Making sure you choose the right kind of stocks is one of the most important steps in Day Trading. You can read, study, and watch videos as much as you like, and you can follow the best advice, know the best strategies, and even have access to proven patterns, but if your stock selection is off, well… good luck to you. In today’s article, we’ll talk about how to find the right stocks and what mistakes beginners usually make.
…while selecting stocks is an important aspect of risk management as it helps minimize your losses and builds better results and profits.
Today we will discuss how risk management is integral while stock selection. Before that, be sure to go through the Investing for Beginners series that has been created for beginners to provide day trading tips and insights into how I started and how you can become successful. Careful analysis during stock selection is integral to long-term success and with an almost endless list of stocks out there, it can be overwhelming to say the least. Day trading can be a risky proposition if you don’t know what you are doing and understand how to go about selecting stocks is crucial.
So before you jump in, make sure your stock selection is the best it can be.
The present economic situation around the world makes it all the more important to be careful about which stocks you choose and to practice proper risk management. Make full use of the resources at your disposal to review the data of the companies whose stocks are available. Let us talk about risk management and how to really scan for the right stocks to trade, based on my experience of how I developed a method for myself to find the appropriate stocks for me, that fit my trading approach and strategies.
Day trading carries inherent risk and therefore while scanning and selecting stocks you must avoid any common mistakes that can hamper progress.
How to scan
And find the right stocks.
There are some mistakes that are so common that I see almost all new traders make them time and time again. And it’s understandable because when I started back in 2016, I too made these mistakes. That is why I write these articles, make videos, and have The Freedom Challenge to help new traders avoid mistakes that I made and reach success quicker.
The lower the stock price, the more volatile it is.
Volatility is the degree to which price moves. It has nothing to do with how low the price is.
In fact, volatility has little to do with how much the price is. There is a misconception that the lower the stock price, the more volatile it is. This is not true and unfortunately, many beginners believe this. I did too, back in 2016. A lot of literature out there is misleading and leads to myths like these spreading and spreading. Volatility has nothing to do with how low a stock price is. A $1 stock is not necessarily more volatile than a $5 stock. The volatility depends on stock demand and float.
Float is the number of shares a company has made available to the public, effectively making these the number of shares that traders can actually trade. This number gives you an indication of how many shares you buy and sell. When the float is high, it means there is a higher number of shares available in the market. If demand for a stock is low and the supply (float) is high, it’s usually an indicator that the price of a stock will go down. If float (supply) is low and demand is high then the stock can get more volatile.
If you are looking at a $5 stock that has a float around 300k or 500k, it will likely have the same volatility (or even greater volatility) than a stock that’s around 50 cents.
If the price of a stock stays stable, it has low volatility. If the price of a stock fluctuates quite a bit then it is showing high volatility. When working with a highly volatile stock, the risk is higher but the chances of success are also higher. This is why it is a good idea to trade during the high volatility hours of the day. The objective is to take a position on a stock and aim to profit within a short time or by the end of the same trading day at the latest.
Developing Poor Habits (Around Risk Management)
Another mistake beginners make is to develop poor habits around risk management.
Let’s look at an example. If you are trading a stock worth $5-$7, and lose around 50 cents, and this continues to happen for a while, you will be prone to falling into this routine. You might become so used to losing this 50 cents that even when you are trading a $1 stock, you might be fine losing 50 cents. At this point, you have developed poor habits around risk management. This should not be acceptable as 50 cents in this example represents 50% of your investment! That is way more than it should be and therefore it requires proper risk management.
Calculate your risk based on a percentage rather than the actual price! Setting your risk according to actual prices is a huge mistake that beginners make and one you must avoid. The sooner you do, the better your future trading career will be. Although there are many more common mistakes, these are the two I see again and again. I too made them as a beginner, and it’s something I strive to help my students avoid.
How to grasp
Risk-Management The “Right” Way.
As just mentioned, a risk of 50 cents for a $1 stock and for a $5 are two very different things. It’s important to appreciate this and to have a good understanding of what YOUR risk management looks like (or needs to look like). It’s one of the most important skills a day trader can develop and is a key factor of growth and success.
1. Fix An Upper Limit For Risk
Proper risk management ensures your losses don’t increase more than you can handle.
Always fix how much risk you are okay handling, in terms of a percentage. As a general rule, keeping a limit of a 1% to 3% potential loss, the general risk remains on the lower side and gives you room to trade more in a day. I call this The 1% Rule! It suggests that the maximum risk you undertake is never more than 1 percent on a single trade. As a trader who is well on the way to making this a full-time career, you’ll make multiple trades each day so setting your upper limit of risk at 1% ensures you minimize any losses (while still allowing you to build your portfolio). It’s not possible to be cost-effective with each and every trade; that’s why one must be practical and keep our losses low.
2. Shrink Price Range Criteria
In most cases (and on most of my trading days), I keep my price criteria between $3 to $10.
Usually, I avoid stocks below $1, even though technically they are Penny Stocks. The problem with them is that they get manipulated to stay around the dollar mark and also carry too much risk. The reason why I prefer the $3 to $10 price range is something I explain in this video. 50 cents on a $3 or $5 is not just optimum risk but also easier to calculate and manage. So when I am trading on a busy day and the trades happen quickly, I’m still able to calculate my risk almost immediately and not delay my entry time. Staying above $3 also ensures one doesn’t have to make a lot of trades just to make some amount of profit. This also keeps your borrow fees within limit, as some brokers charge a considerable amount.
3. Focus More On Small Cap
While scanning for the right stocks, you shouldn’t just look at the price but also the market cap.
Market cap is the total value in dollars of a company’s outstanding shares. The number of available shares multiplied by the price per share gives us the market cap. The market cap number decides whether a company is small-cap, mid-cap, or large-cap. Large-cap corporations are those with a market cap of $10 billion and above. Mid-cap companies are those with a cap between $2 and $10 billion. Small-cap companies are those with a market cap between $300 million and $2 billion. It has been observed that large-cap and mid-cap companies tend to grow slower than small-cap companies. As such, you can usually eliminate stocks with larger market caps from your priority list.
Shrinking your stock selection criteria doesn’t just increase your opportunities for profits but also reduces risk, thereby stocks work for you than against you.
For you and your day trading.
Narrowing down your criteria like this really helps in selecting stocks in a faster and more efficient way. So don’t just pick your stocks randomly.
Take care of these things and focus on the criteria while scanning for stocks. To understand stocks better, make sure you go through my Investing for Beginners series. Day Trading is all about using analytical and historical analysis to come to conclusions about stock movements and patterns. So be sure to be on top of your research at all times. The more you gather, the better you’ll be both in the long and short-term. And for further guidance on how to select the best day trading stocks and how to make the most of them, don’t forget to check out the Freedom Challenge.