Common Questions about Technical Trading - dummies

Common Questions about Technical Trading

When you use technical trading in the stock market, you may have some questions about the best techniques and practices. Here are some of the most common queries about technical trading:

  • How much should I put into technical trading? No single correct answer exists. You have to decide this one on your own. You might start out with 10 percent and move it up to a higher proportion as you gain expertise and confidence.

    One thing is for sure: You should never start technical trading with a stop that costs more than you can bear.

  • How much risk should I take? Before you enter a new position, you should define your initial risk, which is the dollar amount you are willing to lose if the trade goes bad (which is called R). The amount of loss you embed in your stop-loss should be limited to R or a fraction of R. For example, if R equals $2, your stop-loss would entail losing less than $2, say $1.50. Your expected gain should be a multiple of R, meaning you would risk a loss of $1.50 only to make more than $2. Okay, how much more? Let’s say you are willing to risk losing $1.50 only if you can make twice R, or $4. This level of risk ensures that on average, your gains are bigger than your losses.

    Now you examine your security in the context of a possible $5.50 price swing over your expected holding period. If the maximum high-low range of your security is $3, you have no chance of making $4 (unless volatility changes), but you still have a chance of seeing your $1.50 stop get hit. You need to modify your expected gain to no more than $3. Now your risk-reward ratio is 2:1, meaning that you should make $2 for every $1 you lose over the course of many trades in this one security.

  • How many securities should I trade? As a general rule, you want more than one security as a form of diversification (which reduces the risk of losing it all in a single event), but less than 20 securities (which would require too much analysis even for a full-time trader). Three to five securities are about right, especially for a newcomer.

  • Which securities? This question is trickier. You can add up the R values for each of your securities and average them, giving you the expected return. If you aren’t happy with this number, you can alter the portfolio to include securities with a higher or lower R to shift the average. Similarly, you can take the square root of the mean R of the portfolio to measure its variance, and if that is a number that is too high or low for you, you can alter the composition of the portfolio.

  • How do you allocate your capital among the securities you’re trading? You can use several techniques to determine how to allocate your capital:

    • Divide it up equally.

    • Allocate a higher percentage to the security getting the most winning trades over the past 30, 60, or 90 days.

    • Allocate according to the volatility of the security.

    • Apply fixed fractional position sizing, which calls for allocation as a function of total possible loss as a fixed percentage of total capital. Say you have $10,000 in capital and you want to buy Blue Widget stock at $40 per share. You set your stop at $2, meaning you will sell if it reaches $38. At the same time, you want to limit the possible loss on Blue Widget to 2.5 percent of your total portfolio, or $250. Therefore, you can buy no more than 6.3 shares of Blue Widget.