Basic Trading Rules
The whole goal in trading/investing is to make money. To get there, not only do we have to generate good, well-researched, trading/investing ideas, we must keep a level head when it comes to the actual trading/investing part. No matter how good a trader is, the psychological part of trading can get to any of us.
However, if we can do our best in keeping some basic rules in place with our trading/investing strategy, the smoother the whole process should be.
So, before getting into a trade…
#1: Is the trade you’re taking a non-speculative or speculative trade?
Non-speculative trades are those of companies that are typically of higher quality, so the stock generally trades with less volatility, in a somewhat more controlled way, and is viewed as a trade that has lower risk vs. speculative trades.
Speculative companies are typically lower-quality companies, but not always necessarily. I must stress things like this because we must be careful to not apply absolutes in areas of the market where they do not exist.
As an example, Microsoft (MSFT) is a trade that would be considered a non-speculative trade.
Meanwhile, a nano-cap oil and gas stocks such as KLX Energy Services (KLXE), for example, would be known as a speculative trade. Non-speculative vs. speculative:
- Less risk vs. more risk
- Less stock volatility vs. more volatility
#2: Know a stock’s market cap, average trading volume, average true range (ATR) and its beta.
The market cap will give you an idea of its size (i.e., mega-cap, large-cap, mid-cap, small-cap, micro-cap, or nano-cap) and its average volume, average true range and its beta will tell how much volatility to expect on any given day.
Market-cap ranges are as follows: Mega-cap $200 billion or more, large-cap $10-200 billion, mid-cap $2-10 billion, small-cap $300 million - $2 billion, micro-cap $50-300 million, nano-cap below $50 million.
By doing a quick check on market cap size, you immediately know (for example) this company has a $1 billion market cap… it’s not a tiny company vs. seeing this company’s market cap is around $20 million. We could see some real volatility here.
You need to know, are you jumping long into, for example, a stock with a $50 million market cap, thin trading volume and a very high typical daily trading range? If so, you better be ready to maybe risk 10-20% of your overall capital put into that trade with the idea that you want to see 10-20%, or 50% or more on the upside. You also should plan on taking smaller position sizes in this kind of a trade vs. what you would do in a more normal, non-speculative trade.
Or are you jumping long into a large-cap play with very high trading volume (can get in and out of the trade very easily at current prices, give or take a few cents) with a moderate daily trading range? If you are in this kind of a trade, you don’t have to keep obsessively checking quotes on your smartphone when you are trying to relax on the beach.
Pretend you have $100,000 in your trading account. In the example of the stock with a $50 million market cap, we would be taking a position size of maybe $1,000-3,000. In the example of the large cap play, I would feel fine taking a position size that is much larger, maybe $10,000-20,000. Again, though, don’t apply this to every single situation. It’s a general guideline that we follow.
When looking at volume, look at the chart and time & sales. The chart shows if the stock trades in a spotty or choppy way, gapping up and down in a rather annoying way or not. When looking at the actual average trading volume we want to see at least 100,000 to 200,000 shares in trading volume. We mean that’s a minimum. Of course, the more volume there is, the most liquidity there is. Occasionally, we get into a trade that has something more like 50,000 to 100,000 shares average trading volume, but not often.
Looking at beta and average true range…
Let's compare a mega-cap stock that we all know vs. a micro-cap name (MSFT vs. SN).
- Microsoft (MSFT) has a market cap of $2.3 trillian, a beta of 0.8x (meaning that it is less volatile than the average stock) and an average true range of $4.50 (since the stock is currently $305/share, that implies that the stock has the potential to move as much as 1.5% on any given day)
- Let's now look at Takung Art (TKAT). This is a stock that has run from under $1 to a high of $74 as momentum traders got behind it as a play on NFTs (non-fungible tokens).
- TKAT has a market cap of $64 million, a beta of 3.1x and an average true range of $0.98 (since the stock is currently $5.50/share, that implies that the stock has the potential to move as much as 18% on any given day)
Remember that the stock market has a beta of about 1x. So, a stock like TKAT, that has a beta of 3.1, can be expected to move 310%, or 3.1x the general move in the market (S&P 500 move vs. TKAT move, for example).
Combined, these measures give you a quick decent picture of how much volatility you should expect in this trade in any given day, whether you go long or short.
#3: Use a scale-in approach
Don’t plan on getting long a stock all at once. Of course, occasionally we can do this and it’s no problem (i.e., maybe you want to buy U.S. Steel (X) at $31/share and risk a strict $0.50 with size. That’s okay).
But, in general, if you want to get long, plan on adding once or twice… or maybe even a little more, depending on if the trade is with a higher quality company or not. We don’t really want to try and perfectly time when to buy into a stock one time.
For example, if we want to get long Palantir Tech (PLTR) at $25.00/share and we plan on scaling in, we will take our initial position at $25.00/share, but we won’t plan on adding until the stock has fallen about 5% or more. So, as an example, if we were to get long with the idea of adding two more times to my position, we would get long at $25.00/share and then add at around $23.75/share and then again around $22.50, giving me an average price of around $23.75/share.
Other basic rules:
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Make it a habit to not hold a TRADE into earnings results unless you are specifically attempting to play the earnings print.
If you are certain that you plan on holding a stock for at least several months, and it's a quality company, then we can sometimes do it if we feel that we know the company well enough. - Remember, when you think a stock can't go any lower on any given day during a sell-off, it can, and it will.
- Don't make any one stock too large of a percentage of your trading account. If you have a lot of confidence in, for example, a certain long position, then increase the size. Otherwise, constantly monitor your position weighting in your account.
In summary:
Before you jump into a trade, do a quick check on these items. Know if your trade is a non-speculative trade or a speculative trade. Know it’s market cap, trading volume, average true range, and beta ahead of time. And be in the habit of scaling into a trade.
the most part, don’t hold a trade into earnings. And remember, when you think a stock can’t fall any more than it already has in any given day, it can, and it will.
Lastly, make higher-quality (non-spec, higher volume, lower ATR, and beta) trades a larger percentage of your account and lower-quality (spec, lower volume, higher ATR, and beta) trades a much smaller overall part of your account.
By applying these rules, we will properly manage two of the most important things in trading, proper risk levels and correct position sizes.
Disclaimer: Remember, this is a good general guide. This doesn’t apply to 100% of all situations. However, they almost do.
