To win in the stock market, one must learn to ‘play the game’. The discussion below will attempt to demystify what is often regarded as a complex, difficult and often frustrating endeavor – ‘to make money in the stock market’. Although the title (‘the stock market game’) refers to the stock market (as it is what most folks know as it is on the news routinely), the science behind the art of ‘how to get rich in the markets’ can be applied to the forex, futures, options and other trading markets. Despite the title’s reference to a game (‘the stock market game’), the following discourse is a serious discussion of the art and science of how to make money in the markets. People often believe that to make money in the markets, one has to be smart or gifted in ‘picking the right stock’, this is simply not true. As we will see, one can make money irrespective of one’s ability to pick good stocks, but being ‘able to pick good stocks’ gives one an edge over those who cannot – although, actually it’s those who ‘have an edge’ are the ones able to pick ‘good stocks’ and not the converse.
UNDERSTANDING THE STOCK MARKET GAME
The resemblance to a game is more than coincidental, and comparisons can be drawn that are extremely meaningful. As with a game, if one is to stay in the game (“stay in the stock market”), one must learn the rules of the game – mistakes are punished by one losing one’s money. Some might liken the stock market to a game of chance; however, those who are successful in making money in the market know that it is more a game of skill or one of strategy. Games of skill or strategy, whether individual (poker, bridge, monopoly, scrabble, etc) or team sports (football, soccer, cricket, etc), all involve making and following a plan, and making contingency plans for unexpected situations. They all involve practicing repeatedly until one is adept at one’s skill, and learning from failures. Similarly, to win in the stock market (game), one must learn the ‘secrets of successful traders’, the winning strategies that give successful traders an ‘edge’. Having learned and understood the principles, traders who wish to be successful then practice and practice their art until they are successful.
With that introduction, let’s examine and understand some of the ‘secrets of successful traders’ …
SECRETS OF WINNING THE STOCK MARKET GAME (HOW TO WIN IN THE STOCK MARKET)
1. WINNING DOES NOT INVOLVE ‘PICKING THE RIGHT STOCK’
A widely held belief is that one can only make money in the stock market, if one has the ability to ‘pick the right stock’ and hold it until one gets rich. This ‘buy and hold’ strategy has been popularized over the past many decades by many financial advisors, and is epitomized by the likes of Benjamin Graham (the oracle of Omaha). This view suggests that either one is born with a ‘gift to make money’, an uncanny ability to choose the right investments, or one has to spend much time being trained by financial gurus to read, interpret and understand financial reports to be able to learn to pick the right stocks and/or other investments. Unfortunately, by subscribing to this view, we tend to paralyze ourselves into inaction or relinquish our monies to financial advisors to manage. However, the former is not necessary and the latter may not always result in the outcomes we desire. As the next paragraphs will show, proper asset allocation and money management are more important than ‘picking the right stock.’
RULE: Cut your losses short, let your winners run
Individual investors and traders will surely have read or heard this rule before, but it is ‘often taught, but rarely followed’. Human psychology being what it is, we tend to get attached to our investments and trades, and, once we’ve bought a stock, we will it to go up. If it doesn’t do so immediately, we tend to make up reasons for why it isn’t doing so. Despite the caution to ‘cut your losses’, we tend to stay in the trade longer than we should, refusing to believe we ‘made a mistake’, and picked a ‘wrong stock’. The inevitable consequence is that a small loss becomes a bigger loss. Conversely, when a stock moves up like we want and we are making money, we tend to get excited that we are ‘winning’, and we tend to sell ‘early’, often long before the stock has ‘ended its run’. Successful traders recognize that whether a stock rises or falls does not reflect on them as individuals, and that some stocks will not rise as they expect; as such, they have no qualms about selling a stock that does not perform as they expect – and, this makes all the difference in their outcome.
Mathematical illustration that ‘picking the right stock’ does not matter
For this example, we will make the following assumptions.
- We have $10,000/= to invest or trade with.
- We take 10 trades of $1000/= each in stock XYZ
- We buy the stock with no opinion of whether it will rise or fall
At the end of our arbitrary holding period, the results are as follows (data were generated using a random number generator in Excel to give the % increase or decrease)
As seen above, at the end of the 10 trades, we have a net loss of $160. In reality, because most folks tend to hold on to their losers longer and sell their winners sooner, this account would most likely have had a substantially greater loss.
Now, let’s run the same scenario again, but this time we cut our losses if the stock drops 10%, and allow our winners to ‘run’ as before.
As seen in the table above, at the end of the 10 trades, we now have a net gain of $2140. In this second scenario, the only difference is that we accepted the fact that some trades did not go in the direction we desired, and we exited the trade at a ‘small’ loss. The effect of this money management strategy is that it allowed the account to grow as the gains of the winners overcame the losses of the losers.
Importantly, the portfolio gains were achieved with absolutely no consideration for stock direction. As we shall see, if we are able to factor in (i.e. predict) stock direction, the results can be even more startling. (For the ‘naysayers’ who might claim that ‘every stock I pick’ drops, there are ‘bearish’ strategies to ‘make money’ when stocks fall!)
2. SUCCESSFUL TRADERS HAVE AN ‘EDGE’
In the above scenarios, we made no assumptions of market direction, with the stock having a 50/50 chance of either rising or falling. To illustrate the power of an ‘edge’, let us re-examine the previous scenario with one difference – instead of 5 winning and 5 losing trades, we shall assume we have a slight bias to the winning side with 6 winning trades and only 4 losing trades (replacing trade #5).
Mathematical illustration of the power of an ‘edge’
As we can see in the table above, the very slight positive bias when combined with good money management results in significant gains.
It’s important to note that the stock selection builds on sound money management (equal risk per trade and ‘cutting losses short’). If traders and investors do not pay attention to risk management, they will inevitably lose money even if they have a ‘gift’ of ‘picking the right stocks’.
So, how does one get an ‘edge’ in the stock market game?
Ironically, there are literally numerous trading systems that have been devised – and, traders are constantly looking for the ‘Holy Grail’ trading system, one that will always work in all markets. The simple truth is that there is no one system that is 100% infallible that always works. As shown in the scenarios above, if one can learn a system that allows one to gain an ‘edge’ (more than a 50/50 chance of being right), and combines it with good money management – then one has a winning system!
Here are two simple rules that are simple to understand in concept, although not always easy to apply.
RULE: Buy what’s going up, Sell what’s going down
RULE: Trend is your friend
Both the above rules seem simple to the point of being ridiculous, but ironically they form the underlying basis of most stock analysis conducted by investors and traders.
READ MORE ABOUT STOCK MARKET ANALYSIS HERE
To test the above principles yourself, check out the Stock Market Simulator where you can prove that even with a 50-50 chance of picking a stock that goes up, you can make money by limiting your losses.
My own approach to playing ‘the stock market game’ essentially combines stock valuation (to discover which stocks to buy or sell) with technical analysis (to know when to get in and out) with stock options (to use the versatility of options to reduce risk and lock in profits) with automated orders (to allow movements of the stock market to trigger orders per my specifications). Readers are invited to review the ‘How to Trade’ pages, which I will keep adding to over the next many months, to discover more about my approach. As noted in ‘How to Trade’, investing and trading styles are highly personalized, and readers need to spend some time and discover their own personality, vision, risk tolerance and what works for them. Only then will they be successful in winning ‘the stock market game’.