How I Trade Stocks was written for investors who want to take charge of their portfolios and are willing to spend the time to learn how to manage them. It will greatly benefit investors who have little experience and who currently do not possess an overall framework and analytical method for investment decision-making. It also will help investors who take a passive approach with investing but are concerned about performance and risk management. Furthermore, it is a no-nonsense, practical method to achieve superior returns with less risk. It is supported by data, tables and dozens of charts which gives readers insight into the ever-changing dynamic of supply and demand for company shares, the key driver of price discovery. It details investment frames of reference to guide readers through market environments that are at times complex and confusing.

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Introduction

“Investing is an activity of forecasting the yield over the life of the asset; speculation is the activity of forecasting the psychology of the market.”

— John Maynard Keynes (1883-1946), Economist

I want to share my methodology and philosophy for protecting capital and selecting stocks and ETFs (exchange traded funds). It is important for investors to have a well-defined method for evaluating equities and my goal is to cover key topics to give investors insight into my market approach regarding strategies and tactics. This will help readers evaluate their current approach to investing, compare it to mine and make improvements when appropriate.

This is being written for the investor who wants to take charge of their portfolio and is willing to spend the time to learn how to manage it. The book will greatly benefit investors who have little experience and currently do not possess an overall framework and analytical method for investment decision-making. It also will help investors who take a passive approach to investing but are concerned about performance and risk management. Having said this, the book is not for the average investor who wants to make money but is unwilling to do the work.

There have been thousands of books written on investing, but very few with specifics on how to invest. This is the goal of the book. I encourage readers to develop their own style and use decision support tools necessary to achieve success.

Making money in financial markets is difficult and takes a substantial commitment of time to do it well. Additionally, high performance investing requires reading voluminous amounts of information from a variety of sources, along with adaptability, a drive to improve performance, and the ability to be self-critical and to learn from mistakes. Many people may believe investing is relatively easy, because on the surface it appears to be. In reality, it is quite the opposite and an examination of equity hedge fund returns support this. Heed the saying that investing is a “hard way to make easy money.”

The perception that successful investing is not too difficult has been one catalyst in the movement toward “passive investing.” In this environment, investors are not burdened by much decision-making and effort. If a survey was taken of the average investor, I am confident that many people would likely spend more time researching the relative merits of a $50,000 automobile purchase than the equivalent dollar purchase of securities.

There is no other analog to the financial markets. Every market transaction has a 100% uncertain outcome 100% of the time. This uncertainty may give rise to instinctual predispositions that act to subvert investors’ best interests. We delve into this subject later on.

The first goal of this book is to provide parameters, guidelines and rules to aid decision-making and create an organizational structure within an environment of 100% uncertainty. The second is to give readers a conceptual framework for investing and to challenge the validity of investment platitudes that work against investors’ best interests.

It helps if investors enjoy doing research. This is an important point because my method is labor-intensive and requires dedication. If you do not like the work, you will avoid it, and this will increase the likelihood of subpar performance. This book is the substance of what I have learned over many years of trial and error. It will provide investors with a well-defined approach with the goal being to maximize returns under a variety of market conditions.

Investment mistakes are inevitable, but the goal is to avoid obvious errors and keep the cost of all others low. My approach is to eliminate potential negative factors from the investing playbook. Many can be calibrated in advance and by acting upon these barriers, the probability of outperformance can be increased. I examine a variety of investment scenarios in the book and for the convenience of readers, repeat the rules rather than refer readers to the chapter where they are first discussed. This approach also serves a dual purpose of reinforcing the importance of training the mind to think in a different way.

Although much of my method involves technical analysis, this is not a book on technical analysis. During the past three decades, some terrific books have been written on this subject, as well as a handful written in the first half of the twentieth century. Since the advent of the personal computer, there has been an explosion in the variety and sophistication of technical indicators. That being said, I do not want to reinvent the wheel and any aspect of technical or fundamental analysis omitted from this book is not a reflection on the quality and validity of the omissions.

My goal is to impart the most important aspects of my method; its analytical structure, philosophy and psychology. This book does not cover the variety of indicators and tools I use for analysis, nor is it an all-encompassing exposition of my method, though I will consider this for inclusion in another edition. In addition, it does not include discussions on equity options analysis, (although the benefit of using options are explained for specific investment scenarios), foreign equities, preferred securities, fixed income instruments, commodities, alternative investments, short selling, levered ETFs (avoid), tax implications of subjects covered except as specifically referenced, retirement and financial planning.

This is not a book about day trading, nor is it endorsed. Although, the focus is U.S. equities, the principles set forth in the book should work well in global equity markets. Readers with varying levels of expertise likely have developed their own investment process more or less prior to reading the book. It is my sincere wish that all readers obtain something of value that will improve their investment results.

Highlights

“If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong.”

— Bernard Baruch (1870-1965), Investor and Statesman

Protection of capital is and should be the number one priority for any investor. It is preferable to risk losing opportunity than risk losing money. If the risk versus reward is unfavorable, stand aside. You are going to miss moves. This is the reality of investing. Look to obtain at least a $2.00 gain for each $1.00 of risk. This is a minimum acceptable set-up.

As a general rule, do not trade stocks priced under $10.00, equities that trade less than an average volume of 250,000 shares per day and those with market caps of less than $500 million. Never trade OTCBB stocks. All positions should be protected with a sell stop, sell stop limit or sell stop with limit. Do not trade IPOs.

The major market indices have a disproportionate impact on the performance of any given stock. As a result, investors should monitor equities in their portfolio to determine whether they are under/outperforming the major indices over different time frames (more is better). Using relative strength as a basis to acquire, or avoid certain equities is based on the premise that securities outperforming/underperforming major indices market in a variety of time frames may be candidates for acquisition, or those to be avoided. Relative strength analysis (comparing the performance of stocks, indices and ETFs to each other) confirms the wisdom of holding positions or validates selling them after examining a variety of technical and fundamental factors.

Minimize transaction costs—Use stock screeners—Have watchlists.

Transaction costs degrade returns and for this reason many investors seek out ETFs with low fees and ETF families that do not charge commissions. However, obtaining the benefits of low management fees and zero commissions without risk management negates the benefit of reduced costs. It is wise to invest in quality stock screeners for technicals, fundamentals and analytical tools that may help improve performance. Have watchlists that allow for relative strength comparisons of stocks, sectors, indices and ETFs. Spreadsheets are good for this.

Dates of earnings reports for stocks being held or being considered should be on every investor’s calendar. Be proactive about mitigating potential risks as earnings reports approach. This includes taking full/partial profits prior to reports and using options when and if appropriate.

Watch how stocks perform three-four days prior to the earnings report and this occasionally provides insight on the consensus view.

Often stocks move up or down in anticipation of a bullish or bearish report. However, earnings estimates may be wrong and your strategy on how to deal with unfavorable earnings should be implemented prior to the report. This is about managing discrete position risk and not about capital gains considerations, future market performance and current analyst opinions. Do not enter new positions with the intent of holding them into reports. Only use options in this scenario to control risk.

Buy only the strongest equities from a technical and fundamental standpoint. I define technical strength as stocks whose performance exceeds one or more of the major U.S. indices in key time frames. My primary time frame is the one year-to-date benchmark for comparison purposes. My preferred indices are the S&P 500 and Nasdaq 100. For readers who trade stocks in global equity markets, use the leading indices in each country as benchmarks in the aforementioned time frame.

It is important that prospective candidates are trading in a bullish moving average set-up with the 100 day simple moving average (sma) trading above the 200 day sma. Though the moving average setup may be in a bullish formation, expect corrections to key moving averages. It is important that stocks in a corrective mode continue to outperform benchmark indices in the one year time frame after corrections. This confirms technical strength. Although this may be an opportune time to consider purchases, imminent earnings reports can demolish your best laid plans. More on this later.

Follow the leaders and buy stocks in uptrends, but avoid flavor-of-month momentum stocks with little or no earnings history. Do not allow yourself to be stampeded into stocks touted by those in the financial press and their guests who have a vested interest in always being bullish. Be selective about adding securities to your portfolio and remember: you do not have to be in the market all the time to outperform. More on this later.

Screening tools that measure financial performance enable users to compare any stock to its sector and/or industry group to get a fix on its financial health. Although, most investors do not have a background in finance, the ability to compare the relative financial strength of their prospects against sector/industry benchmarks should assist in screening out unsuitable candidates.

Never sell outperforming securities to buy underperforming securities. Never purchase underperformers, which means they are underperforming the one year benchmark and their moving average is in a bearish set-up: 100 day moving average is below the 200 day moving average.

Do not attempt to pick bottoms in stocks because they look cheap, or you have been told they are cheap. With the possible exception of micro-cap stocks that have little or nonexistent institutional following. Stocks are cheap for a reason. Bottom picking appears to be hardwired into the human brain and examples of it abound in the financial press. The ridiculous cliché: “Buy Low-Sell High” is derived from this kind of wishful thinking.

Often, professional money managers and investment advisors recommend bottom picking using the rationale that companies are cheap and if they pay a dividend you are “getting paid to wait.” To support this, they generally cite a glowing narrative about the company’s future prospects. This is predicting, an impossible task, which should be ignored. Also, stocks are volatile, which in many cases negates the value of the dividend due to the risk of losses on paper.

Instead, wait for previously weak companies to gain strength against their peers, relevant sector(s) and major indices in a variety of time frames before considering purchases. Positive moving average action acts as additional confirmation. This is an example of “Buying High and Selling Higher” and is philosophically the opposite of “Buying Low–Selling High.”

Although, buying high and selling higher is not a new idea, newcomers may correctly think it is counter-intuitive. The reality is that strong price action tells a positive story while weak price action speaks to a negative one. No one knows how long weak price action continues; therefore, it is mandatory to wait for a definitive reversal in trend.

Enter sell stops when making purchases and do not lower them, however as the stock advances move up sell stops to protect profits. Losses on any one position should generally never exceed 5-7% of the investment. With some exceptions, this is a maximum number. If the prospective candidate looks potentially risky, or the stop point exceeds 5-7%, reduce position size, or use options with an appropriate time frame and strike price.

Hold positions based solely upon performance criteria. If the stock continues to outperform its peers and the broad market while allowing for normal corrections continue to hold it. If stopped out prematurely, and the stock resumes its uptrend, re-enter the position with a new stop at the most recent major low.

Never allow a positive narrative about a company’s financial prospects be the sole criteria of initiating/holding a position. Price action is key and this should always take precedence over the narrative. When negative performance against benchmarks is contradicting the glowing narrative: red flag.

Do not dollar cost average. Paul Tudor Jones, one of the legendary hedge fund managers of the past three decades says: “Only losers average losers.” Even though dollar cost averaging may work at times (like almost any method), it is undisciplined from a risk management standpoint and contributes to what I call position drift. This is defined as a position without stop loss parameters and performance criteria; a ‘go with the flow mindset’.

Without performance and exit criteria, securities can be profitable or not, but position drift tends to create a mindset of complacency and a psychological commitment to inaction.

This may cause investors to avoid cutting losses, adding to positions or taking profits. Moving averages and charts assist the investor to determine whether stocks are in a position drift mode. Performance comparisons to peers, sectors and indices also will confirm position drift.

The major battle for investment survival is with you and your emotions. Minimizing losses is a little discussed advantage that will substantially increase performance. Learn to evaluate and exercise control over four key decisions: 1)What security to buy; 2) When and at what price to buy it; 3) When and at what price to take profits/losses; 4) How much of a profit or loss is acceptable. The degree of discipline that investors exercise over these four options will determine investment success.

Ignore the predictions of the financial press, their guests and CEOs and CFOs who are overpaid company cheerleaders. The late economist John Kenneth Galbraith said: “There are two kinds of forecasters: Those who don’t know, and those who don’t know they don’t know.”

Remain flexible and adaptive. Be quick to change tactics and strategy if you find a particular approach is not working over a period of time. Learn to be self-reliant and not be influenced by those whose opinions are different than yours. Regardless of whether you win or lose, do it on your terms, not because you followed the advice of someone else.

The important point: develop a method for selection of securities and position management in which you have confidence. Know that any method will work only a certain percentage of the time. Forget trying to get in at the bottom or out at the top. Instead, look to capture the middle of the move.

If investors accept the reality that they will not enter positions at the bottom of the range, nor will they exit at the top, then they must employ a strategy that allows them to catch as much of the middle of the move as possible. This is what I call the ‘half right strategy’: realizing your own limitations and acting within this framework to generate as much profit as possible while containing losses to the best of your ability.

Rather than commit to a holding period based upon a preconceived time horizon, the holding period of any asset should be determined solely by its performance. If conditions indicate that an exit is appropriate, the position should be sold. If the investor is stopped out of the position after holding it for a week, so be it. If price action determines a position should be held for three, six, nine months or longer, then investors should have no reluctance in doing so.

However, this does not preclude taking full/partial profits if the broad market appears to be in a corrective mode and the instrument being held is exhibiting weakness relative to its competitors and the major indices. Call options can be deployed in this scenario when partial or total profits are taken and the position is replaced by the call option(s) to stay in the trade with limited risk.

Sell stops will be triggered prematurely on occasion, but if the security resumes its uptrend, the investor should have no hesitation about re-entering the trade and using the recent low as the new stop. Sell stops should be placed at key price points which indicate that prices have stopped going down (meaning supply has dried up) and demand has re-entered the market. Weekly and monthly charts are good for this because they give the investor a broad view of market action.

As an alternative to stubbornly holding stocks for arbitrary time frames and assuming the inherent risk of doing so, it is important that investors take an agnostic point of view and let the stock tell the investor where it wants to go. If the stock wants to move higher and conditions warrant it, investors should be on board. If not, look for the next opportunity.

It has been said that the hardest thing to do is to ride a bull market to its conclusion, and the second most difficult is to stay out of a bear market until its conclusion. Both are not realistic endeavors and investors should not attempt the impossible. Good money with less risk can be made over time frames based solely upon the portfolios performance. Do not hold securities based solely upon arbitrary time frames (“I am a long-term investor”), nor because of dividends, or the prospect of long-term capital gains. More on this later.

Always know the short interest stats of stocks that you are considering for purchase. The reason: most investors are terrible at short selling and attempt to pick market tops. This means if companies have large numbers of shares sold short, a short squeeze can occur when there is a positive earnings surprise, or some other news event that causes short sellers to head for the exits.

Many investors fail to realize there is a major difference between good companies and good stocks. Many stocks are terrific companies but are simply underperformers.

It is important for investors to distinguish between the two and not make the mistake of investing in fine companies that may not be prime candidates for acquisition.

Investors should be aware of their own predispositions (cognitive biases) that may subconsciously guide their investment decisions. The biases may negatively influence the investment decision making process. If investors are aware of their ingrained biases, they can train themselves to counteract them.

A trading diary should be part of every investor’s toolkit. The reason for this is to understand the logic behind every investment decision. By writing about the decision making process, you will likely see a pattern of good and bad decisions. You want to be able to understand your own thought process before, during and after the trade. This enables you to improve your investing batting average going forward.

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