The other day I was talking with someone about the stock market and we were getting into different investments when all of the sudden he said, “oh who knows what to invest in, the whole stock market is just a big gamble anyway.” Now, I’m a very agreeable person but this struck a nerve deep down and was a statement that I completely disagree with. There is a reason I quit my job to trade in the stock market full time. There is a reason I derive income off the stock market to pay for my living expenses. It’s not because I’m just super lucky and making winning “bets” all of the time. In today’s article, I’m going to be explaining why the stock market in not a gamble by describing my approach to investing.
I like to do a great deal of research before I go into any trade. I have found that quality is better than quantity and there will always be diamonds in the rough at different time periods when it comes to stocks.
- Top-down Approach
o When it comes to looking for stocks, I take a top down approach by looking at certain industries first and then looking at individual stocks within that industry. One thing we know for certain is that industries are cyclical, just like the economy. There are periods where they will be trending up and periods when they trending down.
- The Trend is Your Friend
o We can’t predict the future but we can jump in on trending industries. Take the oil market for instance. Recently the price of a barrel of oil has been driven up by production cuts from OPEC. This has caused the oil and gas industry to be trending up for the past few weeks. If you had bought any oil stock during the past few months, you would be looking at a good return on your investment!
- Recent News
o I always look at the recent news surrounding a company and assess it to see if it’s just media bs or if it’s a legit concern to the company’s health. As Warren Buffet says “Be fearful when others are greedy, and be greedy when others are fearful.” When I see news analyst and news chatter coming out condemning a stock, I know it might be a good time to buy if the company has a solid foundation and their industry is still growing at the time.
- Expected Guidance for the Future
o Every quarter a company will post its earnings for that quarter along with guidance for the remainder of the year. If a company has terrible earnings but strong guidance, it may still be a great company to invest in. Remember, a stock’s price is always forward-looking. Based on expected growth, do you feel as if the company is overvalued or undervalued?
- Screen for charting patterns
o There are many charting patterns that I screen for to enhance my chances of success. These patterns include the wedge, head and shoulders, and the channel patterns. I don’t blindly buy stocks solely based off of good fundamentals. Price patterns dictate 100% of my trades.
- Waiting for Volume on Price Breakouts
o The ultimate objective of charting patterns is to invest in a stock when it breaks out of the pattern with good volume. If there is weak volume then the price breakout is not as likely to happen.
o I like to wait till I see at least two days of above average positive volume to confirm the price breakout before I invest
- At least 3:1 Risk/Reward Ratio
o When you are gambling, most of the time your odds are 50:50. Those are not odds I accept when it comes to trading. I look for trades in which my risk/reward ratio is at least 3:1. This means that for every dollar I risk, I have the chance to make three.
o Kyle Bass, founder of Hayman Capital Management, is one of the kings of finding asymmetrical risk/reward plays. Kyle is famous for turning a 30million dollar investment into 2 billion dollars in just two short years. Kyle made a very calculated bet against the housing market when it crashed BUT he was only risking 3 cents for every dollar of upside.
- Stop Loss
o I always calculate the maximum amount I’m willing to lose in a trade. Not all of my trades are going to be winners and I protect myself from huge downside potential if my trade does not go as planned.
- Profit Exit
o I calculate profit exits from certain charting patterns based on the research done by Thomas Bulkoski. Thomas calculated the expected moved of a stock through thousands of charting patterns and has come up with formulas for target price moves for various patterns such as the wedge and head and shoulders.
- Use Technical Indicators
o I look at different technical studies to help me predict when I should enter or exit a trade. Check out the article, The Best Time to Dump a Trade, for more details.
Many of my trades that I use this strategy for are for short-term investments (investments lasting a couple weeks/months) I believe the same approach could be taken for long-term investments as well but in all cases, I do not consider my trades to be gambling. Trading in the stock market CAN be gambling if all you do is buy a stock and HOPE that it goes up. I am making calculated decisions based off a variety of information and always have an exit strategy in case I’m wrong. Is ultimately up to you whether you are gambling with your money or not.
Homework: Review your approach to investing. Are you buying a stock simply out of emotion or simply because you “like” the company or are you making the time to do research necessary to find the diamonds in the rough?