How and Why Contingency Planning Will Make You a Better Trader

In today's world most professional traders can find quite a bit of information on how to screen and buy stocks correctly. Things get a little more vague when a trader moves to the side of a trade, though. How many times have you heard a trader respond with “cuz” to questions about why they sold a position? This is where contingency planning is important. This post provides an overview of my contingency plan. Stop-Loss Criteria (Selling For A Loss)

A trader must establish a price at which a position must be closed if it moves against them. The stop-loss price should be established before the position is put on and should be written down to avoid subsequent rationalization of giving the position more space. In my case I use one of the comment columns in Q-Charts to enter the stop-loss price. By doing so it keeps it directly in my sight. As a general rule, the percentage loss limit should not be more than half of the amount expected to profit. I know that the popular stop-loss price is 7-8% from the purchase price and for most traders and market environments that is optimal. However, newer traders likely will not generate14-16% gains on average so they need to adjust their stop-loss criteria. For example, in current market conditions (sideways churn) my average expected gain is 7-10%, down from 18% in strong markets. So if I maintain a 7-8% stop-loss limit I will lose money. What I do is maintain real-time 5-day and 10-day simple moving averages of my trading gains. By doing this, my stop-loss limit becomes dynamic and ensures that the stop-loss price is no more than half of the amount of the expected profit. Profit Taking Criteria (Selling For A Profit)

Selling for a profit is one of the skills I continue to learn. If a trader cannot sell properly, the outlook for success gets a little cloudy. A trader must have pre-determined rules for exiting a position at a profit, because at some point the advance will be over and the position should be closed. A tendency for traders is to get complacent/passive as a trade is moving in their direction only to get caught in the vicious decline that seems to come just when everything looks so good. The objective is to be proactive and be ready to sell into strength when buyers are plentiful. The best way to be proactive is to have pre-determined rules for closing a position at a profit. The best place for a trader to start learning how to close a position for a profit is William O'Neil's famous book; “How To Make Money In Stocks: A Winning System In Good Times Or Bad”. Specifically, Chapter 11 (4th Edition). The rules outlined in the chapter should be the basis of any trading program. I use many of them to this day. Some of them are technically based (charts) and some are fundamentally based (PE, etc.). I have 18 core selling for profit rules. Crap Happens Criteria (Disaster Scenario)

A trader must have a rule to get out of a position when something goes disastrously wrong. Some triggers for such a scenario are the announcement of a federal investigation, worse than expected earnings or guidance, negative trial results for a new drug and some type of fraud. If a stock trades below my pre-determined stop-loss price I take the next best price. In the case of big morning gaps to the downside the loss usually is much more. I don't want to watch it and wait to see if it will rebound. I want to close the position and focus on other stocks. The analysis of my trading going back to 2002 shows that these type of disasters will occur 5-8 times a year. I just suck it up and say, “Crap Happens.” Re-Entry Criteria

It is said that the ability to re-enter a position after being stopped out is the hallmark of a professional trader. A trader must have re-entry rules. Traders often get emotional about being stopped out of a position and refuse to consider re-entering a position at a new pivot. In many cases, the second trade becomes a higher probability trade, because the weak shareholders have been knocked out of the stock. Remember, the fundamentals of the company have probably not changed; it just hit your stop-loss limit. A few years ago I worked with a prop trader in New York while I was in Chile. He had worked in the investment industry for several years, but he had not traded professionally. He learned quickly and he did very well, but it was virtually impossible for him to consider re-entering a position after being stopped out. A few stocks that he refused to re-enter rebounded quickly established a high probability entry point and then went on to large advances. Treat each trade individually. Please note that I am making the assumption that the trader is buying stocks with solid bases and at high probability entry points. Otherwise, they could get stopped out all day long. Conclusion

I could write much more on contingency planning, but I think these four contingency areas are fundamental to any trading program. You must be continuously improving your contingency plan by incorporating your experiences and the current market conditions. The objective is to make your trading as mechanical as possible. As experience grows you will be able to know when to the stretch rules that underlie these criteria and by how much. If you stretch the rules too much it can create chaos and unnecessary losses. This article was originally published on investing and economics website, See It Market. Twitter: @hertcapital @seeitmarket Any opinions expressed herein are solely those of the author and do not in any way represent the views or opinions of any other person or entity