Category: How to Master in Trading – Advanced

The purpose of the category How to master in trading – advanced is to give experienced traders an insight into the new trading techniques. Very often they are very rarely used because they require advanced knowledge in many fields – from complex mathematical operations and calculations to the usage of high-level trading tools. Traders-Paradise’s goal is to inform about them. But not only that. The main intention is to make them familiar to all traders. No matter are they beginners or elite.

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In trading, just like it is in many fields, having advanced knowledge is an advantage per se. Thanks to our excellent analysts and experts, the most advanced techniques are available to the traders. Moreover, each of them is fully explained, with real trading examples. All complicated mathematical calculations are explained in detail. So, traders need to have on hand this valuable information and samples.

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This category – How to Master In Trading – Advanced is directed at elite traders. The impressive thing is that all posts and articles are very precise in explanation no matter how complicated the subject is. All advanced trading techniques, methods, strategies are understandable thanks to comprehensive and detailed explanations.

  • Index Trading What is It and How It Works?

    Index Trading What is It and How It Works?

    Index Trading What is It and How It Works?
    In index trading, you are betting on the movement of the stock market as a whole.

    In the stock markets, you don’t need to trade individual stock only,  instead, you can choose index trading. Index trading is actually very popular in stock trading. 

    Let’s make clear what an index is. In short, it is a mix of tradable assets. The most popular indexes are the S&P 500, NASDAQ, Dow Jones Industrial Average (DJIA), etc. They are so-called benchmark indices. In the stock market, these indexes include the shares of individual companies. 

    Besides the opportunity to use the index as an indicator of the market condition, you can use it for real trading. But there is some characteristic of the index that you have to be aware of. An index doesn’t have real value, it is just a measure of the value of a part of the stock market. 

    How is possible index trading?

    We know that trading, in most people’s minds means buying and selling a single stock, currency pair, or some other asset. Well, trading isn’t just buying or selling securities, you can trade indexes also. Yes, an index is a financial instrument that consists of numerous assets with their average value.  As for the index meaning, they are a financial instrument that combines individual assets and represents their average value. 

    Index trading means speculating on price changes in a stock index benchmark, for example, the S&P 500, FTSE 100, the Dow Jones, etc. 

    In index trading, perhaps the most beneficial part is that you don’t need a huge capital. You don’t need to buy the whole index, meaning you don’t need to pay it at full price, you can pay, for example, 20% of its value. How is this possible? If you want to buy stocks you have to pay 100% of the value. Well, index trading is a derivative vehicle. The main difference between stocks and index trading is that you can hold stocks for years but in index trading, you don’t have such a possibility. Actually, you have but only if you enter the same position every month, for example. This means you can hold indexes for a specified period. 

    The other characteristic is that you are actually trading indexes options. Further, index options are settled in cash. It is common for index traders to use index options to hedge stock portfolios. Index options are also excellent when it comes to speculating the market. Index trading is basically the traders’ attempt to profit from the price changes of indices.

    The examples of index trading

    There are many indexes available that you can trade. Index traders can either focus on a single index or trade various indexes as a component of a more extensive strategy.
    For example, stock indexes are the most attractive because they mix some of the most important companies. If the companies are strong with permanent growth, the index value will increase. 

    The stock indexes are the most popular types of index trading. A stock index is a collection of stocks that presents, let’s say, a summary of how a particular section of the stock market is doing. For example, a biotech stock index will track biotech stocks.
    Index trading occurs when you don’t want to buy individual stocks Because you would like to have exposure to a whole section of the market. 

    There are numerous indexes, for example, FTSE100 (London), S&P/ASX 200 (Australia),  AEX index (Amsterdam), CAC 40 (France), DAX (Germany), besides already mentioned above.

    Why index trading?

    Index trading is a comparatively protected form of trading with combined risk management. The risks of index trading are lower than the risks of trading individual stocks.

    An index isn’t a manipulative financial instrument or it is at least. The price of an index will change along with the price changes of the constituent stock that make up a particular index.

    The other reason is that you have an embedded money management system. Index trading simply means you don’t “put all your eggs into one basket.”  Also, the risk is lower in this type of trading. It’s true that indexes can be volatile due to political events, economic predictions, or similar. But when an index is getting or losing 15% in value, the headlines will be full of that, trust us.

    By index trading, you’ll be protected against the risk of bankruptcy. An index can not go insolvent. If an index’s part goes bankrupt, it will be replaced by the next company on the list. That is great protection of your capital because if you own a stock of the same company you could lose everything you invested in it. Also, you’ll benefit from the global financial condition. By index trading, you benefit from the index’s possibility of permanent rise.

    For example, you invest $10.000 for a period of 2 months. At the end of that time, your gains will be 10% of the initial investment, or $1.000. Similarly, index trading permits you to profit from any kind of stock market changes. It doesn’t matter if the market grows or drops in value during these 2 months. Basically, you can profit in any market conditions.

    How to trade indexes?

    Position trading and trading with the trends are very effective strategies in index trading. A powerful approach could be to open the position and hold as long as possible. That is, in short, position trading. Major indexes have almost the same problems, reactions, so this could be a good approach.

    Also, one of the strategies in this type of trading could be trading with the trends. It is suggested to use long-term charts with other technical tools. For example, pattern analysis or indicators are useful to develop your position trading strategy.

    This kind of trading isn’t without risks. It is with the lower risks but still, some quantity of volatility is present. This is particularly true if you trade the stock indexes. So, you’ll need some risk management strategy. You can use some of the very powerful tools like stop-loss orders, trailing stop orders, or limit orders. Basically, in index trading, if you want to lock in profit, you’ll need everything possible that may help you to manage the trade according to your risk tolerance.

    Bottom line

    Traders know the names of the main global stock indexes. These indexes can also be traded through stock index CFDs. In fact, you can also buy and sell them in an alike way to how you trade stocks. Everything is almost the same, except the risk is much lower.

  • Why Read a Balance Sheet Before Investing

    Why Read a Balance Sheet Before Investing

    Read a Balance Sheet Before Investing
    The balance sheet, used with income and cash flow statements, is an important tool for every investor and has to be read before investing.

    By Guy Avtalyon

    Every single investor must know how to read a balance sheet before investing in some company. It is one of the three most important reports that can tell you some valuable information about a company’s condition. The other two sources of such important information are the income statements and cash flow. If you know how to read a balance sheet, income statements, and cash flow reports, you’ll be able to make a proper investment decision.

    While you read a balance sheet you’ll find out almost everything about the company’s financial status for a particular period. The balance sheet reveals what assets the company owns, what are its liabilities, how much in debts. Also, you’ll figure out how big is the owners’ capital, how many shareholders there are, etc.

    The basic balance sheet calculation is:

    Total Liabilities + Shareholder Equity = Total Assets 

    When you read a balance sheet of the company, you’ll notice that it consists of two parts as it is shown in the equitation above. This means the total assets of the company have to be equal to the sum of total liabilities and shareholder equity. In other words, the assets are balanced to the obligations at a particular point in time. 

    What info you can read in a balance sheet?

    For example, information about the company’s financial condition at the end of the year. You have to evaluate a company and read a balance sheet before investing in a company. The balance sheet shows which are the company’s sources, debts, owners’ interests, etc. By examining the balance sheet and with the help of a few calculations, you can improve your odds of getting in a good investment.

    For example, in the assets section, you’ll find the value of stocks the company owns, what are the company’s investments. Also does the company own real estate, how advanced is its equipment. You’ll find much other important info. But always keep in mind that you have to compare the amount of the cash and equivalents balance of the company. It is better if the company has a large amount of cash. That will provide a room to grow the business, and also, to pay dividends. 

    Read the balance sheet liabilities to estimate how much debt the company has. The lower is better, of course. Every investor should know if the company has some loans or deferred wages to its employees. This info might cause the investor to get into investment or stay away.

    Also, you’ll figure out the amount of shareholders’ equity, the higher is better. But also, in this section, you can find how much money the company got from investors from the preferred and common stocks. The balance sheet shows the earnings the company has but has not been paid as dividends from the start-day to the particular period you are examining.

    How to calculate the company’s debt-to-equity ratio?

    To calculate the company’s debt-to-equity ratio you’ll have to divide the company’s total liabilities by its total shareholders’ equity.

    Debt-to-equity ratio = total liabilities/total shareholders’ equity

    If this ratio is below 1 that would mean the company has more equity than debts. So, you can easily conclude that investing in such a company carries less risk. Hence, if the debt-to-equity ratio is above 1 you can be sure the company has less equity than debts. That is in connection to financial problems that could push the company to a business crisis.

    For instance, the company has $200.000 in total liabilities and $400.000 in shareholders’ equity. When we divide $200.000 by $400.000 to count a debt-to-equity ratio we will find it is  0.50. It isn’t the best but still quite acceptable debt level.

    How to check if the company is able to meet short-term obligations

    To calculate this current quick ratio you’ll need to divide its current assets by its current liabilities. Experts suggest, and we agree with them, the better is if this ratio is above 1.5. 

    For example, the company will be able to pay short-term debts if it has $50.000 in assets and $25.000 in liabilities.

    $50.000/$25.000=2

    This is a great ratio. But if the company with $50.000 in current assets has $35.000 in current liabilities, the outlook would be quite different.

    $50.000/$25.000=1,42

    This isn’t a good ratio because it shows the company doesn’t have enough short-term assets to pay its bills.

    Also, if you read a balance sheet, you must read fine-prints. You didn’t pay attention? Well, you should. It can reveal some financial obligations that are not visible at first glance and that are not displayed in a balance sheet. 

    Read a balance sheet before investing

    When you read a balance sheet, you’ll notice that the “current assets” are posted first. Because these are liquid assets, they are placed by order of liquidity. The criteria behind is which one can be turned into cash soon. For instance over the current year. The liquid assets are cash and its equivalents, inventory, accounts receivables, and 

    The next part of a balance sheet is “total assets.” These are holdings that can’t be quickly turned into cash in the current year. This includes land, equipment, marketable securities, prepaid expenses, intellectual capital, etc.

    Likewise, current liabilities are shown first in the section of asset listing. For example, all debts in order of date dues, financial obligations expected within the current year. That could be outstanding interests, rent, salaries, and dividends. This list is followed by a list of total liabilities that incorporates pensions. Also, interest on bonds, the principal on bonds, etc.

    The following is a total equity list also known as shareholder equity or net assets. This list incorporates saved or retained earnings, common and preferred stock, and extra paid-in funds.

    What are the current assets?

    Current assets have a duration of less than one year. In other words, they are accessible to turn into cash. Cash and cash equivalents such as checks and non-restricted bank accounts are the most important among current assets. Cash equivalents represent safe assets and can be easily turned into cash. Accounts receivables represent the short-term obligations that customers owe to the company. For example, when a company sells its product on credit, it will be in the list of current assets until the customers pay them off.

    The inventory is also the current asset owned by the company. It can be everything that the company produces, raw materials, or other goods necessary in production.

    What are non-current assets?

    They present assets that couldn’t turn into cash within the one-year time frame. They could be tangible assets, for example, machines, computers, factories, land, etc. But, non-current assets can be intangible assets also. For example,  licenses, patents, brand name, or copyright. 

    Why reading a balance sheet is important

    The balance sheet is a valuable piece of information for investors but has some limitations. The first comes from its inability to give full insight into the company’s business history since it shows only a part of it. You’ll need to know more to have a full understanding of the company. For example, income and cash flow statements.

    Anyway, read a balance sheet before investing in some company because it can give you a more clear picture of the company’s operations. If you read a balance sheet, you’ll understand what the company owes and owns. Its financial status will be clear to you. It is very important for investors to read a balance sheet, how to use it, how to analyze it. Reading a balance sheet will support your decision to invest or not in some companies.

  • How to Cut Losses in Trading Stocks?

    How to Cut Losses in Trading Stocks?

    How to Cut Losses in Trading Stocks?
    The first and most important lesson in trading stocks is damage control. One of the methods is by cutting losses.

    By Guy Avtalyon

    This is the essence of trading – how to cut losses immediately. You have to learn this because it is something commonly named as damage control. And if you are not ready for the worst-case scenario and you get panicked, your losses in trading stocks can be enormous. One single bad move can destroy your trading account. 

    Not all trades will be winning, so you have to know how to cut losses in trading stocks.
    First and principal, you’ll need a good trading plan. The best plan is to exit a losing position and cut losses when the trade doesn’t match your plan. So, the trading plan is mandatory.

    Every single trader in the world has had or still has losing trades. That isn’t a problem. The main problem is how to cut losses and have control of your trades. You are the one who makes decisions and we are pretty sure you wouldn’t like to have a great loss. There are some methods that will give you a chance to reduce the losses. And here is how to cut losses in trading stocks.

    How to cut losses in trading

    Learn from the kids. When they just start walking it is normal to fall but every single time they will get up and continue walking. The same is with trading stocks. Every trader at some point will experience losses but the true wisdom is how each of them controls the damage. Damage control means cutting losses quickly without hesitation and quickly. So how to cut losses in trading stocks quickly? 

    There is some unique rule: when your stock falls for 7% – 8% it’s time to exit the trade. If it is so simple why would we spend so many words to explain how to cut losses? 

    Well, it isn’t that simple. When you have a losing trade and exit after your stock drops for a significant amount, you’ll have to compensate for that somehow, you’ll have to reclaim your loss. There is some math behind losses. 

    For example, let’s say you bought a stock at $100 and after several days its price dropped 7% to $93. What you have to do? You’ll exit the position, of course, and enter the other trade to recover from the loss. But where is the math? Here. You lost $7 on a single trade, right? And now you’ll need to profit more than it is the case if you didn’t have that loss. Your available capital is $93 now and your gain has to be 8% on that capital invested to cover the previous loss. It isn’t so hard you might think. Yes, your profit is actually zero now.

    What will happen if you hold that stock?

    Let’s say you are pretty sure that your stock will bounce back and it will be worth $150. And you are brave enough to enter the next trade. But the stock market is cruel, it doesn’t take care of your wishes and says you have to think, to make calculations and not to make wishes. What if your stock drops at $50 which is possible. 

    The math behind says you’ll need a 100% gain to cover your loss. That is a bit harder than to reclaim 7%. And, be honest, how many stocks, that can double their price, you own? So it isn’t a smart decision to hold a stock further if it has a 7% or 8% decline. A smart decision is to close the trade with reduced loss and find the new winner.

    The logical move is to cut losses quickly

    The understanding of how to cut losses in trading stocks will help you to protect your overall portfolio. Put your emotions aside, you might love that stock, adore the company but you have to admit that holding a losing stock is dangerous. No, you didn’t buy that stock at the wrong time or you have bad luck, your losses come from your behavior. Your small mistakes turned into a big failure. 

    When trading stocks or any other asset, the main goal is to profit. So, why would you like to hold a loser? 

    If you avoid selling such a stock you are avoiding blame, right? You have to understand that every single human makes mistakes and bad choices. All the time. So, what? It isn’t a problem. The true problem is when you don’t want to admit yourselves you are making mistakes and they cost you a lot. 

    Why would you stay to hold such a losing position? 

    Maybe you hope your stock will bounce back to the buying price and sell it? That isn’t going to happen. Well, it will happen one day in the future but your losses will be bigger and bigger. Nothing will help you to “delete” this mistake. Why? What had a tendency to fall, will continue to fall. In most cases.

    That’s why it is very important to understand how to cut losses in trading stocks.

    If the pattern doesn’t work, exit your position

    It is possible for a pattern to turn against you. There is no other way than to take a loss. Don’t hesitate to exit the position. You don’t need to wait for your trade to become a loss. Even a small gain is better than a small loss. Frankly, small gains are what beat markets every day. Many experts will advise you to get out of the trade with a small gain in case your pattern is working against you. If your stock doesn’t do what you expected and planned, just cut it. In this way, you’ll stay in control of your trades. 

    For example, you bought some high-tech stock in a high spike of your interest. Let’s say it is a new company with a great prospect, with a new product, everything is excellent. In theory, such a stock should skyrocket immediately. Excellent pattern, you may think. But what if the stock misses rising? What if you expected the price could rise up 30% and it hit 25% and suddenly stopped rising? Will you wait for it to fulfill your expectations? If you’re smart enough you’ll get out.  

    Why are we so resolute about this? 

    We assume you have a trading plan before you enter the trade and you shouldn’t care if you could make $1 or $100 if your pattern is working against you. It has to work what you require. Otherwise, get out because you don’t have control of your trade. That is how to cut losses in trading stocks by following your trading plan. If you do that you’ll don’t need to wait for the trade to become a loss. You’ll be able to exit exactly on time and cut potential losses.

    A few ways of how to cut losses in trading stocks

    First of all, you must have a trading strategy. That means you must have all rules on-hand, no matter if you want to buy or sell the stock.
    Further, you must know why you are buying a particular stock, but also, it is mandatory to know why you are selling it. You have to have a criterion. So, set rules for each situation.
    The most important action in trading is to set stop-loss orders. And here is one suggestion, be smart and never adjust stop-loss order when the stock price is dropping, do it when it is growing.
    Analyze your portfolio on a daily basis. Consider why you are still holding some stocks. If you can’t find any reason, sell it, sell them more.

    Controllers when trading stocks 

    Even before entering the position, you’ll have to know how to control your emotions. This is extremely important when you are faced with losing trades and have to cover losses. Always keep in mind that losses are part of trading stocks and learn how to handle your emotions when the bad time comes. For that to achieve, you have to be prepared for every trade with understanding that you may have losses. You are expecting them. That will help you to defeat your emotions. During this long run, you’ll have failures, successes, difficulties, and you have to know how to handle them.

    Further, invest only the amount you can afford to lose. In short, always protect your capital. If the stock price runs against you, cut it. It is better to exit the position than to suffer a bigger loss. Limit the risks. For each trade, you must estimate the risk/reward ratio.

    If your trade goes exceeding the risk you planned, cut it, cut the potential losses. And do it quickly, especially if the stock price reaches your stops. Just don’t hold the position and follow your plan. Never think you can wait a bit more. In a few seconds, your small loss could easily turn into huge losses. Give yourself the space to come back to the game.

    Successful traders aren’t unreasonable and think ahead. By doing so they are prepared to adjust their position size if necessary.

    In trading, it isn’t always possible to avoid losses. Honestly, it is almost impossible. But you can reduce them only if you learn how to cut losses in trading stocks. There is nothing wrong with selling a stock at a loss but do it on time to minimize it. When you cut losses with a clear head you’ll be ready to return to the market. Yes, we know, it’s hard to have a sharp mind when you are faced with the potential loss of thousands of dollars. Just follow your trading plan, stay with it, and follow the basic rules of trading. Nothing more, nothing less. The market always recovers. You will too.

  • What Is Momentum Trading and How To Start?

    What Is Momentum Trading and How To Start?

    What Is Momentum Trading and How To Start?
    Momentum trading is particularly successful in volatile markets. The main rule is “buy high and sell higher.” 

    To understand what is momentum trading you’ll need to know that this strategy is based on the recent strength of stock price. Traders that practice this trading strategy believe the price of an asset will continue to move in the same direction if there is enough force to push it higher.

    Momentum trading is an aggressive approach to trading. You have to know that before even trying to fully understand what momentum trading is.

    The simple answer to the question: What is momentum trading also can be: It is a simple buying and selling of stocks, for example, based on the recent strength of price trends. We mentioned the force behind the stock price, so let’s explain it more detailed. 

    When the stock goes up and as it reaches the higher price, more and more traders are interested to buy. Their interest is driving the stock price higher and higher. That is the so-called relation between demand and supply. As the number of stocks is the same, meaning the supply is the same, the contest among the traders will increase the stock price. And this price growth will continue with the increasing number of buying in the market. But at some point, some of them will start to evaluate if the stock is worth enough to be sold. If there are enough sellers of that stock, the momentum will change the direction and the stock will go down in price. 

    What is the momentum trading here?

    Momentum trading occurs when traders open their positions after they notice there is a strong trend in stock price. They will close their positions when the trend begins to lose strength. Momentum traders don’t need to wait until the trend hits the top or bottom. Their focus is usually the middle range of the price move which presents the main action in the stock price. This range shows the strong buyers sentiment, everyone would like to buy such a stock that has an upward trend. So, what momentum traders do? They are starting to sell the stock at a higher price.

    In other words, momentum traders will attempt to recognize how strong the trend is in a particular direction. Then, they will open their positions to take benefit of the predicted trend development while the stock price is low enough and close their positions when the trend begins to lose strength but the price is high enough to provide them a profit. Momentum traders intend to use the tendency of other traders to follow the majority and profit from that.

    The principle behind momentum trading is “buy high, sell higher.” So momentum traders will keep winning players among bought stocks but they will sell the stocks that are not. The money earned will be used to buy more stocks that were doing well.

    The essence of momentum trading is to sell the stocks that are dropping but not too much. Previously, the traders must have a confirmation that the change in stock price is real and that will continue in the direction. So the trend must be confirmed. 

    What is momentum trading else? It is an excellent strategy with great results in volatile markets where quick access is important. When it is done correctly, momentum trading could provide potentially large profits. This trading strategy requires an outstanding and quick process of decision making and that’s why this approach can provide traders more profits than some other strategy for the same time spent.

    Risks of this trading strategy

    Momentum trading is risky without a doubt and this can be one of the answers on the question of what is momentum trading. But if traders are careful and monitor the market and trends closely, they’ll be ready to buy and sell the stocks on time. It is very important to notice the main change in trend. If the traders miss them, they may suffer big losses. Entry points and exit points or profit targets are extremely important.

    Momentum traders have to recognize the point when to enter and close their trades, the level where to exit the trade. It is also important to recognize the proper time when to take any action. For example, if the trader closes the declining stock sales in time such will end up with the profit. But if the trader fails to close the sale quickly such a trader will end up in great losses caused by the stock’s decline in value.

    It is very important to notice the stock’s sharp drop in price, sell the stock on time, and avoid a dangerous influence on capital involved in the trade. So, the timing is extremely important in momentum trading. The trader has to be absolutely sure that stock is starting to decline and enter the position promptly to sell it. Otherwise, it can be almost impossible to sell it.

    And to answer the question of what is momentum trading. Momentum trading is set to be a remarkably prosperous strategy but has to be performed perfectly.

    How to start momentum trading?

    Identify the stock you are interested in, choose your momentum trading strategy, but first test it on some demo account. But keep in mind several things.

    As we mentioned above, the volume is crucial to momentum traders, because they have to enter and exit positions promptly. That means there are enough sellers and buyers in the market and the good volume shows the stock market is liquid. Volume is the number of stocks traded in the market, it isn’t the number of all transactions.

    Momentum traders seek volatility because the high volatility provides big swings in stock prices. That is an advantage for momentum traders, these short-term increases and decreases in stock’s value give the traders a chance to profit. Of course, only if they have a good risk management strategy as protection. That means they have to set stop-loss and limit orders.

    As we said, time is important. This strategy is adjusted for short-term market movements, but if the trend keeps its strength longer this strategy is useful for position trading too.

    Momentum trading in the stock markets

    To be successful in momentum trading in stocks you’ll have to follow some rules. You’ll need the protection against big losses. So, you’ll need to trail the stop-loss, that will provide you to ride the trend. Set your rules for classifying the stocks to know which stocks to buy. Buy stocks on the uptrend market. 

    For example, if some stock reaches a 50-week high you should go long. If there are many stocks of that kind, make a selection of best 15 or 20 with the biggest raise during the last 50 weeks. Set a trailing stop-loss at a minimum of 20%. Never trade more than 20 stocks at the same time and distribute 5% of capital to each of them. The saying “never put all eggs in the one basket” is relevant to the momentum trading also.

    Momentum traders are focused on price action and rely on technical analysis and indicators because they need to decide when to enter and exit each trade, as we described above. Favorite momentum indicators among traders are RSI (the relative strength index), the stochastic oscillator, moving average. Of course, you can use any other technical indicator but these are the most popular.

    Bottom line

    To be able to understand what is momentum trading you’ll need to have severe risk management. The stock market is volatile and momentum traders need to notice price fluctuations and price pitfalls in the market.
    Don’t neglect the basic elements that could lead to price changes. Sometimes it is better not to think about the next big rally. Think about profit. It might come even if there is no big rally.
    Carefully pick the stocks to trade, set stop-loss levels, place your entry at the right time, systematically monitor the market to notice possible changes, plan, and set your exits.
    Use protective rules for every trade. Momentum traders will set stop losses to protect their trades from unexpected price reversals. There is no other way to be a successful momentum trader. We hope you have a more clear picture of what is momentum trading.

  • Head and Shoulders Pattern – How To Trade

    Head and Shoulders Pattern – How To Trade

    Head and Shoulders Pattern - How To Trade

    Head and shoulders pattern occurs on all time frames. It can be detected visually. The complete pattern gives entries, stops, and profit targets, so traders can easily execute a trading strategy. 

    A valid head and shoulders pattern occurs very rarely. But when it appears, traders recognize it as an indicator that a significant trend reversal has occurred. A usual head and shoulders pattern is held as a bearish setup while an inverse head and shoulders pattern is held as a bullish setup. 

    But let’s start from the shape of this kind of triangle pattern.

    As you can see, the head and shoulders pattern is a chart formation that follows a baseline with three peaks. The outside two, on the left and right side, are similar in height but the middle is highest. This pattern is used mostly in technical analysis because it is broadly accepted that this pattern is a strong trend reversal indicator. One of the greatest advantages of head and shoulders pattern is its accuracy that shows that an upward trend is approaching its end.

    But let’s start from the shape of this kind of triangle pattern.

    Head and Shoulders Pattern - How To Trade

    In the image above you can see a large peak in the middle and smaller peaks from both sides, left and right from it. This pattern is extremely useful for traders because of its ability to predict reversal, from a bullish to bearish.

    And as you can see, the first and third peaks are smaller than the middle one. The horizontal line is known as neckline and all peaks will fall back to this line which represents the level of support. When the third peak falls to the neckline traders believe that a breakout occurred and the bearish downtrend started.

    In our image, you can see a bearish reversal. But if all these peaks are formed under the neckline it would be a bullish reversal.

    How to trade the head and shoulders pattern?

    It’s crucial in trading this pattern that traders wait for the pattern to form. Why is this important? Sometimes the pattern will not develop completely or maybe it will not develop at all. If the pattern isn’t developed completely, meaning it is almost or close to be, don’t trade. Just wait until the pattern breaks the neckline.  

    When you trade a head and shoulders pattern it is crucial to wait for the price move to go below the neckline after the peak of the right shoulder. So the regular pattern has one smaller peak, one fall, second higher peak, second fall, third smaller peak, and third fall to the neckline. Wait for the price action to break the neckline and then trade. When you have an inverse head and shoulders pattern, you should wait until the price action goes above the neckline, once when the right shoulder is formed.

    Open a trade only when the pattern is complete. 

    It is very important for any trader to have a plan before entering the position. For example, the best way is to write down your entry point, stop-loss, and profit targets. Also, do the same with variables that might alter your stop or profit target.

    For the head and shoulders pattern, development time isn’t a crucial element since it can develop over any period of time. Yet, traders believe that pattern that takes a longer time to form is more significant. Meaning, the probability to identify a significant price reversal is greater.

    How the head and shoulders top pattern shapes

    The head and shoulders pattern appears in the precise order and we’ll describe it. Keep in mind that we have only one variable here. It is how long it will take to finish each step in the sequence.

    As we said, in trading the head and shoulders pattern, we have to wait until the price moves a bit under the neckline after it reaches the peak of the right shoulder. For the inverse, wait for the price action over the neckline.

    Once the pattern is complete, we can initiate the trade. Traders usually enter the trade when a neckline is broken. But this is not the only entry point. The other method demands more patience since it’s based on the possibility that the movement may be missed completely. For this entry point, we have to wait for a pullback to the neckline after a breakout has already happened. This is a more conservative method. The point is to be sure if the pullback will stop or continue the original breakout. This is important because if the price continues to move in the breakout direction, we will have a missed trade.

    How to place the stops?

    In the conventional head and shoulders pattern, traders commonly place the stops above the right shoulder, just after the neckline is broken. The other way to set stops is to use the head of the pattern as a stop. This approach is risky and your risk-reward ratio can be reduced.

    When we have the inverse pattern, set the stop a bit below the right shoulder. Also, as previously explained, you can place the stop at the of the head and shoulders pattern, but you’ll be at exceptional risk once the trade is taken.

    How to set the profit targets?

    First, we have to explain that the profit target in this pattern is the difference in price between the head and low point of any shoulder. When you find out that difference, just subtract it from the neckline breakout price. It is important to provide a price target to the downside for a market top, right?

    For the market bottom, the difference should be added to the neckline breakout price to provide a price target to the upside.

    Here is an example.

    Let’s say that $100 is high after the left shoulder and $90 is the low of the head, so the difference is $10. And let’s say the breakout is $100,50. What you have to do is to add the difference to the breakout price, which is $110,50. That is giving us a target price of the same amount. 

    In the case of the regular head and shoulder pattern, you should subtract this difference from the breakout price.

    We already mentioned a timeframe. Sometimes traders will wait more than several months until they reach the perfect profit target after noticing the breakout. That is the reason to monitor the trades in real-time.

    Head and shoulders pattern really serves

    It is impossible to find an ideal pattern that will work in any circumstances and all the time. But we’ll point out several reasons why this pattern works.

    Firstly, when the price drops from the market high (which is the head in the patter), sellers would enter the market and there will be less aggressive purchasing. Further, when the neckline is met, traders who purchased in the last wave higher or on the rally in the right shoulder of the pattern, are confirmed wrong and thus facing large losses. They will exit their positions, which will drive the price to the profit target.

    The importance of stops

    Setting the stop above the right shoulder is reasonable because the trend can move downwards if the right shoulder is lower than the head. So, there is a little chance for the right shoulder to be broken until an uptrend continues. The profit target reveals that traders who made wrong trades will exit their positions, which will create a reversal. The neckline is a painful point for many traders. Many of them will decide to exit the positions, which will drive the price to move closer to the price target.

    Also, you can examine the volume from this pattern. When the inverse head and shoulders pattern occurs it would be ideally the volume to grow as a breakout happens. This presents a rising buying interest. It is very important because it provides the price to move closer to the target. When the volume is decreasing, that means that the traders’ interest in the upside move is lower.

    The traps of trading head and shoulders pattern

    Nothing is perfect and this pattern also. You can be faced with some problems when trading this pattern.

    First of all, this pattern isn’t easy to spot. More harder is to wait until it develops and completes. Sometimes you’ll have to wait very long. The other problem that may occur is stop-levels. It is hard to set the proper stop level. Also, the profit target couldn’t be easily reached every time. Sometimes, you’ll need more detailed data to uncover how the market condition may influence your exit from the trade.

    One of the widely spread beliefs is that this pattern could be traded always. It isn’t true. 

    For example, when you notice a massive decrease in one of the shoulders caused by some event, your calculated price targets will not be reached. Also, not all traders are able to notice this pattern. Some will do it without a problem but the others will never notice one.

    Bottom line

    We hope you have a better understanding of the head and shoulders pattern now. If yes, put it to work. Try to recognize both the head and shoulders and inverse head and shoulders patterns. When you recognize them, just monitor the development. This pattern can help you to find trends ahead and establish fair targets. Also, you’ll be better prepared to enter the trade when the time is right.

  • Metrics For Short Selling Stocks

    Metrics For Short Selling Stocks

    Metrics For Short Selling Stocks
    Different traders can adopt different metrics for short selling stocks but these few can point out the current market positioning and traders’ sentiment.

    Metrics for short selling stocks are used to uncover the potential short-sell candidates and to track the activity on stocks. There isn’t a formal method but, in short, different traders use different metrics for different purposes. The common thing for all of them is to recognize the best candidates for short-selling and to track them.

    Of course, each trader is unique in style, appearance, or goal and the same comes when deciding what metrics for short selling stocks they use.

    Some traders would add many variables to take into account everything that possible can influence a company’s earnings. For example, they will examine all factors that might cause the earning to go lower which would show a great opportunity for short-selling the company’s stock.

    However, other traders will look at a few important metrics for short selling stocks in several main variables but they will examine them in-depth.

    But both types of traders would like to gather as much as possible data, so it isn’t unusual that there is no clear separation on categories. So, metrics for short selling a stock can be divided into several different methods of measuring. We will present to you several metrics that we found to be important.

    SIR as one of the metrics for short selling a stock

    Short interest ratio or SIR, basically tells traders the number of shares available for short selling. If this SIR ratio is high that means that there is higher attention on that stock because short-sellers are expecting the stock price to fall very soon. That also means that traders believe that the stock is currently overvalued and they assume the stock will fall in price.

    For traders, this is a bearish indicator, meaning the market is pessimistic on that stock since it has a high short interest ratio. Should traders get into stock with a high short interest ratio? That depends. If high SIR is caused due to mispricing there are a lot of chances to go short with it. But SIR can be high due to the fact that the stock is simply bad. The ability to make a distinction why the SIR is high makes the difference between winning and losing trades. 

    As you know, short-sellers have to buy back their position if they want to profit and that might cause increasing interest and the stock could increase in price. This uptrend may occur very fast if too many short-sellers would like to cover fast in a short time frame. This situation is described as a short-squeeze. The consequence is that traders will not profit from this trade.

    Nevertheless, the SIR is one of the metrics for short selling stocks and can be calculated to get a quick tip if the stock is massively shorted or not, compared to its daily trading volume.

    SIR is easy to calculate, the total shares held short should be divided by the average daily trading volume of the particular stock. 

    SIR = Short Interest / Average Daily Trading Volume

    The short interest ratio

    You can find more than one definition for the short interest and several ways to calculate this ratio. The short interest ratio could mean the same as the days to cover or the short interest as a percentage of float.

    But the principle is the same: a stock with a high short interest ratio has a high number of shares sold short or, in other words, a low number possible to trade. 

    The short-interest ratio is simple to calculate. Take the number of currently short sold shares and divide that number by the average daily trading volume for the particular company. For example, if traders have shorted 6 million shares of that company and its average daily volume is 2 million shares then the days to cover is 3 days. Hence, if all of the short-sellers want to close their positions at the same time, it would take around three days for them to do so.

    The ‘days to cover’ expresses the total amount of time for all short sellers participating in the market with particular stock to buy back the shares that the broker borrowed them.

    Short Interest To Volume Ratio = Current Short Interest / Average Daily Share Volume

    “Days to cover” is a useful ratio for traders. 

    High value to this ratio is a bearish indicator. It might be a signal that everything is not great with company performance.

    It can be a sign of how bearish or bullish traders are about some company. Also, traders could get the idea of potential future buying pressure thanks to this ratio. The short-sellers don’t have too much time to buy back stocks and to get out of the position. Hence, this is one of the possibly most important metrics for short selling a stock. Naturally, they want to buy the shares back at the lowest price possible. Hence this need to get out of their positions could force prices to move higher. The longer the buybacks take, the longer the price rally will continue. A high “days to cover” ratio can be a signal of a short squeeze.

    Short interest ratio expressed in percentages of float

    The other way to calculate the short-interest ratio is by dividing the number of shares sold short by the total number of shares available for shorting. But expressed in percentages.

    For example, the company has 20.000 shares but 5000 shares are locked-in and cannot be sold because the company gave them to the management. So, the company has a so-called public float of 15.000. Let’s say that another 5.000 are sold short. So we have to calculate the short-interest ratio.

    (5.000/15.000) x 100 = 0,33 x 100 =  33

    This gives us a short interest ratio of approximately 0,33 or 33%.

    Short interest of float above 50% means that short-sellers wouldn’t have an easy covering of their positions if the price turns to rise.

    How to trade by using metrics for short selling stocks?

    The same as we use metrics to evaluate the stock, these metrics can be interpreted in several ways.

    For example, when we have many short-sellers on one stock, it may be because the company isn’t successful. There are numerous reasons why the company isn’t profitable. Sometimes it can be due to the market shifts and the company’s business model that became unprofitable. Also, maybe the officers of the company are connected to some gossip about possible nefarious actions.

    Or the other example, a high short interest ratio could be a signal that the stock is a bargain. When some company is developing a new product, reports in its early stage might indicate the product could be risky. What is possible to happen? Short-sellers will open their positions driving the short interest above, for example, 20%. But later, when the product appears as very useful and popular, short-sellers are forced to cover their positions because short interest is high. This could cause the stock price to rise, and there will be a strong rally. 

    This potential for unexpected rallies in stock with a high short interest ratio, causes many experienced traders to see this metric as a bullish indicator.

    Bottom line

    Different metrics can be used to classify short-sell candidates. But these metrics are worthless if you never compare SIR and current short interest with previous levels and recognize possible overexpanded levels of stock. Compare the current metrics for the same company’s performances over time. Metrics for short selling stocks are worthless if you don’t do that. Your plan to become a short-seller will probably fail, and you would end up empty-handed.

  • Short Selling Stocks Carries Big Risks and Profits

    Short Selling Stocks Carries Big Risks and Profits

    Short Selling Stocks Carries Big Risks
    Many investors made money by “short selling.” How did they manage that? Short selling strategies offer high risk but high rewards.

    By Guy Avtalyon

    Short selling stocks carry big risks, but when this trading technique is done properly, it might provide huge returns as much as big losses if it isn’t done properly.

    In short selling stocks, traders are placed to profit when and if the stock price goes down. This strategy isn’t suitable for long-term investors with the maxim “buy low, sell high.” The point with short selling stocks is to sell high and buy low. For example, when investors believe that the company is overvalued they will sell its stock short.

    The strategy is criticized and from time to time meets aversion from company managers, policymakers, and in the public. 

    Is this strategy legal? Of course, it is absolutely legal. 

    What is short selling a stock?

    Shorting a stock happens when a trader borrows the shares from the broker but under specific conditions. The trader is obliged to return the shares later. The stock can be sold immediately. Short-sellers are betting that the stock price will fall further. If the stock price drops, the trader is in a beneficial position because the trader can repurchase the shares at a lower price and return them to the broker. The difference between these two prices is the trader’s profit.

    That’s the beneficial part but there is a risky part too. The problem with short selling stocks may arise when the price rises and continue that because the upward trend increases. That may force short sellers to get out of the trade. It could cause the so-called short squeeze.

    If more short-sellers cover their position by buying the stock, the expanded volume can launch the stock price much higher. So, short-sellers will have big losses. 

    The risk of loss on a short sale is endless because the price of stocks or any other asset can grow to space.  

    Is Short selling stocks risky

    Short selling stocks can be a very helpful and profitable technique for traders but some circumstances have to be met. Also, it carries big risks. To make this clear, when you buy stocks, in the worst possible scenario, if everything is against you your potential loss cannot go over 100% of your total investment. But your gains are potentially unlimited. On the other side, when shorting stocks your potential losses could be unlimited, but your gains couldn’t go over 100%.

    Another warning comes due to the increased costs that you don’t have when buying regular stocks. The first notable cost comes from your broker. So, you’ll have, as a short seller, to pay for borrowing stocks. Your broker will charge you that. That could be extremely expensive. Sometimes, borrowing costs could be bigger than the value of trade, for example, you want to borrow some stock that is especially difficult to borrow.

    The other risk comes from the side of a specific account you’ll need to execute the trade. Short selling can be done in margin accounts only, so you’ll need to pay margin interest on your position. 

    Further, you’ll be a short seller obliged to pay dividends on the borrowed stock. This financial obligation can take a big portion of your gains.

    Additional risk comes when you borrow heavily shorted stocks. They are very often subject to buy-in. That appears when the broker covers a short position at the market price but has no obligation to warn you. This situation can happen when the lender, stock owner from whom the stock was borrowed, demands from the broker to return the stock. In this situation, without warning you, the broker will cover your short position at market price even if it is the worst time for you.

    How to short a stock?

    Of course, we’ll give you a powerful example of how short selling works. 

    For example, you borrow 100 shares of ABC company that’s trading for $20 per share. That shares are sold very quickly for $2.000 in total.

    After, in our example, the stock price drops to $15 per share. Now, you can buy that 100 shares for $1.500 and return them to the lender. Your profit will be $500 minus fees. 

    As a short seller, you borrow stock from the broker. The broker is one who holds stocks for investors who own a great number of shares. But stocks for short selling aren’t always available because all of them are already borrowed and sold. 

    On the other hand, some brokers don’t like short selling and rather will stay away from that. They will not participate in it.

    How short selling stocks can be a bad thing?

    Short-sellers are actually betting that a stock’s price is going to fall soon. But instead of buying, they are borrowing the shares. We explained the whole process above.

    Short selling is actually a bet against a stock, but it is not the only way for short selling. For example, if a seller believes the price of a stock will fall, the seller can buy a “put.” That means the seller will by the right, but not the obligation, to sell the stock at a predetermined price at a specific date in the future. 

    If the price drops below the price accepted in the “put,” the buyer has the right to buy that “put” at this lower price and sell at the “put” price. In this way, the buyer would make a profit. There will be no sales if the price doesn’t drop below the”put” price. The trader who bought this “put” can lose only the amount paid for that, so the whole risk goes to the seller.

    Some other bad things related to short selling are not in connection to stocks but maybe, this is the right place to mention them. For example, a trader can buy a “credit default swap.” If the price of the security falls or failure which is possible with bonds, for instance, the buyer of the swap will get the amount equal to the par value of the security. That’s how the short-seller will profit on security drops and, what is more interesting, the short-seller doesn’t need to buy the security, such can buy the “swap” only. 

    Betting against security in this way is a bit like buying fire insurance on the apartment of a friend but a trader knows that the building is old and not built from a solid material and, also, his friend doesn’t pay too much attention to safety. 

    Some people don’t like short-sellers because they think that this kind of trading is immoral.

    Critics of short-selling  

    Critics of a short-selling claim that it generates unwanted and extreme ups and downs in the stock market which may have a bad influence on the wider economy. 

    The significant short-selling on the stock of some company has the same impact on the company because it might cause drops of stock’s value and price will drop.

    Some investors who started to learn about short-selling probably think the short-sellers know some unusual techniques if they want to make success. So they greatly sell their shares, and what happens? Does the stock price drop? Of course, and the short-sellers are the winners. 

    Proponents of short selling 

    They think it is a valuable practice, a technique to force companies to work productively. And it is obvious how they do that. For example, if some company doesn’t work well, the short-sellers will bet against it. Defenders think that short-selling can be stimulative to the companies because it can force the companies to be responsible for their failures. 

    That’s the exact meaning of the stock market, someone will lose, the others will win. 

    Short selling can be a true problem when used as “short and distort.” For example, a hedge fund can short the stock of a company and then begin to discredit the performance of the company. If such a campaign causes a decline in the price of the stock, the hedge fund wins but that gain doesn’t come because the company was really weak. This is an example of manipulation. 

    Short selling stocks is one of the most effective ways to make money when the market is in an extended downtrend. But you must have a deeper knowledge, deeper than it is necessary when buying stocks.  

    You have to know how to handle risk and keep the chance in your favor. Even before you start shorting stocks. That’s why only really experienced traders can follow this trading technique with success.

  • Sell in May and Go Away Strategy – Repeated Every Year

    Sell in May and Go Away Strategy – Repeated Every Year

    Sell in May and Go Away Strategy
    April is the past, and May is here. “Sell in May and go away” is an old saying that investors repeat every year without giving any actual belief to. Should they?

    “Sell in May and go away” is a popular maxim in the market. Investors noticed that some stocks are underperforming over the summer when they compare their performances to the winter period. The stock market summer-period starts in May and finishes at the end of October. The six-months period from November to the end of April is known as the winter period in the market.

    Sell in May and go away is a strategy which investors use to sell their holdings in May and come back again in November to invest. They usually sell their holdings in late spring, sellings are not in May exactly.  But nevermind. We have “Sell in May and go away” as a well-known saying in the market.

    A lot of investors find this strategy is more comfortable than staying in the markets over the whole year. They believe that when warm weather occurs, volumes are lower and the number of market participants is also lower. Investors hold that vacations may cause trading to become riskier and, at least a lifeless period in the market.

    Where the saying “Sell in May and Go Away” came from

    The old custom among English aristocrats was to leave the city of London and spend their vacations in the countryside and come back to London in early autumn when St. Leger’s day is. So the full phrase is: Sell in May and go away, and come back on St. Leger’s Day which is in September. For British aristocrats, it was a very important day because it was a race day for pureblooded horses as a final part of the British Triple Crown competition.

    Later, traders from America adopted the habit of going on long vacations after Labor Day. Moreover, they adopted this phrase as an investing saying. What is really interesting, all data from almost the whole of the past century confirmed the theory behind this strategy.

    For example, in the span of 60 years, DJIA reported average returns of 0,3% during the period from May to October. In contrast, in the same span of 60 years, the average return was 7,5% from November to April.

    But despite the historical background of this seasonal trading pattern in disparity in performance during summers and winters, it looks that it isn’t relevant in modern times. In recent years, some excellent runs occurred during the summers, the stock markets were very dynamic and generated lucrative gains to the investors who stayed in the market. 

    Some markets closed higher in May and rose in June giving an increase of over 50% from the end of June until the end of January. So, the phrase “Sell in May and Go Away” isn’t correct anymore.

    “Sell in May and go away” strategy 

    Some investors use this phrase as a strategy to manage a portfolio over the summers based on the perception that markets underperform during summer. They believe that lower trading volumes from May till October can boost share price volatility and weigh on stocks also. Selling off in May is a method to react to the slowdown. Our suggestion is to look at facts before you adopt this strategy.

    The strategy requires the stock allocation before and throughout the summer months to protect your portfolio against seasonal changes in trading. That means you would sell off stocks you own in May, then stay out of the market for the summer. When the autumn comes you would buy stocks back.

    In an academic study of the saying “Sell in May and go away,” we found that from 1998 to 2012 the returns from November to April surpassed the returns generated from  May to October by nearly 10%.

    Maybe this strategy is good because you’ll be out of volatility that might occur during summer, so you would be able to protect your portfolio from losses caused by volatility. Also, when you reinvest in autumn and do it just before stock’s upward trend you’ll probably generate better returns. The problem might occur when to seek what stock to buy and when to do that. In other words, timing the market is the key question.  

    That can be a critical part because timing the market isn’t a precise science. Actually, it is difficult for even the most skilled investors.

    The other benefit is that you would have a chance to re-evaluate your portfolio and remove losing players. But for this to do, you must have a great understanding of the market subtleties. For example, how a particular stock acts during different periods of the year. 

    For long-term investors, this strategy might be irrelevant but investors with a shorter horizon or for active traders it can be very profitable since they have a more active approach to investing.

    Drawbacks of this strategy

    Sitting out the stock market during the summer and having a long, long vacation might seem attractive, but you have to be cautious. What if there is the potential to miss out on great opportunities? The 

    This strategy is based on past trends. But here is the key problem. Not all investments or stocks will act according to this date-based investing, that to say.

    The “Sell in May and go away” strategy neglects the performance of particular assets or prevailing market or economic circumstances, changes in interest rates, or inflation, for example. Also, as you already know, everything and literally anything may influence the stock market. It might be the political atmosphere, natural disasters, change tariffs, etc. For instance, you sold your stocks in May but they hold strong during the summer. What the consequence can be? It will cost you your gains. No one has the ability to predict what the market will do during a few months.

    The impact on your portfolio is very important also when we talk about the “Sell in May and go away” strategy. It is very important, even if your stocks hold steady, to invest constantly, which means, you shouldn’t avoid summer investing. Otherwise, your portfolio could be hurt. 

    Time is probably the most influential tool you have as an investor. This is all about compounding interest and how long you are invested. That is the power of the time. If you go in and out of the market you will lessen the chance for your portfolio to grow. Also, to compound.

    The “Sell in May and go away” strategy can cause increased trading costs. Yes, online brokerages offer commission-free trading, but not all of them. Also, free trades could be set for stocks or ETFs but what if you sell options in May?  When you buy them back later, the fees could be higher which could lead to lower returns.

    Maybe the most important drawback of this strategy is that it could go against you. For example, the volatility is increasing in May and you decide to get out of the market because you’re panicked. Well, in June, for example, stock rebound, the prices increase. What do you have? You’ve missed the opportunity to get the returns.

    Bottom line

    Instead of “Sell in May and go away” strategy, sometimes rotation is a smarter move. This means, to not sell your investment and cash it out. It is better to diversify your portfolio to the assets that could be less influenced by the seasonal slow market growth. For example, the health or high-tech sector.

    For retail investors with a long-term objective, a buy-and-hold strategy continues as the best choice.

  • Traps of Buy and Hold Strategy In Investing

    Traps of Buy and Hold Strategy In Investing

    Traps of Buy and Hold Strategy In Investing
    In the long run, buy and hold strategy is less costly than other more active strategies but has some traps also.

    Some may ask how are possible traps of buy and hold strategy? So many investors have this approach in investing and see this strategy as the best and safest one. But recently, due to the coronavirus pandemic that caused, and still has influence, on the stock markets over the globe, as well as on the overall economy, we can hear different sounds. Lately, some investors propose some other strategies and marked some traps of buy and hold strategy in investing. 

    News of the end of the “buy and hold” strategy in investing was blooming. But, those sounds are also greatly magnified. Saying that this strategy isn’t able to survive the last market downturn is nonsense, at least. The truth is that this strategy is able to survive any market condition. This pandemic environment cannot decrease the importance of this strategy. 

    But is the buy and hold strategy perfect, is it possible that it has some traps, downfalls, pitfalls? That is exactly what we would like to point out. Also, it is important to notice that the majority of traps of buy and hold strategy are developed from investors’ behavior. They became more worried about their investments, which is normal in the situation when we have had a great market decline. But this strategy is still relevant and it will be despite some traps it has.

    Traps of Buy and Hold Strategy

    Trap 1: Buy and Forget 

    This is the first of many traps of buy and hold strategy in investing.

    Managing your portfolio is a must. Long-term investing doesn’t mean that you can neglect the importance of developments and adjustments, if necessary, in your portfolio. We all know that famous Buffet likes to keep the investment for a long time, but do you think he never looks at his portfolio? It’s 100% opposite. He, and many other investors who do care about capital invested, are fully informed of each of their holdings. So, as you can see, one of the traps of buy and hold strategy is the approach to this investing expressed in the mantra “buy and forget”. 

    You simply have to keep your eyes on your portfolio. It is very important to check if the company you bought is really the right one. Times are changing, management is changing, the trend is changing, and since literally everything and anything may affect your holdings, it is smart to stay fully tuned on your investment. 

    For example, let’s say you bought the shares of stock in some company that looked pretty good but suddenly you reveal that it wasn’t such a good pick. What are you going to do? Will you keep holding that stock? Why not, your strategy was the buy and hold? See how you can jump into the trap very easily? If you bought the wrong company even at a low price, the buy and hold strategy is a stupid move. 

    What if you were smart and purchased the right company but the price was wrong? Do you still think you did a good job? Of course not. So, you should never even try the buy and forget strategy because it is a losing strategy. And also, one of the traps of the buy and hold strategy.

    Trap 2: The simplicity of buy what you know

    It is a nice mantra, seducing like a poem, but that level of simplicity can be very dangerous. Why is simplicity one of the traps of buy and hold strategy in investing? To make this clear, do you hold stocks of the company whose products you use in everyday life? Yes? Look, there is nothing wrong, you can like the company’s product because of its quality, design, smell, whatever. However, it is unreasonable as a criterion when it comes to picking the stock for long-term investing. The meaning of buy what you know is something else. You don’t need to buy Disney’s coats or sleepwear if you want to buy the shares of the company. 

    Investing is a very serious job, so when you choose stocks some other things you’ll need to know before buying them. For example, what is the company’s prospect, how the company is positioned among competitors, is the stock fair valued, etc. 

    Some studies unveiled that inexperienced investors have a disabled blind spot when they estimate what they know and what not in the sense of picking the stocks. Remember, stocks are not your lover. You don’t need to love them. Keep that love in your private life. But when you estimate and evaluate the stocks you’ll need your rational mind. Free of feelings and emotions. It’s simple. When you are choosing the stocks where you’re gonna put your hard-earned money, the emotions are a burden and could lead you to the wrong and harmful decisions.

    Trap 3: Stay to your investment plan

    Of course, it is a good decision and you have to do that but not always. We said that numerous times: Stick to your plan! Yes, but only if you hold well-evaluated stocks in your portfolio. If you have a portfolio filled with stocks you “love” and you picked them randomly, you’ll have to change your plan and your portfolio. What else can you do? Nothing. You can do nothing with wrongly chosen stocks. Why would you like to hold stocks with poor performances? And there is a great chance that you picked losers if you didn’t build your portfolio based on investment outlook. So, how to stay with your plan if you have losers? The only reasonable action is to improve your investment portfolio. You have to change your holdings, and you’ll need to be more realistic when picking the stock. 

    Don’t be afraid! You don’t need a detailed and exact outlook for growth in the next year. But you surely need to have a basic understanding of the economy and the market.

    For example, the whole world has an economic downturn today. The fears of many companies regarding solvency are rising. But this situation is likely not to continue. Actually, we are 100 percent sure it will not. The economy will bounce back soon or later, there is no doubt. And you as an investor also have to know that. 

    To put it simply, if you have a long investment horizon, why should you be worried if prompt recovery or a slow recovery will come. Your only concern should be your ability to be clever enough and to be prepared to adjust your position if your investment outlook has to change.

    If you stick to your investment plan and you do not manage your investments with due diligence, you’ll be faced with traps of buy and hold strategy in investing. 

    Trap 4: The money is locked

    Despite the fact that it looks like a great strategy, the “buy and hold” strategy has some traps and drawbacks. First of all, this strategy means investing for the long run, so your money invested will be locked in stocks. During the holdings period, it might happen that you’ll have to stay away from other investment opportunities. It will be hard for all of the investors to have such discipline, particularly if they made bad purchasing and choose lagging stocks. Especially today when many investors realize that their choice wasn’t that good.

    Trap 5: Time is my friend

    Well, it can be true especially if we count on compounding. But just because you owned the stock for 15 years, does not mean that you are qualified for a generous reward for your capital invested. Just look at the differences in return between your stocks. If your portfolio includes a few great investments, over time it can be dragged down by the losers. Of course, what or who can stop you from holding all losers in your portfolio. That’s your choice. But think about diversification or buying some index funds. We hope you understand that time isn’t always your friend and that your investments may drop over time. There are no guarantees unless you keep your eye on your investing, manage your portfolio, adjust it is necessary, or engage some to handle it. But yet, nothing is 100 percent sure when it comes to long-term investing. You should count on it. And try to avoid traps of buy and hold strategy because it has them many.

    Trap 6: My best players will always beat the market

    Really? What if the market crashes? Despite the fact that the markets will survive even an Armageddon, the market crashes can lessen the value of your investment significantly. For example, if a prolonged bear market occurs, investors stick to the buy and hold strategy and can lose all gains. Yes, your winners are solid stocks and they may bounce back, but if you own the stocks that are notably going down, your portfolio will be hurt a lot. That kind of stock could wipe out your portfolio. Think about the oil sector today. What do you think, will it be better? Of course, but the damage is done.

    If you prefer the buy and hold strategy it doesn’t mean that you’ll never need a risk management strategy in place. Every single investor or trader must know when to pull the plug and avoid bigger losses. 

    Bottom line

    Buy and hold strategy in investing is one of the most popular ways to invest in the stock market. In most cases, investors who practice this strategy have no worries. But, if we say it has no drawbacks we’ll lie. Moreover, this strategy has some serious traps and failures. If you pay enough attention to your portfolio it is possible to avoid them. That will require your time and money to secure your investment against market crashes. Also, you have to know how and when to cut your losses and take profits.

  • Concentrated Stock Portfolios – Are They Risky?

    Concentrated Stock Portfolios – Are They Risky?

    Concentrated Stock Portfolios - Are They Risky?
    A portfolio of fewer than 10 stocks can be more volatile than a portfolio of 200 stocks and riskier. But it is able to produce greater wealth.

    Concentrated stock portfolios are portfolios that hold a small number of different stocks. The aim is to reach a specific level of diversification. But it is different from diversified portfolios because concentrated stock portfolios can consist of less than 10 stocks. This kind of portfolio can increase the risks but at the same time, it increases potential gains. While we are broadly talking about the importance of portfolio diversification concentrated portfolios actually generate the highest returns. And if you examine the results of both, you’ll see that concentrated portfolios that include only a few stocks are better solutions for creating huge wealth. 

    How is that possible?

    Concentrated portfolios also allow investors to be focused on a small number of investments but high-quality. Many famous and extremely successful investors made fortunes with concentrated stock portfolios. 

    We don’t want to neglect the importance of diversification. It’s the opposite. Diversification is by far the most important lesson that we can learn. Also, the importance of spreading money across different stocks and sectors isn’t doubtful and will significantly reduce risk. But a lot of investors don’t follow that advice and are growing their wealth as a result. Warren Buffett once said “diversification is a protection against ignorance” and what is interesting, data shows that concentrated stock portfolios generate more profits. Simply, they are better performers. 

    Disadvantages of diversification

    Diversification has benefits but you’ll need a balance between risk-controls and returns. This highlights investors that diversify across concentrated stock portfolios rather than diversified. Diversified portfolios have a lot of market risk, anyone can confirm. 

    But, how much is proper?

    All investors are faced with this question and it isn’t a simple one. If you have a concentrated stock portfolio you may experience the stressful event if you don’t understand the company you are investing in completely. However, if you are ready to explore and spend time to get to grasp the companies you want to buy, the concentrated stock portfolio might be a great choice and it can generate high returns.

    But be careful, invest only in the companies that you believe you have an advantage. Concentrated stock portfolios aren’t necessarily risky but only if you are ready to work more. This means you have to be responsible for your investments and never neglect the dangers that may appear. You have to pay a lot of attention and spend time to be able to reduce the risk if you want to build a concentrated stock portfolio.

    Diversified portfolios hold stocks of numerous companies. 

    It is between 40-75 stocks. Concentrated stock portfolios hold less than 25, and it is common to hold less than 10. For example, the structure of such portfolios means that you have 5 to 10 stocks which constitute over 50% of your overall investments. It is important to follow this structure because if you don’t follow these percentages and your portfolio holds under 40%, your portfolio will be diffused.

    Diversification has some advantages. It can reduce the level of portfolio volatility and potential risk. When investments in one sector perform inadequately, other investments will offset losses. But you have to hold assets that are negatively correlated. 

    But diversification can have negative effects on your portfolio. That is a great disadvantage. A diversified portfolio can limit your potential gains and produce average returns. For example, you hold a few winning stocks but beside them, you hold 20 stocks with poor performances and they will reduce your overall gains.

    Also, diversification requires to rebalance your portfolio. If you created a widely diversified portfolio you’ll have a problem monitoring and adjusting your investments. And if you don’t pay sufficient attention the risk may increase.

    The benefits of a concentrated stock portfolios

    Conventional thinking states that diversification reduces the overall risk of investing in stocks. And what is interesting, investors support that approach but, for some reason, avoid concentrated stock portfolios as too risky. It is understandable, but having too much can be bad.

    But not all investors are opponents to concentrated stock portfolios. For example, Warren Buffet who advocates for a concentrated portfolio suggests: ‘‘An investor should act as though he had a lifetime decision card with 20 punches on it. With every investment decision, his card is punched, and he has one fewer available for the rest of his life.’’

    How to build concentrated stock portfolios

    It isn’t as hard as you may think. For example, buy stocks of companies you know well, stay focused on your main investment purpose, invest for long-term to gain the benefit of compounding. And, what is most important, research a lot to find the best stock to invest in.

    When you invest in a limited number of companies you actually have a great opportunity to invest in high-quality companies. There is no need to compromise on quality. What you have to pay attention to? Be informed and buy the stock when it is priced below its worth when the market undervalues it. This gap will provide you significant and profitable upward potential. 

    Legendary John Maynard Keynes suggested investors hold concentrated investment portfolios. In 1938 he wrote:

    1. A careful selection of a few investments (or a few types of investment) having regard to their cheapness in relation to their probable actual and potential intrinsic value over a period of years ahead and in relation to alternative investments at the time;
    2. A steadfast holding of these in fairly large units through thick and thin, perhaps for several years, until either they have fulfilled their promise or it is evident that they were purchased on a mistake;
    3. A balanced investment position, i.e., a variety of risks in spite of individual holdings being large, and if possible, opposed risks.”

    The ideas for concentrated stock portfolios

    Let’s examine two possible portfolios and compare them.

    The first one consists of all stocks in the market. You can hold such a portfolio without a problem if you use mutual funds and index-tracking investment trusts, for example. If we ignore all fees, the return of this portfolio will be an exact match of overall market returns.

    The second is a concentrated stock portfolio with one single stock. Let’s assume that stock is a great player, so its return could beat the market. Of course, if the investor made a bad pick the total loss is guaranteed.

    So where is the point of holding concentrated stock portfolios? 

    If you have a smaller stock portfolio, the possibility to have a higher return than the market average is greater. If you want to hold a smaller portfolio everything depends on your ability to identify all details of some company, you have enough time to find some low-priced stock that can outperform the market greatly. A careful selection of stocks will maximize your long-term returns. 

    But the concentrated portfolio should be balanced 

    Concentrated stock portfolios hold several stocks and as being such, are resistant to the risk of a total loss. Even if the value of a single holding falls to zero. It is possible if every stock from the portfolio performed the same. So, you should hold stocks with incompatible risks or opposed risks. For example, you could reduce the risk if you invest in some hedge funds.

    Bottom line

    No risks, no rewards is the most meaningful sentence in investing.

    When you know all the company’s details, that allows you to decide which investment concept has the highest profit potential. If you want your capital to put to work, your investments should be your top choices. Of course, you have to be selective. No one has hundreds of top choices.

    Try to think of a small portfolio with several stocks like this: a small portfolio can increase risks, but it will also maximize the returns with a few outstanding players. Always keep in mind the investors in Microsoft. Why should any of them want to hold any other stock?

Traders-Paradise