Stock Trading Strategy

Stock strategy – invest money 1A like a professional

Stock strategy or planning is half the battle.

This old saying carries much wisdom in itself and all, which began already times without planning a journey, can confirm the truth content of this statement.

In the video “The Trading Puzzle” you will find further important thoughts on trading approaches. This knowledge is important for all investors, no matter whether they want to buy company shares and build up a stock portfolio or acquire gold. Therefore, you should definitely watch this video!

You need a plan if you want to go on vacation, if you want to prepare a meal, if a team wants to win a soccer game, if you want to do well in your job or just for your investment.

The word plan can also be replaced with the word method when it comes to the question of what a stock strategy is, and we don’t want to get bogged down in sophistry about what makes a strategy or plan different from a tactic.

For what is discussed in this article has no relevance. For the introduction, we will state that equity strategies are nothing more than a plan that you set up to invest successfully in equities.

But before we turn to the topic in detail, we need a certain basic understanding of the topic of investment, which we now want to work out together.

The basics of investing money

Investing money and saving money are ultimately two terms that have similar meanings.

Our parents taught us to save money when we were still children. Saving is in our society thus always already deeply rooted and therefore handling personal finances wants to be learned already from small on.

Of course, when we were children we didn’t know that there were shares or a stock exchange, so we regularly threw the money we received from grandmothers and grandpas, aunts and our parents into the piggy bank to put it into our children’s savings book – preferably on World Savings Day, when we got really cool savings gifts.

There is no getting around the fact that saving at that time was still worthwhile at interest rates between 4 and 6%, whereas today all our money is sour in daily allowance accounts and loses value when the inflation rate is taken into account.

But that is not the point at all.

What is much more important is that there are many ways of saving or investing money and one of these forms of saving is an investment in shares, for which, we repeat, a plan is needed.

But you can also save with various other savings products such as funds, ETFs, insurance, bonds or other, more complex financial products and a whole industry is trying to present its methodology as the best and safest to compete for the investment millions of customers.

Now it should not be about which investment form is the best because as with everything in life there are advantages and disadvantages everywhere.

We hold here here only firmly that an investment in shares is the most lucrative form from historical viewpoint to put on its money at higher interest, although shares Investments hold also certain risks, which one knows and against which one can arm oneself. But in addition later more.

How do you find the right approach?

We have just talked about risks and in this context the question is often asked which investment strategy suits whom. An investment strategy for stock trading or something completely different?

In their risk questionnaires, financial service providers are required by law to check whether the product desired by the investor really fits the customer and his ideas about risk.

Among other things, they are asked how the financial circumstances are, what experiences the investor already has, and what their personal risk tolerance is like.

First of all it should be noted that this is good and reasonable and serves in principle also the investor protection.

Which financial products?

But the question of finding the right investment strategy also has a completely different aspect, which is not so much aimed at the consumer but more at the financial product development itself.

Of course, you as an investor do not want to develop financial products. But you don’t want to chase after every stock tip in the future either, are we right?

It does no harm, however, if you understand a few basic principles, because this way you can make a better choice on the one hand and on the other hand you have the opportunity to take a more critical look at the work of your bank or your investment advisor or manager.

Therefore the question about the right way of doing stock trading must be understood in such a way that your project must fit the environment.

What do we mean by this?

No matter whether you invest in individual shares, buy funds or subscribe to bonds yourself today – in one way or another you will come into contact with the stock markets.

Sometimes more directly, as in the case of individual investments in shares, sometimes indirectly, as in the case of a life insurance policy, which in turn invests in the financial markets for you.

And somebody like a fund manager manages these products, decides which company shares or bonds are bought or sold and this somebody – hopefully – uses a plan for this.

And now comes the first crucial point: it is not enough to have a plan.

A plan is not enough

The plan must also work in the respective target market, otherwise it makes no sense at all. So you need more information to be successful.

What kind of trading approaches exist for the stock exchanges and here in particular for the stock markets, we will work out in the next sections.

What options are there?

There are as many stock strategies or stock market strategies in general as sand at the sea.

But first you have to answer the fundamental question of whether it makes sense to search the stock markets for promising companies in order to improve your pension.

Does it make sense, for example, to subscribe to a product with a German equity strategy that picks out certain values?

Why not, you might ask now.

Because there are many people who believe that the capital markets are 100% efficient.

Put more simply, this means that no matter how hard you try, you have no chance at all of being better than the market, in other words, beating it.

Here is an example: You invest in German companies from the Mdax and Dax. They use a value approach and focus online on companies that are currently undervalued (cheap) and also pay a good dividend, using various key figures such as the price/earnings ratio (P/E) or the price/book value ratio (RBC).

Are the markets efficient?

According to the supporters of the efficiency market hypothesis, who like to present themselves as absolute and infallible experts, this does not make sense, however, because all information that is publicly available or known about these companies is already reflected in the price development.

Or, as it is often called in the jargon: because these circumstances are already priced in.

The targeted selection of securities – regardless of the plan – therefore makes no sense, because one can only ever achieve a return that corresponds to the respective benchmark (in this example Dax or Mdax).

So, following this assumption and putting it in a nutshell, they can never beat the Dax or outperform it, no matter how hard they try and no matter how big their focus is on this subject.

This is supported by numerous analyses as well as the statement (the proof of which, however, often cannot be provided) that 80% of fund managers whose focus is to find undervalued companies simply do not manage to outperform the index belonging to the shares.

We do not want to discuss the truth of this statement now, but another important lesson that we connect with a question is: do all fund managers want to beat the markets at all?

Because most people associate “better than the market” with “more return than the market”.

However, some financial products are deliberately designed in such a way that they generate less return than the market, but on the other hand, in bad times, they fall much less than the market.

This is – intentionally or not – usually not said when discussing the work of fund managers.

But back to the efficient market hypothesis.

The advocates of this theory, however, cannot explain why markets repeatedly collapse (crash) at regular intervals.

Nor can they explain why, for example, the US stock markets lost almost 10% in December 2018.

Is such an exaggerated price movement rational?

Or is it rather the emotions of the market participants that cause such capers?

Even more: it may be true that in our information society all information about every share is available.

But who says that available also means known? And of course, said (known) means not understood by a long way.

And whoever observes the stock markets for only a few months quickly learns that good news can cause stocks to plummet and bad news can cause prices to rise.

Two examples: Company XY publishes a very poor financial statement.

Actually, the share price should fall as a result.

However, the analysts who are observing this company had expected a much higher loss and because this is basically bad news, but it is not quite as bad, the share price rises.

In the other case: a company produces an excellent quarterly result and exceeds the expectations of the analysts.

The outlook for the next quarter is also optimistic – but when it comes to the outlook one would have expected even more and the share crashes like a stone.

Good results or not.

And finally, if the markets are efficient and the use of rules and regulations makes no sense, there should be no more stock market trading at all, because in every stock market transaction a buyer faces a seller.

Even if they are not face to face, they have different views about the future, because otherwise one would not buy while the other wants to sell.

All these explanations are owed by the followers of the doctrine of efficient markets.

Active or passive investment?

At this point we will summarize that there are active and passive investment approaches.

Passive means buying, preferably through a fund or an ETF, an overall market like the Dax and holding this investment for several years if not decades.

One neither tries to pick out individual stocks from the index nor to time the markets, i.e. to find the ideal time to buy, because it makes no sense according to this methodology.

Buy, go to sleep and get out.

Admittedly, the supporters of inefficient markets are of a completely different opinion here. They select the best companies according to their methodology and keep them until they no longer appear lucrative – also according to their usual approach.

We will talk about how the efficiency of markets is really determined a little later.

The fact is that if you believe in passive investing, you can stop reading this article here.

But if you have the slightest doubt about this doctrine, you should stay tuned and read on, because we have very important information for you as an investor on the subject of shares – understanding strategies.

Fundamental strategies vs. technical methods

As indicated earlier, from now on it is all about active investing.

For this, as has already been said, you need a plan.

And here there are two fundamentally different methods: you buy shares based on economic or company data (fundamental analysis) or you buy shares based on historical price data (technical analysis). Depending on the focus, the emphasis is completely different.

The supporters of the two groups usually have very little understanding for the other group, but in the end, it should be said that success is all that counts.

If someone is successful with the analysis of balance sheet data (fundamental analysis), then he should remain true to this methodology, no matter what others think of it.

And if someone is successful with charts (technical analysis), it doesn’t matter what others think about him either.

Yes, even exotic methods have their justification as long as there is a return on investment left at the end of the day.

But are there tendencies which of the two approaches work better? No, because if you understand your craft, every method has its justification.

The psyche of the investor

But you have certainly heard that expertise on the stock market is one thing.

The other is psychology.

Fear and greed move, it is said and we agree with this, the stock market prices. What good is it to me if I am good at understanding complex economic interrelationships only to find that I cannot put them into practice because I tend to become greedy and take too much risk? How does the professional focus help me when there is a mental lack of everything?

Why so many investors fail on the stock markets has to do with the topic of security.

Or the lack of this component.

We all look for confirmation, security.

We want to control, influence and or know what will happen. And we are looking for the safest way to invest money and achieve a balanced chance-risk ratio.

But even if there are daily TV shows on the stock market, where alleged experts spend hours discussing how the world stock markets will develop, in the end nobody knows what will happen.

And that is exactly what makes stock markets so difficult mentally.

Because – at least at first glance – you have to get along completely without security. Because prices are constantly changing and movements cannot always be explained logically.

But what would help to increase security?

Facts at Dax & co

Facts are irrevocable facts that cannot be discussed away. 1+1=2. exactly 2. and not 1.5 or 2.5.

And now comes something decisive: Very few company data are facts.

For example, a company can manipulate its profits, and this does not mean illegal behavior.

Rather, provisions can be made or released, for example, and a bad quarter can be presented as not so bad after all.

As an investor, if I now orientate myself solely on fundamental data and take the price-earnings ratio into account, for example, I do not necessarily use facts.

Yes, the P/E ratio as a figure is a fact, but not how it was formed (possibly with the release of provisions, etc.).

Not exactly ideal to improve the security when implementing a stock strategy.

What makes fundamental analysis moreover problematic is the delay in its announcement.

Usually companies publish their quarterly report 6-8 weeks after the end of the quarter.

Certainly the stock markets react to this, but the published information is no longer up-to-date.

Let us summarize important fundamental key figures:

  • P/E RATIO
  • KUV
  • KBV
  • KCV
  • Equity ratio
  • Return on equity
  • Return on total investment
  • Return on sales
  • Gearing

Technical data on the other hand can neither be manipulated nor are they outdated.

The closing price of Siemens shares, for example, on January 8, 2007, was XY.

The exact value does not matter.

Much more important is the basic understanding that it is impossible to discuss or be divided about this closing price.

That is a fact. Point – off.

And the Siemens closing price of yesterday is today, before the opening of the stock exchange, brand new and not outdated.

And if we now remember the introduction that one should use a strategy that works, it is logical that I base my plan on hard and current facts and not on things that leave some room for interpretation and 8 weeks old or more.

In the last sentence there was the word “room for interpretation”. This leads us to the next distinguishing feature.

Discretionary methods vs. rule-based investment approaches

Here, too, there is a real camp thinking among the followers of the various methods.

Advocates of discretionary methods try to proceed with their investments according to the situation.

They may have a rudimentary plan, but it is more loose than rigid, and there are situations where they throw their loose rules completely out of whack and instead focus on their experience because they think it is appropriate.

Rule-based approaches do not allow this to be thrown overboard.

Here you work with exact specifications.

The plan is precisely defined and no deviations are allowed when it comes to implementing a stock strategy.

What is better now?

Here, too, the end justifies the means and what is successful is allowed.

A major problem with discretionary methods is that this scope for interpretation makes the psychological component of stock market trading even more difficult.

What do I do, if I bought shares, because I BELIEVE the share will rise and it makes starting from the purchase time pact exactly the opposite?

I have no exact plan how I proceed.

Buying, selling or sitting out?

Rapidly one becomes a plaything of the own emotions and that leads directly into the ruin.

Is it possible to implement a stock strategy completely without emotions?

We maintain – no.

No matter how much experience one has, how supposedly calm one is, emotions are always present.

Because emotions come from our subconscious.

They are stored memories and here one could start now the philosophical discussion whether humans have a free will at all.

But as in some other place of this contribution that would lead too far to speak about it.

We summarize here that with a discretionary approach, emotions are always involved, whereas with a rule-based approach, you simply follow your strategy 100%.

Of course, even with a rule-based approach it is not always easy to follow your rules.

The temptations on the markets are too great.

But if you resist the inner urge and stick to your rules, which on top of that work, it’s an essential step towards sustainable stock market success.

The best investment strategies ever

Let’s make it short.

This strategy does not exist.

Neither does the matching equity strategy for 2019.

Because no matter whether active or passive, discretionary or rule-based, fundamental or technical.

There are market phases where one works better than the other. Looking for the holy grail makes no sense.

If it existed, companies like Google, Microsoft or Apple with their thousands of employees and billions in their accounts would have found it long ago.

The stock markets are and remain fragile.

The markets are – and this is our answer to a question that we deliberately left open earlier – almost efficiently – never completely. Little things that no one had on the bill before are causing industries or individual stocks to collapse.

The code of the markets will never be cracked, and here we are deliberately leaning a little out of the window.

And in the hypothetical case that it does, it would lead to an immediate collapse of the stock markets.

But since this will not happen, we will now delve even deeper into the question of what a stock strategy is and how to design a stock strategy in a meaningful way.

Why it is better to have an active, rule-based technical plan

After we have made the distinction in the previous paragraphs, it is time to get down to business.

A good investment philosophy consists of an active rule-based approach based on technical analysis.

This is all the more true since we have outsourced stock exchange trading to computers.

The job of the people at the trading desk is simply to monitor the computer.

But let us take up the question of this section heading.

Why do we do this?

Why don’t we just buy good stocks and hold them for decades?

The answer to this question is provided by the following chart.

Here you can see the development of the German stock index, the Dax, since 1970. The first thing that stands out is the upward trend, which has intensified significantly in recent years. However, the sharp price declines are also striking.

Here the periods 2000 – 2003 (burst dot com bubble, 9/11, Iraq war 2) and 2008 – 2009 (financial crisis) stand out.

These sharp price declines, which we also call drawdowns, were well over 50%.

The Dax, for example, lost more than 65% in value between 2000 and 2003 (see orange box).

65% loss!

We have been working in the financial industry for several years now to know that no client accepts a 65% loss in value in his investment.

In fact, nervousness starts with a minus of more than 10% and when the 20% threshold is reached, there are many people who get out of their investment unnerved.

But minus 65%?

The average consumer is absolutely not prepared for this, because he wanted to build up assets on the stock market.

When you see your hard-earned money and your retirement provisions melting away almost daily, you don’t want to stand idly by.

The flight reflex strikes and flight at the stock exchange means panic selling.

And then one has usually enough from the financial markets and represents loudly the opinion that shares are only something for gamblers and the markets resemble a large Casino.

Exactly because this is the case, and because if you filter out individual stocks and invest in them, you can hope even less than with an investment in the overall market (Dax & Co) that these stocks will return to old highs, it is not advisable for private investors to pick stocks on their own without extensive prior knowledge of the stock markets.

Investments in the Dax or another index by means of ETFs, funds & co are easier to manage from a mental point of view, but even here the chance/risk ratio is often insufficient.

An annual return of 6% of the Dax is offset by a maximum loss in value (2000 – 2003) of 65%.

Is it worth 6% return before costs to bear a loss of 65%?

With a recovery period of over 7 years? (see again the indications in the Dax chart from before).

The answer is definitely: No!

This is the reason why the approach is different.

Although a targeted stock selection is carried out, our investment periods (holding periods) of the individual stocks are significantly shorter.

Which leads to products with a completely different risk/reward ratio. How to proceed exactly, we will find out later.

Let us now explain the advantage of exact rules.

Another major advantage of a rule-based approach

Once you have created a plan consisting of exactly predefined rules, you can check this plan for its suitability.

Powerful computers and intelligent algorithms make it possible to run hundreds or hundreds of thousands of test series in just a few minutes, searching the markets for anomalies or exaggerations.

These patterns exist, you just have to find them in the millions and millions of data records of the last decades.

And of course you need a lot of experience in how to set up such a strategy in the end.

But the advantage of this approach to developing a stock strategy is obvious: before you invest real money in a strategy, you let the computer check if what you have in mind has worked at all.

But once you have found such rules – is that a guarantee that it will continue to work?

No – of course not.

But it’s a very good indication, because even if the stock markets change over the years, it doesn’t happen overnight.

So rules that have worked once don’t have to work forever and you have to look closely and observe a strategy.

But you know a broad range and you know what to expect.

How do you recognize if or when a plan no longer works?

This is an immensely important question on the one hand, but it is also a very difficult question to answer.

Because the first idea one might have, namely that the right time has come to discard a strategy when it no longer works, is disenchanted with a counter-question: how long must a strategy not work?

Or how far down can it go, i.e. how much loss can a strategy make until I crush it?

Or how long may it take to reach new highs again?

How long, in simple terms, do you watch before you take action?

The answer is: there is no patent remedy.

There are several key figures that ultimately decide whether a strategy is discarded or not.

Because a rule-based investment approach always works only on a statistical basis, as we will see in the next chapter.

How an equity strategy works

Do you think we know the ideal time to buy Apple?

Or that of Disney?

Yes and no.

No, when it comes to the individual case.

Yes, if you look at it from a statistical point of view.

But that also means that we have to buy and sell Disney very often in order to make a statistically relevant statement.

Buying Apple once at the best price – that was luck. You probably won’t succeed a second time.

But to buy and sell many shares hundreds of times over many years – that’s where things look a bit different.

If you test when, from a statistical point of view, it is the right time to buy shares from the Dax, Dow Jones or Nasdaq, sensible answers to the question of timing are possible.

At the same time, however, this means that not every single buy followed by a sell (we call this “a trade”) involves a professional.

There will be situations where our set of rules, our strategy, does not work. This is not a tragedy as long as the bottom line works.

But what are the core elements of a stock strategy and how does it all fit together?

Let’s look further.

The components of a good plan

No matter what methods you use to invest your money on the stock market and no matter what markets you prefer, every strategy consists of these components, as the following practical tips show.

Stock portfolio

First, you need a pool of stocks from which to make your purchases.

Here it makes sense to use the values ​​of an entire index such as the S&P 500 or the S&P 100. 

In principle, slightly larger portfolios are better suited for statistical methods, because more individual stock exchange transactions will then occur, which gives the set of rules a certain stability. 

Mainly for this reason we also invest in the US American stock markets and not, for example, in Germany, because the number of tradable stocks in the US is much higher.

Time of purchase for a share strategy

TimingThe time of purchase, i.e. the timing, is a very important component of a stock strategy. After all, no one will advertise when to buy which stocks.

We will discuss this in more detail in due course and elsewhere, but technical analysis knows three types of basic strategies:

  1. Trend sequence or momentum
  2. Outbreak
  3. Reversal.

Here, too, there is something crucial to consider, but as already mentioned in the introduction: not every strategy is suitable for every market.

The most important task of someone who wants to buy and sell stocks, for example, is to first find out which basic strategy is more suitable for which target market.

Only then can he refine his plan and improve his stock strategy.

Time of sale when trading shares

When using statistical methods, which is any form of technical analysis, it is important to understand that every purchase signal has a very short validity period.

This sentence is one of the key statements regarding technically oriented, active stock exchange trading.

We will deepen this essential statement elsewhere.

It is important here that the time of sale must also be planned exactly and that there are good and bad rules for selling. And by this we do not mean simple rules such as the end of the year.

Even more: bad rules for the sale can ruin a good stock strategy.

Scope (position size) – how many shares should one buy

Diversification – you have certainly not only heard about this since Riester.

An old proverb says not to put all eggs in one basket.

Or don’t put all your eggs in one basket, this also applies off the stock exchange.

But on the other hand, you will hardly be able to hold a whole deck of cards in one hand. They lose the overview or individual cards fall out of their hands because there are simply too many.

In stock market terms, this means: diversification yes, but don’t exaggerate.

Furthermore, the choice of a suitable position size can also reduce the risk.

For example, you can certainly buy shares that are currently subject to greater fluctuation.

But perhaps one should consider to put in such a case somewhat fewer pieces into the share depot.

Ranking (Position Priority) for share investments

What do you do if you still have money to buy 2 shares, but the purchase criteria are met by 6 shares on the same day?

One will try to find additional purchase criteria for these 6 shares and then make a ranking.

This is exactly what the Priority position does, by helping us to keep track of the situation.

We will not go into this very complex topic any further in this article.

So we are now at 5 core elements that make up every stock strategy.

  • Portfolio
  • Purchase
  • Sale
  • Quantity (piece)
  • Row (Position Priority).

It should be mentioned for the sake of completeness that these components apply not only to shares but to each asset class.

And because all this has so far been only theory, we will look together at a technical set of rules as it could be designed.

Portfolio: all shares from the S&P 500

Purchase: if the price of a share has fallen in the last 4 days and at least 5%.
Sale: after 3 days or if the share has risen at least 3% after the purchase
Quantity: 5% of the total capital per individual share purchase
Position Priority: sort the purchase candidates according to the % loss in the last 4 days. The shares with the highest loss are ranked on top and thus bought with priority.

Attention: this set of rules is only an example. It is not a stock tip and has not been checked for suitability.

And now it is time to test and become an expert

And if you have defined such a set of rules, you should test it before you apply it.

Of course, this statement also applies to rules that are taken from the technical literature, for example.

Always test and never believe anything. That means working with facts.

In the following video we talk about possible returns or return expectations for traders and investors.

Conclusion Investment and stock market strategies

Never underestimate the stock markets.

It’s easy to open an account with an online broker (get an overview and test each broker before you decide on a provider) and buy or sell stocks and other securities such as a CFD, ETF or certificates.

On the other hand, it is difficult to understand the complexity of the stock market. Difficult – but not impossible.

Think about it: nothing that offers such high profit opportunities can be easy.

Otherwise, nobody would work in a supermarket or as a cleaner for a few hundred euros a month.

You can become successful in the markets.

But not overnight.

Neither the next stock exchange deal nor the next trading week will decide whether you will be a winner in the long run.

What is decisive is your attitude.

Your willingness to learn. And this is exactly what this article was designed to convey. It pursues the question of what is a stock strategy.

Because without a strategy, without a plan, you will sing and fail soundlessly.

Maybe or probably not overnight.

But certainly in the medium to long term.

Understanding stocks is possible in its entirety.

Therefore, deal with different target markets and learn to understand the asset class shares, which is still relatively simple compared to other asset classes such as currencies, so that you can become a winner.

And if you don’t have the time or the desire to do so, give your money to someone you trust and who has done a good job so far.

Everything you need to know in order to understand stocks, you have learned in this article.

You know what stock rules are, what different approaches there are to a stock strategy and what a stock strategy is.

Namely a rule-based investment process that works and helps you to get your emotions under control.

All these are the ingredients for successful stock trading. And if you are interested in learning how to develop stock strategies, we recommend our free Basic Trading Course, which introduces you step by step to the subject. You can sign up for this course for free below.

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