I want to share with you how a basic trading framework looks like.
I learned this stuff over the years from professional traders and my own experience. I am a retail trader.
- Generating trade ideas
- Build a watchlist
- Put a position on when the time is right
- Trading plan - implementation
- Portfolio structure
- Manage positions and keep the watchlist fresh
Generating trade ideas
The starting point for generating trade ideas comes from a broad analysis of the economy. After that, you need to filter down from the economy to the individual stocks.
- make an analysis based on leading and coincident indicators.
- have a predisposition after the analysis.
- with your predisposition about the economy now you look at the sectors.
- you analyze the sectors and decide what sectors will perform well and what sectors will underperform in the next 3 - 6 months.
- after you have analyzed the broader economy and the sectors it’s time to drill down more at the industries level.
- each sector will have industries that will outperform/underperform.
- choose wisely the industry that you want to be in, for the next period.
4. Individual stock
- here you need to choose wisely a stock.
- in each industry, you will have winners and losers.
- you can peak winners and losers by analyzing the financial metrics and then do some fundamental analysis.
- Quantitative analysis = financial metrics.
- Qualitative analysis = reading / listening to the earnings calls, reading analysis about the company, and understanding what their business does and how they generate profit. You will also learn here, the nature of the industry in which the stock operates.
Any trade idea comes from the fundamental analysis of the company NOT from looking at the chart (technical analysis).
Golden rule: Fundamental analysis first and Technical analysis later. Keep this in mind.
Do not do it in reverse, do not look at a chart and think that the chart looks good, and then find some fundamental metrics that you like.
Technical analysis is used primarily for timing the entry and exits of the trade.
I know that I do not provide you with specific economic indicators to analyze the economy or the sectors, but in the future, I will write in more detail about each point. I want to keep this letter as an overview.
Build a watchlist
What is the purpose of a watchlist? Why have a watchlist?
The purpose of a watchlist is to time the entry of your trade.
You can have a company with great fundamentals but the chart looks horrible. You keep it on the watchlist.
To put a trade on your fundamentals needs to be aligned with the chart.
Another purpose is to have ammunition in case you want to add or change positions in your portfolio. If you want to have a portfolio of 8 - 10 positions long/short, you need to have at least 10 stocks on your watchlist. Your watchlist needs to be kept up to date, you need to refresh your watchlist from time to time. Keep it fresh keep it ready.
After you generate trade ideas you put them on a watchlist.
Put a position on when the time is right
At this step, you do the “almighty” technical analysis. Here you can use as many metrics, instruments as you want (MA, RSI, MACD, etc.). Use common sense, do not overcomplicate.
My only recommendation here is to not make it very complicated and time-consuming.
Keep it simple.
Trading plan - implementation
When you put a trade on you need to have a trading plan.
You need to have a hard stop loss, a soft target, and a defined time horizon on your positions.
My personal time horizon for my trades is 2 - 4 months. That means I expect my trades to work in that period of time.
The ratio should be at least 3 to 1.
The chart image is for visualization purposes. Do not put this trade on!
Simple example: You have 30% upside versus 10% downside.
We have a stock with a price of 100$.
Our soft target is 130$.
Our hard stop loss is 90$.
If the ratio is not in your favor do not put the trade on. Search for trades that have a very good ratio. The US stock market is full of opportunities, you need to find them.
The idea of a soft target is basically: you have the possibility but not the obligation to sell the stock. You can imagine that you will be put in a situation in which you do not want to exit a trade or even more you want to add to your trade, this is why the target is a soft target.
The idea of a hard stop loss is essential. You need to be disciplined with this one. Most people have a problem with this one because of the emotional attachment to the positions. Do not get emotionally attached to your positions. Do what is needed to be done.
Of course, in real life, things are more complicated. But I hope this will guide you when you are thinking to put a trade on.
The main takeaway is that you need to have a trading plan.
A long/short equity portfolio if is done correctly will reduce your market risk.
First thing first, your portfolio should always reflect your view of the market.
If your portfolio does not reflect your view then change your portfolio accordingly.
Here we need to destroy some myths about diversification.
The more positions you have the more diversified you are. FALSE
If you have 30 positions in the same sector or even worse in the same industry, you are not diversified.
The more positions you have the less risk you have. FALSE
If you have a lot of positions that you cannot follow the companies actions. You will end up with a lot of positions that you do not know much about. You will not know when to exit positions or to take some action about them. You do not have control.
Diversification it’s a myth and you need to invest all your money in one stock. FALSE
Of course, this is not true. If you have only one position with all your money in, then the risk it’s too concentrated and you will rise or die by a single company decision. If you want to sleep well then do not put all your money in one basket.
The truth is that you need moderate diversification, not too little, not too much. You want to reduce the risk and also have control.
You need a portfolio with 8 - 12 positions long and short. 4 longs - 4 shorts for example. You can start with one single position to be 10% of your portfolio.
One single position should not be more than 20% of your portfolio, for obvious reasons.
You need to have real diversification. Your positions should not be in the same sectors or industries.
Do not confuse diversification with “no direction”. You need to have a direction, but also be aware of the risk.
For example, if you have a portfolio of 10 stocks, it’s quite manageable in terms of keeping up with the news about the stocks and their actions. Because you do not have a lot of positions, your portfolio will be flexible, you can change the direction of your portfolio very easily.
You will be more informed, flexible, and in control of your portfolio.
Manage positions and keep the watchlist fresh
First: Managing positions
After you build your portfolio and put your positions on you need to manage your positions. Your portfolio is live.
Stay informed about your stocks. Do not waste time reading non-sense journalists and click-bait articles. Filter out the noise from the real data. Be aware of the earnings dates release, read/listen to the earnings calls. Stay on top of the situation.
Cut losing position, increase winning positions, change direction if you think it’s necessary.
There is nothing permanent except change. - Heraclitus
Everything flows, nothing stands still. - Heraclitus
Here are no hard rules. Use common sense and learn from your mistakes.
It will take some time to learn to manage your positions and to avoid obvious mistakes.
Second: Keep your watchlist fresh
Keep your watchlist fresh, remove stocks that you think are no longer relevant, add new ones that are in line with your view. Some positions that you add to your watchlist will end up in your portfolio, keep this in mind, take this seriously.
You will learn about your shortcomings, you will adjust, you will improve.
Do not get stuck in your past trades, good or bad.
This is how a basic trading framework looks like. I hope it gives you some clarity about trading and steers you in the right direction, away from charlatans “day trading“ educators.
In the future, I will write about each step separately in much more detail.
Rational emotionless decisions.