Five questions you need to ask yourself before you start investing and trading in the stock markets

The roadmap to Wall Street starts with a plan. Here are some questions you should ask yourself before starting the journey.

Are you investing—or looking to start? If so, it’s best to have a plan. It can make the difference between making money and becoming just another unsuccessful investor. But where do you begin?

How much money do you have to invest or trade? Review your personal balance and only take a portion of what you can afford to risk. “Risk capital” is money that won’t affect your lifestyle if you lose it tomorrow. The reason for taking only a portion of risk capital is that if you lose part of your trading capital, you still have a chance to adjust your strategy and possibly recover your losses. You need to have money left for the next day. If you have some of your capital remaining, you can try again. If you’ve exhausted everything, then you’re out of the game.

There’s also a second argument for not being fully invested. If you are 100% long and a new investment idea (e.g., AI) comes up that looks promising, you will need to decide what to sell to free up funds for this new idea. Having some capital in reserve is useful in case all your open trades start losing more money than expected.

How much of your money or net worth to allocate for trading or investing depends on several factors. Consider your age and willingness to risk money; this will likely change over time. Reflect on your motivation for trading; it could be to make money or seek excitement. Your profession and the time you have for trading also play a role in your decision.

How much are you willing to risk or lose? Determine a total amount and decide how much to risk in a single trade. You might believe you’ve designed and tested an instant winner, but despite all the confidence you have in quick gains, you should anticipate market adversity (e.g., the drop in some tech stocks in June and July). Typically, the acceptable loss per trade is 10% or less. If the stock moves 10% against your entry price, exit the position. No matter how confident you are in the investment or the company’s stability, when your position moves against you by 10%, exit. Your plan might use 5% as the exit criterion. We feel better when we’re right, but in investing, the only thing that matters is the end result—how much money you’ve made. Discipline needs to be practiced and even planned. Without discipline, you are likely to become just another statistic—another loser. Futures traders might allow losses of only 1% or 2% of their capital per trade. By keeping losses small, you can withstand a series of losses without going bankrupt.

What are your specific investment plans and goals? It’s interesting how people respond to this question. Sometimes people answer with the comment, “I want to make as much as the market allows.” Others say they should just let profits grow, following their stops until they are stopped out. Another way to take profits is to avoid exiting until you see a pattern of peaks or troughs on a candlestick chart. Candles form quickly and can help in marking reversals. Although these responses seem logical and may work, a psychologist working with one of the most successful hedge funds has found that setting goals helps good traders become even more successful. If you choose the “let profits run” approach and don’t have a predefined profit target of 25%, 50%, or 100%, then risk becomes crucial. It’s better to find a target on the chart and consider the risk with that target in mind. Over the years, stock traders have applied the method of trades where the target or target value is three times or more the risk. If you look for trades with a risk/reward profile of three to one and are diligent, then you don’t need to be right half the time to make money.

How do you enter your trades? What signal will you use? For this part of planning, you’ll find many books on when or how to buy. What is often overlooked is the method for exiting trades. You can use moving average crossovers to enter trades. You can use one, two, or three moving averages. You might use mechanical methods, such as a long or short position when the market makes a new 2-week high or low, or use the 4-week rule. There’s also a breakout model supposedly used by famous stock speculator Richard Dennis. This approach is to go long if the price today is the highest in 30 days or try a short position if the price today is the lowest in 20 days. The short position will be closed if the price today is the highest in 20 days. Profits are taken according to the same rules as stop losses. When you consider this approach, you’ll find that the exit rules are the same for both profitable and unprofitable trades. In practice, this means trying to capture trend movements and exit breakouts that fail. Losses can be quite large, but you still need to have money to invest when a really big move occurs.

Another model that is simple, elegant, and sensible comes from Stan Weinstein in his book “Secrets for Profiting in Bull and Bear Markets.” He uses simple tools like the 30-week moving average in combination with breakouts from base formations and increasing volume to buy stocks and mutual funds when they break out. Some methods are based on buying pullbacks or discounts to previous support levels, but Stan admits that some of the most powerful breakouts didn’t have pullbacks, allowing for low-risk buying.

How do you add to your positions, take profits, or move stops? Suppose you bought near a breakout and the market has moved in your favor. You can increase your profits by adding to the position, but what does experience tell us? First, always add to positions in the direction of the trend. If you are in long positions, add to the position on strength. If you are in short positions, add on weakness. Second, add smaller or equal positions. If you start by buying 1,000 shares of XYZ, add 1,000 or fewer shares of XYZ. Equal amounts will build a rectangular position, while smaller added positions will build a pyramid, with the largest positions at the lowest price. Never add to your position if the market moves against you. Always wait for the market to show you that you’re right.