So you want to be a stock trader. Great!
Now where do you start?
Read a book on trading? How many books should you complete before trading?
What about taking an online course? Maybe a seminar?
Better yet, why not just follow another profitable trader through a subscription service and piggy-back on their trades?
All of these approaches have merit and I must confess that I have tried all of the above. But one of my biggest lessons did not come from a course, book or subscription service.
It came from learning how to play guitar.
Learning To Shred
It was the late 1980s when I learned to play guitar on my brother’s acoustic. My older brother had a red Yamaha axe and boy-oh-boy could he shred. I wanted to be like Yngwie Malmsteen, George Lynch and Paul Gilbert all rolled into one. My brother gave me an extensive and in-depth course to build my chops.
And it went miserably!
What was the problem? I was bogged down in theory learning the Mixolydian Mode before I could form a common two-note power chord. Despite by brother’s assurance that this was the quickest route to being a master of soloing, I was crashing and burning.
The fix? I learned a few simple riffs.
In just a couple of days I could play recognizable chord progressions from popular songs. No, I couldn’t play Eddie Van Halen’s rendition of “Eruption” but I could hammer out the opening chords of “Panama”. That was the push I needed to keep learning and improving my chops.
What’s the lesson when it comes to stock trading?
At the beginning you should learn a few trading “riffs” or setups. Start with something manageable.
Don’t jump head-first into complex theory based on Fibonacci retracements or Elliot Wave Theory. Ignore the dozens of bullish and bearish candlestick formations.
The most important part is to gain valuable experience trading something simple and then work your way up to more advanced concepts. Don’t do it the other way around.
Here is an example of a very simple setup that I like. Maybe you will too.
The Sweet Music of The Reversal Trade
The first thing you should know about the reversal trade is that it is less common than trading the trend. The reason why I love this progression is that I like to be the first person on a new trend. It means there is more upside.
But it also means that you have to be quick to exit your position if you are wrong – which is common. This isn’t for everyone.
This is the setup:
1. Look for a downward trend where the price has hit the trendline at least 2 times.
Notice that I have stripped away all other data from this chart. You know neither the price nor the time-period of each bar. The truth is, it doesn’t matter. I have found this to work on minute or monthly bars and everything in between. It’s a great set-up.
2. When the price breaks through the trendline, get ready to trade.
I have highlighted this area with a light blue circle. This is where the price might be reversing. It could also be a sucker’s rally or just a consolidation phase before the next leg down. There is no way to know for sure but it has the potential for a reversal.
3. Draw a new trendline under the uptrend if possible. Trade on the first bounce.
You buy as soon as the price bounces up so that you can draw a trendline underneath. Do you see the 2 long red candlesticks that touch the line and the three green candlesticks after that? Somewhere in there you should have went long.
When Does The Music Stop?
When do you cut your losses and sell?
If the price falls back down heavily through your new trendline … bail! Your new stock reversal is not yet fully baked.
When do you take a profit?
That is a little more difficult to answer. There are many right answers.
One tactic is to sell out half of your position at a certain profit point and let the rest ride. You could use a moving average.
Another technique is to draw new trend lines as the price goes up. Chances are that if the price moves up sharply, it will go parabolic. Keep drawing steeper and steeper trendlines and sell when one is broken.
The red circle highlights the area where this trend brokedown.
Sometimes the best of intentions don’t work out. Even Eddie’s finger-tapping sometimes failed him on stage. The same is true when trading. Below is one example of a failed set-up.
The stock is US Steel Corp and the ticker symbol is X.
- The stock was trending downward and in early April 2018 the downward trend was broken.
- Depending on how quick you are, you would have purchased the stock somewhere between the 4th and the 12th in the range of $34 to $35.50 per share.
- The price was trending nicely when it broke to the downside. $35.77 was the point where the price broke the trend.
If you were lucky enough to get out as soon as the trend broke, you’d be sitting with a small profit. But all to often the price drops so rapidly that by the time you respond, you are sitting with a loss.
The potential for a great trade was present but it just fell apart.
This is just one trading lick that you can practice over and over again. Add a few more riffs to your trading collection and you’ll have enough tools to begin seeing the patterns and making profitable trades.
Don’t be fooled into thinking that you must get ridiculously complex to get more return per trade. You can become a trading rockstar with simple power-chord setups.
So get out there, learn a few riffs and trade away until you find your style.
Kurtis Hemmerling is a quantitative analyst who consults with family offices and one large global asset management firm. He is skilled in designing multi-factor equity models which take advantage of profitable anomalies found in the furthest reaches of the stock market. Kurtis has a particular passion for small-caps and micro-caps where alpha is abundantly available for those with the knowledge and the skill to extract it.