Whether you are curious about the stock market and just starting to build a portfolio or you have started trading full-time with the goal of growing your wealth quickly, understanding how professional traders think – and the best professional trading strategies – is the first step on your road to success.
There is no single answer when it comes to which is the best professional trading strategy. A long list of stock market icons have amassed extraordinary wealth using a mix of trading methods.
The key is discipline – committing to a trading strategy that has been proven effective and then seeing it through. Of course, the strategy you choose must also be appropriate for your lifestyle, your level of risk tolerance, and your specific financial goals.
How Do Professional Traders Think?
There are two critical differences between successful professional traders and their amateur counterparts – the ones who lose money and move on to other hobbies. First, professional transfers are process-oriented. They understand that the market is – at its most basic – unpredictable.
Sometimes, traders can do everything right and still lose money. That doesn’t necessarily mean it is time to abandon an effective strategy – just that short-term losses are part of the trading experience. Professional traders stick with their evidence-based strategy. They don’t abandon ship the moment they start to feel anxious.
The second way professional traders think differently is their risk first/reward second perspective. Instead of seeing dollar signs when they examine fundamental and technical aspects of a prospective investment, they focus on the level of risk. Once they fully understand what a loss could look like – and how likely it is that a loss will occur – they consider upside potential. Then they move forward if – and only if – the risk/reward balance makes sense.
Proven Professional Trading Strategies
Professional traders put together complex strategies that pull in a proprietary mix of data to guide trading decisions. While the strategies differ in the details, the most successful have certain characteristics in common.
[1] Defining Risk – and Setting Stop Loss Thresholds
There is a reason why gamblers run into trouble. They don’t know when to cash in their chips and go home. Instead, they keep trying to win back their losses, which leads to a downward spiral that leaves them with nothing.
Amateur traders often demonstrate the same behavior. They hold onto losing trades because they are convinced they can turn things around. By the time they accept that there is no reasonable path forward, it’s too late.
Professional traders don’t allow that sort of spiral to start in the first place. Before they make a trade, they calculate risk and determine a point at which they will cut their losses. Then, they have the discipline to sell losing positions at the predetermined threshold, no matter how tempting it is to hold on a bit longer. As a result, they keep small losses from completely decimating their portfolios.
One sure-fire method of guaranteeing an asset doesn’t stay in your portfolio after it falls below your preset minimum is a stop-loss order. You don’t have to monitor market conditions – your trade will be executed automatically if the asset price declines to the point you specified.
[2] Investing Across Asset Classes
If there is one word that sums up professional traders, it is diversification. Without exception, the most successful investors of all time agree that relying on a single asset class is unwise. Instead, they invest across asset classes, so their portfolios are resilient to market changes.
They begin with the basics – stocks (equities), bonds (fixed income), and cash or cash equivalents. Then, depending on their strategies, some add other types of assets like commodities, futures, real estate, and cryptocurrency.
In combination, multiple asset classes offer a measure of stability for portfolios, as asset classes tend to move differently when faced with bear or bull markets. The relationship is referred to as a negative correlation. For example, when the economy is booming, and stocks are trending up, bonds are less profitable – and vice versa. The same goes for stocks and gold.
[3] Investing Across Geographies
Investing across asset classes isn’t the only way to prevent the value of a portfolio from experiencing dramatic highs and lows.
Investing across geographies is another method of ensuring diversification. For example, while the United States and Europe tend to move together from an economic perspective, conditions in China, India, and Latin America are often on a separate trajectory.
[4] Investing Across Industries/Sectors
Securities are far more popular than fixed-income and cash/cash equivalent assets because they have the potential to deliver outsized returns. However, within this asset class, there are wide-ranging differences in how subcategories of stocks behave.
For example, as a whole, technology stocks are assumed to be high-growth opportunities, so they often trade at prices that are much higher than the company’s intrinsic value would suggest. In many cases, investors are so excited about the companies’ potential that they drive share prices up despite the fact that the companies are operating at a loss.
Meanwhile, there are entire industries devoted to must-have goods and services – energy, utilities, and consumer staples, to name a few. Companies that fall into these categories turn a reliable profit, and their share prices reflect slow, steady growth. They aren’t as exciting as their high-risk/high-potential-reward peers, but they still support investors in building wealth long-term.
There is room for both types of stocks in a well-diversified portfolio. The high-growth side can push total returns higher, while the slower, more consistent side protects against volatility – and that’s if you only choose to trade the two ends of a wide spectrum. In between, there are industries and sectors that offer a bit more balance between growth and consistency, making it possible to customize your portfolio even further.
[5] Investing Across Market Caps
When it comes to diversification, the size of a company – that is, its total market value or “market cap” – makes a difference.
There are five common terms that categorize companies by size, though the exact size to which they refer can vary slightly depending on the source and the current market conditions. The five market cap terms include:
- Micro Cap – less than $500 million, e.g., Iridex (IRIX) and FAT Brands (FAT)
- Small Cap – $500 million – $1 billion, e.g., Perion Network (PERI) and Bark (BARK)
- Mid Cap – $1 billion – $5 billion, e.g., Global Blood Therapeutics (GBT) and Sunnova Energy (NOVA)
- Large Cap – $5 billion – $200 billion, e.g., Starbucks (SBUX) and MercadoLibre (MELI)
- Mega Cap – greater than $200 billion, e.g., Microsoft (MSFT) and JPMorgan Chase (JPM)
Investing across market caps adds another level of diversification to a portfolio because the size of a company generally corresponds to certain underlying traits.
For example, large and mega cap companies tend to be well-established with dependable profits. In other words, they are less risky, and as a bonus, they are more likely to pay dividends. However, they don’t usually have as much room for growth as smaller companies, so smaller companies have higher reward potential – along with higher risk.
[6] Managing Liquidity
Professional traders include managing liquidity as an important component of their overall strategies. It can take time to enter and exit positions, which means funds are tied up in previous trades.
That can be problematic if a time-sensitive opportunity comes up and there isn’t enough cash to take advantage.
Ensuring there is sufficient liquidity in place to handle a large purchase can mean the difference between a mediocre year and a great one.
[7] Selling Calls on Stocks to Maximize Income
Finally, experienced professionals have mastered the science of selling calls on stocks to maximize income.
Essentially, they purchase a stock they would otherwise be glad to own, then they sell calls, which give the buyer the right – but not the obligation – to buy the shares at the contracted price. Typically, the contracted price is above the current market price of the stock.
The investor who purchases the contract pays a premium, which the seller of the call keeps as profit, and if the contract holder chooses to exercise the call, additional profit is realized. There is a bit of risk if the stock price drops below the breakeven point, but the primary risk is missing out on large price increases.
What Is The Most Successful Trading Strategy?
It’s hard to choose the most successful trading strategy when the stock market icons have taken different paths to success. However, most would agree that the best trading strategy is the one that most effectively manages the risk to reward ratio. A particularly clear example of managing risk vs. reward is Ray Dalio’s All-Weather Portfolio.
Through his firm, Bridgewater Associates, Dalio has developed a “lazy man’s” portfolio that can survive and thrive regardless of market conditions. Thoughtful diversification is one of the biggest features of the portfolio, as this adds stability and prevents drastic losses if there are sudden, unexpected changes in the market.
Dalio says that the maximum drawdown in the All-Weather Portfolio is just 5 percent. That’s impressive in a world that is just two years removed from the stunning 34 percent drop in the S&P 500 that occurred between February and March 2020.
Is Ray Dalio’s trading strategy the best or the most profitable? For some investors, the answer is a definite yes. However, there are a number of professional trading strategies that, depending on your specific preferences and goals, could be a better fit.
The best professional trading strategy for your situation comes down to an honest assessment of financial goals, skill level, risk tolerance, and other personal characteristics.
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