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The 1-2-3 of trading.

1. Timing

There is nothing more important for a trade than good timing. Many times, what in essence is a winning trade turns out to be a losing trade due to poor timing. Buying a stock too early might mean, for example, that the stock you are eyeing has another 5% drop before it hits bottom and reverses trend. This could mean that you envisioned the correct trade, but executed it prematurely. At this point, being down 5% might scare you and make you think that you were wrong. So you end up selling the stock in panic just to see it bounce and make a 50% move from where you sold it. Let me tell you, that's not a good feeling.

What you need to understand here is that patience is key. One of the biggest mistakes amateur traders make is thinking they will miss the move. This will make you act anxiously and enter a trade prematurely. Hey, if you miss the move, you missed it. There are literally hundreds of moves DAILY for you to catch.

As bad timing can make you enter a stock prematurely and thus turn what could've been a winning trade into a loser, bad timing can also make you "chase a stock." This happens when you wait too long to enter a trade. Your stock is now doing what you thought it would but is getting overextended from your desired entry point. In a panic, you again enter the trade thinking you will miss the move just to see you overpay for the stock. Sometimes overpaying is not that grave, for it could mean you still make a profit. However other times, as you again entered the trade in panic mode, overpaying makes you enter a trade that turns out to be a loser. Either way, overpaying is a consequence of bad timing and should be corrected with self-control.

2. Discipline

Having discipline to stop a loss is going to make you last a long time in this game. Let me clarify, discipline is required in every aspect of trading, however in this instance, I refer to discipline as a function of stopping or cutting a loss.

I like to trade with a rule I came up with: the 80/20 rule. Here, 80 means 80% discipline and 20 means 20% intuition. Let me start with intuition. Intuition doesn't mean luck, hope, gut feeling, or any other abstract concept. Intuition means recognizing something, be it a pattern or a valuation number, that MAKES YOU WANT TO trade a certain way. Intuition is only obtained after years of experience. The brain, after repeatedly witnessing certain scenarios play out, sends a signal of significant magnitude for YOU to notice. This signal gives you a sense of security on to what might happen next. Since in a way intuition is still not something scientifically proven, I only use 20% in this rule. I recommend using 0% intuition for beginners.

The other part of the rule is discipline. Even after years of experience, the stock market is always bigger, better, and stronger than the traders that trade it. That is why using 80% discipline while stopping a loss is absolutely necessary. This means that 80% of where to stop your loss is based on discipline. This will vary from trader to trader. Some traders have a bigger tolerance for losses than others. Some traders like to cut losses at 3%, while others can tolerate losses of 8% or greater. It all depends on your specific situation. What is not flexible though, is the fact that you need 80% discipline in the decision making process for stopping a loss.

Let's say you enter a trade and it starts to go sour. You need to define your strategy. If your tolerance for losing is of 3%, then there is an 80% chance that you DO enter a stop order at 3%. The other 20% for determining to put a stop order at 3% will be your intuition. Maybe you sense that you have entered a trade prematurely, and that your position might drop more than your loss tolerance but will come back to what you had previously thought. If your intuition is true enough, then your 20% aspect of the rule will win and you will override the discipline part. Let me tell you something, many winners have come ffrom favoring the 20% intuition of this trading rule. However doing this requires experience, I do not recommend it for beginners. As I said above, I recommend 100% discipline for beginners.

3. Intuition

Being intuitive will make you pull the trigger and actually make profits on your trades. It takes time to develop it though. Here, rule #2 gets flipped. Rule #3 requires for you to have 80% intuition and 20% discipline. I would like to tell you that this rule is also made for experienced traders. It's as aggressive a strategy as it gets. I recommend being more conservative when you are starting out, thus balancing the ratios to about 50% intuition and 50% discipline.

As where you have to close an order to stop a loss, one needs also to take action for a profit to take effect. You might be winning in a trade but as long as you don't close the trade, those winnings are not real. Having a strategy for closing a profitable trade is paramount. Otherwise you can spend your whole life watching your account "winning" without you actually ever seeing a dollar.

Some traders like to have rules where they take profits at 5%, 10%, 15%, and even 20%. Any rule is valid as long as it fits your style. However I like to use my own rule, the 80% intuition and 20% discipline rule. Just as the stop loss rule, this rule has an 80% component and a 20% component. However this one is turned around. Here's how I see it: making a profit if a blessing. If you are winning, then you're already there; it doesn't matter by how much. The only thing that matters is that you are NOT losing. This is why I like to be very aggressive when taking profits. Hence the 80% component is intuition, not discipline. This is where the great traders take off while the good traders are stuck in the 5% to 10% yearly bracket. Great traders can consistently make 100% a year or more. They do it by making decisions mainly (80%) on their intuition. Again, intuition requires experience. Intuition is only developed after witnessing countless scenarios played out so that the brain starts recognizing intuitively what might happen next. You might intuitively recognize that your trade is heading much higher (or lower, depending on whether you are long or short), than what your discipline (say 15%) is telling you. So instead of ending up with a 15% profit, which is by no account bad, you end up with a 50% profit. Again, patience is also required for this one.

In this rule, discipline, although not as emphatic as intuition, also plays an important role. While intuition will let you turn singles into home runs, discipline will turn strike outs into singles. If you understand the analogy here, when you are in a rut, you would rather make 15% than make nothing at all, or even worse, lose. So discipline is required 20% of the time, when your intuition is failing. Understand this, just as stocks go up and down, your winning streak goes up and down. Great traders also recognize that when you are in a rut, you absolutely need to exercise discipline. I like to have a 5% profit rule when I'm basing my decision on discipline.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.