Finger on the Trigger, Eyes on the Clock

If you’re like other individual investors who’ve recently caught the stock-trading bug, your trading career can probably be summed up like this: You’ve had some winning stocks and you’ve made money overall.

But--ouch!--you’ve also suffered a few huge losers that have shaken your wallet, not to mention your psyche.

If so, you’ve already learned the first rule of trading: Always keep your losses small--and never let small losses mutate into big ones.

Individual investors are being drawn into the trading game thanks to rock-bottom brokerage commission rates, disappointing mutual fund performance and mouth-watering short-term gains in some highflying stocks.

But profitable trading requires more than a fast Internet connection and a TV tuned to CNBC. It begins with a few simple rules that can improve results.

Above all, seek to avoid big losses in even one or two stocks because they can wreck the return of an otherwise solid portfolio.

Imagine, for example, that you buy 10 stocks. Perhaps six will register moderate gains or losses. Two might notch big gains. But if the final two incur sizable losses, they can nullify the big winners, leaving you with middling gains--at best--for the portfolio overall.

And if you weren’t lucky enough to pick a couple of big winners, two big losers could mean that your portfolio overall will show a loss.

“People let one or two bad trades ruin their profitability,” said Michael Green, head of the Santa Monica office of day-trading firm Landmark Securities. “It’s [sometimes] the difference between making money or losing money.”

To avert that scenario, some longtime traders recommend dumping shares of a newly purchased stock if the price drops as little as 5% to 7% from the purchase price.

That flouts the conventional wisdom that individual investors have heard for years. Traditional thinking says investors should hold on to a stock as long as the slide is due to general market queasiness rather than trouble with a company’s sales or earnings. And with many stocks repeatedly rebounding from losses in recent years, hanging tight might seem smart.

But that misses the point, many veteran traders say: In all investing, the ultimate goal isn’t to own companies with good fundamentals. It’s to make money. If a stock goes down immediately after you’ve bought it, you’re not making money.

To bolster their case, traders pose this question: Once a loss develops, what if a stock simply doesn’t come back? In recent years, for example, plenty of small-capitalization stocks with seemingly good fundamentals have gone down and stayed down.

“Most big losses start out as small losses,” said Jeff Cooper, author of three books on trading and a co-founder of the Tradehard.com Web site. “I’d rather get out at a small loss.”

Consider that if a stock falls 50% before you sell it and reinvest the funds in another stock, the shares of the second company must rise 100% for you to recoup your capital.

Even big-name stocks can spend months or years getting back to previous highs, so traders should dump them, too, if they dip 7% from their purchase price, many veteran traders suggest.

Take the recent performance of brokerage giant Merrill Lynch, for example. It peaked just above $109 in mid-July before falling to $35.75 in October. It has since rebounded to $76.44. But an investor who bought at, say, $100, would still be underwater.

Imagine that the investor has a $50,000 trading account. If he bought 100 shares of Merrill at $100 (a $10,000 total investment) and held on, one-fifth of his account has been dead money for seven months. So not only is that investor showing a loss, but he wasn’t able to use that capital elsewhere during the market’s roaring recovery in fall.

William O’Neil, an investment legend and founder of the Investor’s Business Daily newspaper, has long advocated selling a new position if it slumps 7% or so from its purchase price. But note: The sell-early rule doesn’t apply to stocks that investors have owned for a while and in which they already have profits.

In those cases, it can be OK to hold on to a stock during a market downturn as long as the stock isn’t weak in comparison to the market.

If the technology sector, for example, is 20% off its high but your tech stock is down 15%, that “relative strength” could indicate that your stock is holding up well and might be a good performer once the pullback ends.

In no case, however, should you ever let a profit turn into a loss.

Yet most individual investors hold on to losers because they don’t want to admit they’ve made a mistake.

“A lot of times you have to be humbled by the market before you become more concerned with return of capital than return on capital,” Cooper said.

Once new traders have pledged to limit their losses, another good lesson is learning when to trade.

Though many individuals spend entire days glued to their Internet trading screens, most pros say the best times to trade are the first and last 90 minutes of each day.

In California, that translates to 6:30 a.m. to 8:00 a.m. and 11:30 a.m. to 1 p.m. These often are the times when stocks are moving fast and with the most volatility. In other words, if you want to jump on short-term trends, the patterns are most pronounced in those periods.

Though there are several theories about why the early morning is good for trading, one of the more widely accepted is simply that when East Coast market makers eat lunch during the middle of the day, the understudies who head trading desks in their absence are hesitant to allow stocks to move outside a trading range.

“I assume it’s because they’re having martinis at lunch in New York,” Cooper said, half-jokingly.

If you trade in a slow-moving market during the middle of the day, the risk is that any profits would be small and eaten up by commissions.

Another reason stock movements are more extreme early in the day is that major economic data are released in the morning.

Often, the tone set early on will persist for at least the first hour or two of trading. But be wary of the first 20 minutes, Green said. This is when brokerages execute orders they have received overnight, such as those from investors who placed orders electronically after getting home from work.

The risk is that overnight buy orders initially push a stock up, but the trend of the new day is down. In that case, a stock could rapidly reverse course once the overnight orders are filled, Green said.

“You’re like, ‘This stock was going up and all of a sudden it stopped,’ ” he said.

The final hour is considered key because many institutional investors, after watching the market’s action through the day, wait until then to make their moves. Often, their buying will amplify the market’s prior gains while their selling will intensify losses.

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Times staff writer Walter Hamilton can be reached by e-mail at walter.hamilton@latimes.com.