Building an Investment Strategy: A Guide for Beginners

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    Recently, investing has become a relatively widespread activity thanks to the advent of discount brokers and other ways to enter the stock market at low cost. Some people invest in the market as a “side hustle” or part-time job to supplement their 9-to-5 salary. Others want to actively manage their money and consider investing their full-time job.

    Regardless of the means and methods each uses to invest in the market, one thing has proven true over the years: successful investors have a plan.

    That plan does not have to be an overly complex or innovative strategy, and it does not even have to require constant monitoring and active management. A great investment strategy is one that the investor feels comfortable with, every step of the way.

    Even though an investment strategy should not consist of a set of strict rules that the investor must follow, it is important that some clear boundaries are established before taking a position in the market. The parameters that should strictly follow certain rules are, for example, the amount to be invested and the time when a position should be closed.

    This is because investing is an activity that involves many risks, including losing the entire capital and receiving a margin call. Therefore, all the rules established to limit the risks should be very strict.

    In this article, we will go over how a beginner can set his investment strategy starting from the basics, and then discuss step by step all the basic features that a great investment strategy must have.

    Step 1: Decide on How Much To Invests

    The first step in any investment strategy is to determine how much money to invest in a particular trade or investment opportunity. This is an extremely important step because, as we have just said, acting in the market is a risky activity, and it remains so even if an investor uses all possible methods to reduce the risk.

    The golden rule that should never be broken is: invest only as much as you are willing to lose. Although this rule may seem exaggerated, it is one of the basic rules of investing and trading.

    On the one hand, it is true that someone who checks his open positions at least once a day will recognize when something is not going according to plan, and therefore will be able to close the position. And if someone opens a position with a stop loss, in most cases it will be closed automatically when an order goes down. However, the market is extremely unpredictable, so it is always better to be safe than sorry.

    Case Study on Meta’s Tumultuous Decline in 2022

    A good example of this is the META stock on the second of February 2022. Facebook had reported earnings that were below expectations, and in after-hours trading, the stock price fell by over 26%.

    In this case, any stop loss would have been skipped and then executed as a market order once the market opened the next day.

    Even though these are extreme and rare situations, such risks are always present. If someone had bought a stock before the crash of META, it would still be down at least 5% today, almost a year and a half later.

    How to Limit Downside Risk with a Stop Loss

    It is important to note that stop losses and actively monitoring the position at least once a day are not surefire strategies, but they are activities that can help an investor limit downside risk.

    Therefore, when considering how much money to invest, you should also consider the risk of the position and the presence of compensating factors such as the effectiveness of stop losses and the ability to closely monitor the position.

    Ultimately, at the end of the day, the amount to be invested should not be higher than what the investor is willing to lose.

    Step 2: Finding a Great Investment Opportunity

    The next step is the research process, another fundamental step necessary to limit the potential risks when opening a position. The research process strictly depends on whether someone wants to open a short-term or a long-term position.

    However, since there are thousands of different stocks on the market, the research process is often done with a stock screener that filters out stocks based on some thresholds entered by the user.

    How to Find a Short Term Trading Opportunity with Stock Screening

    The most common method for traders to find a short-term opportunity is to use stock screeners based on technical information. There are a variety of stock screeners on the market. Some are offered for free by some financial websites, others are linked to a brokerage account, and still others can be purchased as standalone software.

    Choosing the right stock screener depends entirely on personal preferences, but you need to be sure that it offers enough filters to narrow down the number of stocks to look at to a manageable amount. Also, it would be ideal if the stock screening platform also had parameters for technical indicators, as this could speed up the following process of technical analysis.

    One of the most used platforms by traders around the world is the free website Finviz.com, as it offers all the customization options imaginable, from technical indicators to volatility and stock patterns.

    After identifying the best stock screener for your needs, you should look at the results with a sharper eye and finally open the stock chart and perform a technical analysis.

    Although this process may seem very time-consuming, you should not skimp on any of these steps, as any additional checks and redundancy will help limit avoidable risk when trading.

    How to Find a Long Term Investment Opportunity with Fundamental Research

    If an investor wants to open a long-term position, he must perform a thorough analysis. In this case, the use of a stock screener is also recommended by many investors. In this case, however, the parameters that should be set in the screener are not technical, but fundamental.

    For example, when looking for a long-term position, fundamental ratios such as the price-earnings ratio (P/E), price-earnings ratio (P/E), current ratio (current ratio) and so on are extremely important. In many cases, looking at a stock chart is not considered useful if you want to take a long-term position, because in the long run, only the fundamental aspects of the stock and not the current price performance will be important.

    However, it is important to do the research carefully as the next steps of the investment strategy will depend heavily on the research. If you do not take enough time to carefully examine all the potential weaknesses of a position, it can significantly affect the profitability of the position.

    Step 3: Planning and Entering a Position In the Market

    Then, after an investor has decided which stocks may represent a great buying opportunities, then they must determine how and when a position should be entered. It is often the case that entering a position at the market price right after the research is not always the best strategy.

    Planning and Entering a Short Term Trading Position: Strategies and Order Types

    Especially in short-term trading, it is often the case that after identifying a trading opportunity, traders wait for a “confirmation candle,” i.e., a candle that confirms a possible price reversal and thus gives the green light for the buy order.

    If you want to open a short-term position, it is also extremely important to choose the right entry order. Depending on the broker, there are many different orders that traders can choose from.

    The most common, but also the least recommended order for short-term trading is the market order. With this order, a position can be executed at the current market price as soon as the order is sent. Although this is usually the order type that is executed the fastest, it is not recommended because it does not provide control over the opening price of the position.

    Another commonly used order type is the limit order, which allows filling a position at the maximum limit price set by the trader. Thus, there is no minimum price, only a maximum price. This order provides more control and limits the risk of opening a position at a very high cost, which significantly reduces the profitability of a trade.

    The last type of commonly used order is the stop limit order. It works like a limit order with the additional “stop” function, which consists of a price level above which the order takes effect, to prevent the limit order from being executed immediately at the market price if the limit price is above the market price.

    However, it is important to note that there are also other order types, but they are rarely used, especially because not all brokers offer them.

    Planning and Entering a Long Term Investment Position: Strategies and Timing

    On the other hand, with a long-term position, there is no need to use fancy order types, as a few cents difference is unlikely to matter in the long run, so market orders are the most used order type.

    However, when planning the entry for a long-term position, there are other many different aspects that come into play, for example the debate between timing the market and the dollar cost averaging method.

    Timing the market costs in waiting for a short-term decline in the stock price to enter a position at an advantageous price. Dollar Cost Averaging, on the other hand, consists of buying the stock in various installments spread more or less evenly over time as the stock price declines.

    The debate arises because someone who hypothetically would be able to perfectly identify the bottom of a correction could buy the stock at the lowest possible price and thus make the highest potential profits. Over the years, however, it has been shown that it is extremely difficult to identify a low point with such precision, and in most cases those who have been waiting for the best opportunity have missed it.

    On the other hand, dollar cost averaging could be compared to casting a fishing net. You may not catch the exact fish you were looking for, but you will most likely find something. By buying the stock when the price is falling, you can bring the price as close as possible to the theoretically optimal price, increasing the chances of a profitable position.

    Step 4: Monitoring and Exiting a Stock Position: OCO Orders and Active Management

    The last step is planning the exit and monitoring the position. Planning the exit consists of establishing a set of situations or conditions due to which the position must be closed.

    The most common way to close a position is automatic closing, which occurs when the stock price reaches either the take profit or stop loss set at the time the position was opened. These other two orders are often used, especially by traders, in an OCO (“one cancels the other”) configuration, so that a position can be automatically closed by the broker when it reaches either limit.

    It is extremely important for traders to stick to these orders and not change the price of either position due to an emotional reaction during the trade. These practices often lead to a reduction in the profit of a successful trade or a larger loss on a trade that has gone down.

    On the other hand, for long-term positions or other situations where there is no OCO order, it is important to define strict criteria that must lead to the termination of the position. For example, a position should be closed if the profitable conditions that existed at the time of opening no longer exist, or if the technical or fundamental structure has changed significantly, or if the stock is overvalued and it is possible to make a profit.

    In any case, it is important to monitor the position at least once a day for short-term trades and at least once a week for long-term positions to ensure that all important events, both positive and negative, are noted.

    Conclusion

    All in all, investing, although it might be a daunting and complex activity for a beginner, is actually easier to master than you might think if you break it down into small steps to develop a basic investment strategy.

    Once the scope of the investment, either long term or short term, and the amount that can be invested have been determined, the investor can begin with the technical details.

    The first step is to select the best stock screener for you and perform an initial analysis to narrow down the number of stocks to a much smaller number. After that, you should perform a more thorough analysis of these stocks and choose the best ones to invest in.

    Then, it is important to determine the type of entry order and the price to ensure that the position is opened at a suitable price that will help increase profitability. Finally, setting the conditions for the closing order and monitoring the trade is crucial to either limit the losses or close the position with a nice profit.

    If you enjoyed this article and you are looking for more guidance on how to start investing as a beginner, be sure to check out our website where you will find many more tips and tricks!

    FAQ

    Is Fundamental Analysis Always Needed?

    Usually, no. Fundamental analysis is mainly used for evaluating a long term position on the basis of the underlying business. If instead an investor is looking to open a short term position, it is often more important to look at technical indicators, patterns and technical structures.

    How Does a OCO Order Work?

    OCO stands for “Once Cancels the Other”, and OCO orders are also commonly known as “bracket order” or “complex order”. They consist of two orders, usually a take profit and a stop loss, and as soon as one of the two orders is filled, the position is closed and the other order is cancelled.

    What Is A Trailing Stop Loss?

    Usually, by default, stop loss orders are “stop market” orders, meaning that once they hit the stop price you set, the stop loss order is set as a market order. However, it is possible in some cases depending on the broker, to edit the stop loss order and changing it to other order types.

    The trailing stop loss order is very common and it consists of a stop loss order that it moves together with the stock price, trailing at a certain distance that can be specified either as a percentage or as a dollar amount. If the stock price moves away from the stop loss (i.e. goes in the expected direction) the stop loss moves up following the price. If instead the price goes down towards the stop loss, the trailing stop loss remains fixed ad it works as a normal stop market order.

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