If You’re Going to Trade Stocks, Read This First

by Lee Distad

Regular readers of Automatic Finances will know well that we advocate long term, buy-and-hold investing.

Overall, for both small and large investors, it remains the most stable and consistent approach to both wealth creation and preservation.

Short-term trading, in comparison, carries considerable risks to an investor’s capital. That’s why it’s important to make that distinction between investing and trading.

I believe wholeheartedly in value investing, but at the same time recognize the faults in human nature. We know that smoking, drinking or eating junk food isn’t great for us, but we do it anyway.

Moderation is the key, of course. Small indulgences in your vices are okay — it’s when they make your life unmanageable that there’s a problem.

I will admit that I actively trade. That and too much coffee are my major vices. Trading is not my sole financial strategy, but it’s certainly the most entertaining one.

Education, Experience are the Only Teachers

If you intend to actively trade, educate yourself. There are plenty of books and online resources on the subject. Just bear in mind Sturgeon’s Law that 80% of them are going to be worthless. (I can’t be the only person who thinks that Day Trading For Dummies is one of the most unfortunate book titles ever.)

Bear in mind that while book-learning is important, your real education is going to come from actually doing it — with your own real money. As the saying goes, you learn more from failure than from success.

If you’re a complete newbie to active trading, there are some small but important details to consider. You may or may not see them spelled out for you all in one place, but knowing them and living by them will save you some expensive lessons.

Volatility Is Key

Don’t expect to make a short-term profit on a stock that moves very little. Stable stocks with a long-term growth capability are what you want for investing, but in the short run, look for stocks that have broad highs and lows in their recent trading history.

Volatility is what you’re looking for as a trader, but it’s not your friend. If you bet wrong, it will cost you. But you already knew that, right?

Trade in Size

Just as important as volatility is the need to trade in large blocks of stock. There are two very good reasons for this.

First, when you buy, the cost of your brokerage fee is added to the book value of your holdings, and when you sell, it’s deducted from your proceeds.

For example, if you buy 5 shares of ABC at $100 and your brokerage fee is $9.95, then your book value is $509.95, for an average price of $101.99. The $2 difference may not seem like a lot, but it means that you’ll need to sell your position at over $519.90 (your book value of $509.95 plus a $9.95 fee for selling) or $103.98 a share in order to break even, never mind make a profit.

Contrast that with buying 1000 shares of CBA at $1 each. Your book value is $1009.95, or $1.01 a share. Now price movements above $1.02 are something you might profit from.

No one who’s honest can guarantee that you will make a fortune trading, but If you actively trade in blocks of less than thousands of shares, I can guarantee that you will lose your shirt.

With that in mind, you need to confine your research to stocks with a low share price. If you can afford to buy thousand or ten-thousand share blocks of Fortune 500 companies, you don’t need to take advice from me.

Note the Bid/Ask Spread

If you don’t know better, selling your shares while looking at the current price might be a rude awakening. The posted price is just the price of the last trade.

The Bid/Ask spread is the difference between what a seller wants and what the buyer wants to pay. When the two agree, a sale occurs, and the price of the trade is listed.

When you sell “at market price” instead of setting a minimum, you sell at the Bid, which can be lower than the last trade price. Don’t get stars in your eyes when you see your stock price has soared. If you’ve already missed the rush, you’ll either make less than you thought or actually lose money on the trade.

Ignore the Peanut Gallery

It’s a point that’s been made before, but when it comes to “financial news” from either the mainstream outlets or the blogosphere, it’s impossible to separate the signal from the noise.

Don’t stay glued to news channels and websites, and never read investing bulletin boards. A smart person can conclude that bulletin boards and anonymous stock tip blogs are all noise, but mainstream media can be seductive.

Remember that news sources will tell you what happened — not what’s going to happen. Don’t rely on their predictions.

Don’t Kid Yourself

It’s human nature to accentuate the positive and downplay the negative, but it’s not conducive to self-improvement. Be totally honest when assessing your trading results.

I won’t lie, in the course of my active trading hobby, I’ve made spectacular picks; some were spectacularly good, others were spectacularly bad.

At the end of the day, I’m just a monkey with a dartboard. I may not be a broke monkey, but I’m a monkey all the same.

Don’t let your wins go to your head, and find lessons to learn from your losses. Both are going to happen, so demonstrate moderation and don’t let trading be a roller coaster ride with awesome highs and terrible lows.

A friend of mine who’s very good with money is fond of pointing out that the average bike messenger makes more money than the average day trader.

I don’t know if he’s right or not, but the lesson here is that you should be diversified, maintain a long-term investing strategy, and don’t look to active trading as a sole financial plan.

About the author: Lee Distad consults with CE integration firms on design, installation and project management processes and Best Practices, and offers provides professional copy writing services for websites, brochures, and marketing initiatives. Visit him at www.leedistad.com.

{ 5 comments… read them below or add one }

Brad Castro September 29, 2009 at 11:25 am

I’m glad to have come across this blog . . .

I can relate to your investing and trading philosophy. I’m also a long term buy and hold investor. But I also employ certain conservative option trading strategies to perpetually lower the cost basis on my holdings (which I’ve termed, “Leveraged Investing”).

Actual Investing is the easiest (and most likely) way to grow wealth, but the option trading helps stack the deck as well as satisfying what you referenced as the “entertaining” aspect of trading.

The only point where I would disagree is the need to trade low priced securities so that you can trade thousands of shares at a time. If you have $10K to trade in a position, what difference does the share price make? Whether it’s $10/share (i.e. 1000 shares) or $100/share (i.e. 100 shares), you’re still working with the same amount of capital.

Lee Distad September 29, 2009 at 4:32 pm

Hi Brad,

Thanks for the kind words. While it’s true that a 10% gain in share price will be the same gross number if a $10K position is composed of $100, $10, $1, or even $0.10 shares, the reason why block volume matters is that it requires less dramatic price movements to realize a gain. Remember, we’re not buying and holding, we’re speculating on the short term volatility of a share price.

Let’s assume we’re really aiming low as traders here:

If you have 100,000 $0.10 shares, a one cent gain is $1000
If you have 10,000 $1 shares, a one cent gain is $100
If you have 1000 $10 shares, a one cent gain is $10
If you have 100 $100 shares, a one cent gain is $1

Net of your brokerage fee, only one of these outcomes is worth trading on.

Let me reiterate that I think short term trading is no way to make a living, but does that example clear up my perspective on book size?

Brad Castro September 29, 2009 at 4:58 pm

Sure – I understand where you’re coming from, but I think the implied advantages from the increased volatility of penny stocks is mitigated to a large extent by another implied possibility – that the company might trade down to zero.

Of course, when I speculate, I’m just trying to pick up another couple hundred shares of MCD or SBUX at a discount.

Looking forward to reading more . . .

Lee Distad September 30, 2009 at 9:26 am

Ha, there is always that! It doesn’t even have to be as dramatic as going to zero, just going in the wrong direction and staying there indefinetely, which is why market timing is not a good strategy.

Thanks for your comments!

rene January 5, 2012 at 1:57 pm

I actively trade on our market here in Hong Kong
we are lucky to have no tax on capital gains and a very active market.
I have made money trading actively and lost money trading on longer term, in my experience there is a lot of money to be made but it all depends on the market condition and not so much on the skill of the trader.
make money in a strong bull market and make sure to make enough to be able to sit it out when conditions are not so good.

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