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Five Steps to a Winning Strategy

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Most strategies will work when the market is in raging bull mode, but the most important time to stick with your strategy will be when the tide turns and the action gets ugly.

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One of the things I always find interesting when I start to talk with another investor is to learn about their trading strategy. Occasionally I will run into someone and when asked what their strategy is, they will give me a strange look and mumble something about buy and hold. I am a firm believer in a set strategy, regardless of your time frame. Whether you are looking at buying General Electric (GE) for the next ten years or Advanced Micro (AMD) for the next ten minutes, it will always help you to have a clear strategy for entering and exiting trades.

A strategy helps to eliminate the emotional decision making that often dominates when the markets move to extremes. Whether the market is falling and everyone is predicting the demise of stocks as we know them, or the market is flying and stocks are going to the moon, adopting and sticking with a strategy helps one to avoid being sucked into a mentality one way or the other.

Regardless of the common knowledge that the way to make money in the market is to buy low and sell high, so often investors do exactly the opposite. Why? Because when extremes are reached the emotions are so high one cannot help but succumb to whatever theme is prevalent at the time. This is precisely why so many bought stocks at the height of the technology bubble and it was the same people who swore them off at the bottom.

Regardless of whether you invest in mutual funds, ETF's, common stocks or baseball cards, a trading strategy will help you stay on the narrow path to success while so many others flail about just trying to stay on their own two feet.

I always encourage everyone to find a style that correlates with their personality; however I thought it helpful to relay my strategy so you can get an idea of what I am talking about.

1) A Fresh Watch List: I am constantly on the prowl for new ideas. Whether I am scanning through the NASDAQ 100, the S&P 500 or reviewing the long list of stocks I keep on watch, I am always seeking to weed out the laggards from the winners. Stocks that are trending lower are not for me as I would much rather know the wind is at my back when I am considering wading into a new name. I also have a fundamental criteria, but the key point is that I always have a list ready and therefore I am not scrambling for ideas when I feel it is time to commit capital.

2) Position Sizing: I have learned that position sizing is one of the, if not the most, important variables for longer term success as a trader. I learned early just how damaging an unexpected reversal can hurt your capital when you are holding too much size in individual stocks. Presently, I know exactly on a percentage basis what a full position is for me, and before buying any stock I will do a quick calculation to know how many shares a full position would be in that particular name. I don't alter this based on the stock price, or any "gut feel." At times I wish I would hold more of a winner, however I am never upset that I stuck with my position sizing rules when a draw down comes and I can weather the storm.

3) Averaging In: Typically I like to do my buying in pieces, looking to average into a stock in thirds. Because I already know what a full position would be for me, I can easily divide this by 3 to know how many shares I need to buy at each juncture. Typically, I will buy my first piece without regard to some technical criteria. For example, yesterday, I started Celgene (CELG), a stock I have been watching for some time that continues to consolidate in a narrowing range between $57 and $61.

In my opinion this stock is not ready to really move just yet, however, I wanted to get a better feel for how it trades and put the stock on my radar. I took a 1/3 position in the stock with a loose stop. I will now continue to watch the stock and see how it acts within this narrowing channel. If the stock continues to coil up, looking as though it is going to try for a break, I will take my second piece, still ahead of the break, anticipating the potential coming move. I will use the same stop as my initial piece.

My next add point will be on the technical break, which often changes as a stock continues to move sideways. For example, the current break for CELG would be above the $61.00 level, but as time goes on, this may come in as the trend line continues to descend. Should the stock break out of the technical resistance level, I will have my full position and raise my stop to the technical break out level. This way I am ensuring a locked profit on the initial portion and a break even on the added piece.

4) Let it Run But Trail the Stop: I work very hard not to micromanage a position, especially if I have caught a break in the appropriate manner, but I will also work very hard not to let a gain turn into a loss. Once a stock breaks out and starts trading in new territory, I often feel as though it doesn't demand much attention from me. Maybe that is wrong, but I feel good about my gain and I often will let it run its course. I will, however, keep a close eye on the trading pattern that develops and raise my stop accordingly.

Sometimes, depending on the market, if a stock breaks out and really catches momentum, I will take a partial sale to book some of the gain. This helps to alleviate the anxiety one feels when a trade starts working and the thought of giving back all the gains creeps in. Rather than sell it out completely, I will sell off a third and let the rest run. One thing I have often learned is that stocks can run much longer in either direction than you would imagine is possible. Selling a winner too quickly is often more painful than holding a loser.

5) Repeat: Once you have a set style it is important to stick with it and repeat accordingly. Obviously you will be able to tweak areas here and there as well as alter nuances that suit your personality better, like specific stock styles where some prefer small or large caps, or ETFs etc. Furthermore, the same style can be applied by viewing the broad averages as a guide for investing in mutual funds. Most mutual funds will trend with the market so having a set strategy for when to be in and out of a mutual fund is often beneficial as well.

I am always tweaking my style and altering time frames and stocks held based on the current market action or my feelings on where we are going. Once you adopt your own strategy and stick with it, over time you will gain more and more confidence in this strategy which will help you to remain calm when it is really put to the test. Most strategies will work when the market is in raging bull mode, but the most important time to stick with your strategy will be when the tide turns and the action gets ugly. Then it will be time to stick with your plan and not deviate. After you go through a few cycles such as this, you will be amazed at how comfortable you feel with your strategy and your profit and loss should also grow in correlating fashion.

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