As I mentioned in a previous post, I believe that stock market speculation is one of the best ways for the average person to build wealth. What I want to touch on now is three basic ways that people can make money trading stocks. Keep in mind, I am talking about trading and not investing.
When I discuss trading, I am generally referring to any strategy where you hold a position for under one year.
There are three basic approaches for traders to make money trading stocks…1) Trend Following, 2) Swing Trading and 3) Day Trading.
Trend Following and the Stock Market
The general approach to trading that most people should employ, simply because it requires the least amount of time, is trend following.
Trend following when it comes to trading is simply buying high and selling higher, or selling short at a low price, and covering that short position at a lower price.
The idea is to exploit the few large trends in the markets that occur from time to time within the larger context of generating long term, positive absolute returns.
When the markets are not trending, these strategies tend to experience losses. In an effort to generate more consistent returns then, CTAs will employ trend following strategies of varying length to capture long, medium and short term trends.
Trend followers do not try to forecast direction. They simply react to the the current price action. If a stock is moving up in price, they will be long. If a stock is moving down in price, they will be short, or simply flat.
Trend following is actually the most common strategy employed by money managers in the futures markets, known as Commodity Trading Advisors (CTAs). These traders typically employ a systematic approach to trading, and trend following strategies lend themselves well to automated trading.
The concept of trend following is certainly not new to the investment world. One of the most famous traders of the early 20th century, Jesse Livermore, clearly employed trend following as his primary trading strategy. You can read his autobiography in the book Reminiscences of a Stock Operator written under the pen name Edwin Lefevre. This book is among a select few that are often required reading within trading firms.
There are three basic trend following strategies employed by professional commodity trading advisors and private trend following traders. These include moving average strategies, channel breakouts and reversals off highs and lows. I’ll cover these in another post down the road, but here is a basic example of a trend following strategy at work…
This is a chart of crude oil futures with three moving averages. The green line signifies the longer term trend, and with this triple moving average strategy, you only take trades in the direction of the trend. The red line indicates the fast moving average, and the blue moving average represents the signal line. If both the red and blue moving averages are below the green line, you look for shorting opportunities. In this case, you had a new shorting opportunity in July when both the red and blue line were below the green line, and the red lin crossed back below the blue line. You would simply exit the short position when the red line crosses back above the blue line.
Due simply to the fact that the universe of stocks is quite a bit larger than the universe of futures markets, it is more difficult to implement a purely systematic trend following approach to the stock market. And, the fact of the matter is that most stocks do not trend very well to begin with.
Discretionary Trend Following
A better way to employ trend following in the stock market is with a discretionary trend following approach. This is the approach employed by William O’Neil and his disciples at Investors Business Daily.
O’Neil’s approach, known as CANSLIM and outlined in his book How to Make Money in Stocks uses fundamental data, such as earnings growth, to screen the stock market.
The strategy then looks for the stocks with the greatest relative strength, and then buys stocks when they breakout from trading bases of at least seven weeks in duration. If the stock exhibits significant strength from there, he looks to hold it as long as possible.
O’Neil’s book is an excellent resource for the stock market altogether, as it covers a variety of information on chart reading, some history and a variety of technical indicators for monitoring the market.
Swing Trading and the Stock Market
Another approach that some traders take in an effort to make money trading stocks is swing trading. Swing traders look to enter positions at market turns, and exit within a couple days to a couple weeks, depending upon their strategy.
Swing trading is a sort of hybrid between day trading and trend following. Swing trading involves anticipating the market’s next move, and determining the most probable outcome. For example, if a market broke resistance and had a significant move to the upside, a high probable trade would be to by the first pullback.
The primary goal of a swing trade is to minimize risk. Most swing traders do not trade mechanically. Therefore, there is no set profit target, and we do not try to capture a large trend. Trades are managed according to how the market behaves after we enter a position. The outcome is unknown.
On this chart of AMD, there was a new breakout in early February that took the stock to new 52 week highs. The stock then took a breather for a little over a week, and the price pulled back to near the rising 20 day exponential moving average. A swing trade could be entered at some time on that trading day, or the next day as the stock gapped higher. The exit is then dependent upon the trader themselves. Some will exit when the stock fails to make further upside progress after a couple days, while some might wait for the bigger move that occurred on February 27th.
While swing trading looks easy, it is far more difficult than it appears due to the subjective nature of the exits.
One of the best books written about the concept of swing trading is Street Smarts: High Probability Short-Term Trading Strategies by Linda Raschke and Larry Connors. It covers the three basic swing trading set ups and a variety of indicators that can be employed to monitor potential trades.
Day Trading and the Stock Market
The last way that some traders make money trading stocks is through day trading. Many novices try their hand at day trading as a means of escaping their day job. Most are doomed to fail as it is very difficult to make enough money trading to cover your bills every month, and the pressure to do so is immense.
There are two basic approaches to day trading…scalp trading and the opening range breakout.
Scalp traders simply look for opportunities to get in and out of a trade in minutes in an effort to capture some small profits. The most popular time of day to do this is the morning, after the stock market opens. That is when volatility and liquidity are at their greatest.
The dream of many of these traders is to make a few hundred or thousands of dollars in the first hour or so, then call it a day and head out to the golf course or beach.
In reality, there aren’t many of these traders out there.
The second approach to day trading is use of the opening range breakout. There are a wide variety of strategies that employ this approach, but the basic idea is that you enter a position early in the session based upon a breakout of a trading range, and then hold that position until the close.
This is the 5 minute chart of NewLink Genetics. This stock exhibited some early session strength as it broke above the previous day’s high in the first 10 minutes.
A trader who employs an opening range breakout type of strategy might simply buy the stock when it breaks above the highest price of the first 30 minutes of trading. As long as the stock doesn’t sell off, he’ll hold it until the close.
In this case, the trade paid off. The stock broke above the high of the first 30 minutes shortly thereafter, which was around $17.79, and then continued a steady trend higher the entire session and closed at $19.76. So, if you were able to buy 1,000 shares early in the session, you made nearly $2,000 on the trade. Not bad for a days’ work.
The difficulty with day trading is that you need to be extremely nimble so you can jump on board the stocks that are moving on any given day. Thus, you need a strategy and a trading platform that allows you to screen the entire market to find stocks that are exhibiting unusual early morning strength.
Not every trade will work out like this one, so beware!
As you can see, there are several basic approaches by which a trader can make money trading stocks. The key is to figure out which approach is best for you. Some of the factors that will make that determination will be how much capital you have available, how much time you have to monitor the market during the day, etc.
I’ll be covering a variety of strategies in more detail down the road. I also offer a newsletter to help you find those big winners that you can use a trend following approach with, and I provide a lot stock market insights and education in that newsletter as well. Check it out here…. Stock Market Opportunities
As always, if you have any questions or comments, just fill out the form under this post and I will be sure to respond.