as it is no longer co-operating with your initial view. Every successful trader has premeditated the conditions of exit before entering the trade.

Many people set a stop-loss, but when it is hit they convince themselves the trend will reverse and they just need to give the share more time to prove itself. This is detrimental to your psyche as well as your bank balance. Do not bury your head in the sand by holding on to a losing trade as a ‘long-term investment’ when you should have sold it months ago. Set your stops and follow them. When the share moves in the anticipated direction, you can trail your stop behind the share price to lock in your profit.

Before placing an order, decide how or where you will exit. Use a stop-loss to capture your profits and avoid large losses.

Some traders day-trade and spend three to eight hours a day in front of their screens. Others trade weekly and devote only about one hour a week to trading. There is no ideal amount of time. It depends on you, your lifestyle and how much time you need to create the results you crave. Short-term traders do not necessarily earn more than longer-term traders, but they definitely spend more time watching a screen.

Position sizing

The key to managing risk is to size your positions correctly. Buy fewer shares and give the price action room to move if conditions have become lumpy. Seek risk by buying more shares when in profit, or if conditions are more stable. There are many ways to gauge your position size according to sound risk and money management principles. Whichever method you follow, make it explicit by writing it in your trading plan.

Consider position sizing and capital allocation based on risk. Here are some basic guidelines to ensure you do not get blown up while frolicking in the financial jungle:

  • Commit a maximum of 15 per cent of your total equity to higher-risk sectors of the market. As an example, with a trading float of $100,000, $15,000 can be devoted to speculative shares. This will allow you to buy a maximum of four or five lower-risk shares, and up to three or four speculative ones. This will still provide exposure to possible high returns, without the potential to devastate you financially if the market drops from the sky. 
  • Before you enter a trade, determine where or how you will exit if the market turns against you. By only allowing yourself to incur a loss of a maximum of 2 per cent of your total equity per position, even a string of losses will not destroy your capital. Your number one goal in the market must be the preservation of capital. When traders have learned how to consistently make more money than they lose, they enter the realm of the professional trader.

Successful traders are among the most highly paid professionals in the world, yet many beginners in the market expect to earn exceptional income immediately, without undue planning and effort.

Profitable trading does not rely on luck. It demands the highest levels of skill and discipline, and lucratively rewards the people who develop these qualities. This is a marathon, not a sprint, so make sure you get set properly before leaping from the starting blocks.

About the author

Louise Bedford has a free five-part e-course at www.tradinggame.com.au. She is also the author of The Secret of Writing Options, The Secret of Candlestick Charting, Charting Secrets and Trading Secrets.

Download a trading plan template. It will help you work through all the vital issues that need to be included in a sophisticated trading plan to give you an edge in the sharemarket.

From ASX

Learn about trading through the ASX Sharemarket Game, one of the world’s great real-time trading games and the only type of its kind in Australia. Each player has a notional $50,000 to invest over 10 to 15 weeks, with a maximum of 10 orders a day to buy and sell. No more than 25 per cent of the portfolio’s value can be held in one share. 


The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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