InvestorPlace Blogs is powered by Marketocracy. Marketocracy has authorized Investor Place Blogs as an official registrar for voting through Marketocracy's Investment Research Rating service. Registered members of InvestorPlace Blogs are linked with a Marketocracy account to establish voting power based on their performance of trading and posting on stocks.
With market volatility so high, there are some excellent day trading opportunities out there if you know how to manage your risk. Many consider day trading quite risky, and indeed it can be. However, I would argue (and I have argued) that buy and hold investing can be just as risky, it's just not advertised as such.
So how do we manage risks while day trading? There are several ways, but today I'd like to highlight the basic strategy of using buy and sell stops.
1. Use a buy stop to determine a good entry point.
Many people are familiar with sell stops, but not as many people use buy stops. The concept is simple. You set your buy stop at a certain percentage, certain dollar amount, or certain technical level above the current price. So if SRS (Ultrashort Real Estate) is currently trading at 130, a buy stop could be placed 1% above at 131.30, for example. If SRS trades up to 131.30, you will buy the stock at that price. If SRS never gets there, you will not buy it and you should be happy because that means the stock is either moving sideways or down, which would not be a profitable day trade.
It may seem counterintuitive to want to buy a stock at a higher price, but day trading is all about catching upward price movement. This is not an excercise in fundamental analysis where you are buying the stock at an appropriate value and giving it time to realize that value. In day trading, you simply want to buy a change in the stock price, and it doesn't matter if the change is for legitimate reasons or daily noise. With a buy stop, you are betting that the price will continue to move up as it triggers your stop. If you buy as the stock is moving downward, chances are high that you will immediately be underwater on your day trade. That's not good.
Personally, I like to use trailing buy stops in order to catch reversals in price movement. Let's say SRS, again, is trading at 130. If I set a trailing buy stop at 1%, my initial buy point will be 131.30. If SRS goes down, my buy stop will trail the price downward, and maintain a distance of 1%. The benefit here is that as SRS continues to get cheaper, my buy point continues to get more attractive. Once SRS turns around and starts moving up, I will buy that upward price action. Instead of buying a hard stop at 131.30, I buy a trailing stop in this example at 127.26--a significant difference in price. Here's how it looks on the chart (click on chart to enlarge).
2. Use a sell stop to cut losses or lock in profits
So I own SRS at 127.26. The key to day trading after buying a stock is to prevent losses and lock in a gain. The best way to do this is to set a sell stop. Without sell stops, day trading can be very risky because you could be down several percent in a flash. Initially, I like to set a sell stop either at the day's purchase price or at a minimal loss, like 1-2%. If I set the stop at 127.26, I will likely get stopped out quickly unless I caught the move just right. Therefore, I often give my trade a little room to work, but no more than 2%.
If the trade is working and I'm up 1-2%, I start thinking of how to preserve the gains. The first step is to never let a winning trade turn into a losing trade. In our example, I'd set my stop at 127.26. The worst case scenario at this point is to finish the trade flat. After that I might set a hard stop after the stock has gone up and I see some support on the chart, around 130.
Again, trailing stops can be very useful. After I see that my stop at 130 has held and SRS is continuing to move up, I can set a trailing stop of 1% to try to maximize gains. In our example, SRS makes it to 140 and my stop trails it to 138.60. When SRS pulls back, the trailing stop is triggered for a very nice gain. I might have made more if it goes higher, but I can rest easy knowing it was a successful day trade (click on chart to enlarge).
That's an example of a big winner (almost 9%), but even gains of 1% can be worthwhile over time, as long as you don't lose more than 1% on any given trade. Let's say you start with $10,000 and you trade the full amount each day for 20 days. If you lose 1% 5 times (25% of your trades), are flat 5 times (25% of the trades), and gain 1% 10 times (50% of trades), you will probably end up with around $10,500 when it's all said and done, a gain of 5%. Of course it depends on when you make your gains and when you make your losses, but my calculations are based on a random order of gains and losses. The point is that sometimes you will win and sometimes you will lose, but you only need to win half the time for some nice gains. 5% is not bad at all for a month's worth of trading.
Here's the key. Some days you might catch a big move and make much more than 1%. Those will be great days and they can make your month or your year. But you should never lose more than 1-2% on a single day trade. Not only will a big loss be difficult to make up, it can be psychologically and emotionally damaging, and will affect your trading negatively. Using stops takes the emotion out of trading. You will undoubtedly get stopped out plenty of times, and perhaps become frustrated by missed opportunities. But opportunities are made up easier than losses, and risk management is all about avoiding disaster.
Day trading is not for everyone--it's time consuming, takes planning, and you need to be able to focus on the market during trading hours. Also, many brokers have rules that limit day trading. Unless you have $25,000 in your account, you may be restricted to 3 day trades in a 5 day period, and if you exceed 3 you may face restrictions. That said, I think day trading in a volatile environment can be a low risk endeavor as long as you stick to your stops. As you close out trades each day, you will never wake up and helplessly see your stock gapping down 10%. In my day trading account, I have missed the recent 15% or so up move in the S&P 500, but I also missed the 25% decline since October 1st. In day trading, I'm not a slave to relative returns, I can pick my spots and try to make money whether the overall market is going up or down. In my opinion, this is an important skill in a difficult market.
[Read more on my personal blog at www.thestocksurfer.blogspot.com]
| 
RSS 2.0
