How to Make Money Trading

1. Master the Market's Big Picture: Trends and Cycles Drive Returns.

The single most important thing you can do for your investment framework is to understand what the US economy is doing – the US economy drives the UK economy.

Economic cycles dictate. Understanding the broader economic environment and identifying whether you are in a bull or bear market is paramount. The business cycle, measured by Gross Domestic Product (GDP), shows economies expand and contract predictably, directly influencing stock market performance. Ignoring this overarching trend is a common mistake, even for experienced professionals.

US economy leads. The US economy is a critical lead indicator for global markets, including the UK. Tools like the Institute for Supply Management (ISM) Manufacturers Survey can predict US GDP changes by several months, with an accuracy rate of almost 98% since 1947. An ISM above 50 indicates expansion, while below 50 signals contraction or recession, providing a powerful framework for anticipating market direction.

Trend is your friend. Trading with the prevailing market trend significantly increases your probability of success. In a bull market, a long bias is favored; in a bear market, a short bias. Secular trends, which span decades, can offer immense rewards if understood, or destroy capital if misjudged, as seen in Japan's long bear market or the US's long bull market.

2. Challenge the Experts: Develop Your Own Informed View.

My aim is to encourage you to be sceptical of so-called ‘experts’ and do the work yourself.

Skepticism is vital. Giving your money to experts often results in them getting richer while you gain experience. Many investment professionals and media outlets offer advice that is either outdated, biased, or designed for entertainment rather than profit. Their "tips" are often already priced into the market by the time you hear them.

Conflicts of interest. Analysts and company management frequently have conflicts of interest that compromise their objectivity. Analysts may issue "buy" recommendations to secure future banking business, while management might prioritize short-term stock price boosts for their options over long-term shareholder value. The Enron scandal serves as a stark reminder of how fraudulent management can render fundamental analysis useless.

Trust your judgment. Your job is to "predict" tomorrow's newspaper, not react to yesterday's news. Develop your own investment framework, combining economic understanding, historical context, and company analysis. This self-reliant approach protects your capital from external biases and ensures your decisions align with your best interests.

3. Ideas are Your Edge: Cultivate Originality and Deep Understanding.

SPECIALIST KNOWLEDGE IS YOUR KEY INVESTMENT EDGE. LEARN TO TRUST YOURSELF.

Knowledge is power. Generating profitable trading ideas requires time, experience, and a deep understanding of what you're investing in. Avoid blindly following tips; instead, focus on sectors or companies you genuinely understand and are passionate about. This "specialist knowledge" provides conviction and a competitive edge.

Beyond the obvious. Market reactions to news are often counter-intuitive; good results can lead to a sell-off if already anticipated, while bad news might be ignored if priced in. Your goal is to identify ideas or macro themes that haven't yet run their course, allowing you to act before the consensus forms.

Practical research. Before committing, conduct thorough background research. This includes:

• Visiting stores or company websites.
• Reading news stories and analyst reports.
• Attending annual general meetings (AGMs).
• Reviewing historical stock charts.
  This diligence helps you avoid falling "in love" with a company and instead focus on its potential to make money.

4. Fundamental Analysis: Know the Numbers, But Don't Fall in Love.

For our purposes, a good stock is a stock that goes up when we buy it, and down after we sell it, i.e. a stock that makes you money.

Good company vs. good stock. A fundamentally strong company with excellent products and management isn't necessarily a good stock if its price has already discounted all the good news. Your objective is to identify stocks that will generate profit, regardless of the company's inherent "goodness."

Understand financial health. Familiarize yourself with basic financial statements like the balance sheet and income statement. Key financial ratios provide insights into a company's health and valuation:

• Liquidity Ratio: Cash vs. short-term debt (ratio > 2 is safe).
• Debt Ratio: Total assets vs. total liabilities (long-term debt capacity).
• Profitability Ratio: Net income vs. sales (return on capital).
• Market Ratios: Price-to-Earnings (P/E), Price-to-Book (P/B), EV/EBITDA (valuation metrics).

Margin of safety. Adopt Benjamin Graham's "margin of safety" principle, aiming to buy stocks significantly below their intrinsic value. This protects against unforeseen events and analytical errors. Remember, a company's future is influenced by its customers, industry trends, and potential disruptions, not just its current numbers.

5. Technical Analysis: Read the Charts for Timing and Sentiment.

CHARTS ARE VALUABLE TOOLS WHEN MAKING INVESTMENT DECISIONS.

Timing is everything. Technical analysis, the study of past stock movements, helps forecast future prices and, crucially, aids in timing your trades. It assumes that all market participants' combined knowledge is already reflected in the price. Charts reveal whether a stock is trending (clear direction) or ranging (within defined bands).

Building the technical picture. Analyze charts across multiple time periods—from daily to multi-year—to understand major and minor trends. Use open/high/low/close charts to capture daily price action and volume to gauge the significance of price movements. High volume on a price move indicates greater conviction.

Indicators and patterns. Employ technical indicators like moving averages to smooth price action and the Relative Strength Index (RSI) to identify overbought or oversold conditions. Look for classic chart patterns:

• Reversal patterns: Head and shoulders, double top (signal trend change).
• Continuation patterns: Flags, pennants (signal trend pause before resuming).
  Divergences between price and indicators can also signal trading opportunities.

6. The Reality Check: Question Everything Before You Trade.

THE BEST TRADERS ARE THOSE WHO ARE STREET SMART. THEY HAVE A SIXTH SENSE OF WHEN NOT TO TRADE.

Beyond the analysis. After completing your fundamental and technical analysis, step back for a "reality check." This involves asking critical questions that might reinforce or challenge your trading idea, often revealing hidden risks or confirming contrarian views. Street smarts and intuition are invaluable here.

Avoid common pitfalls. Be wary of situations that often lead to losses:

• Pension deficits: A huge drag on company profitability.
• Excessive executive bonuses: Indicates management prioritizing self-enrichment over shareholder value.
• Rumors and tips: Rarely reliable, no substitute for your own research.
• Profit warnings: Often come in multiples, signaling deeper issues.
• Rights issues: Companies usually need money because they're in trouble or making risky acquisitions.

Psychological readiness. Assess your mental state. Are you focused, disciplined, and free from personal issues that could lead to unnecessary risks? Avoid trading in sectors where you've consistently lost money, as you may lack an "edge." Ensure your idea has enough originality to offer a balanced portfolio.

7. Conquer Your Mind: Psychology is Your Greatest Asset or Enemy.

THE PAIN OF LOSING IS FAR GREATER THAN THE JOY OF WINNING.

Emotions impact performance. Trading is an emotional roller coaster, where the pain of losses often outweighs the joy of gains. Human beings are hard-wired for short-term gratification and prone to "herding behavior," making it difficult to act against the crowd or cut losses quickly. Recognizing these psychological biases is crucial for survival.

Self-control is finite. Psychologists note that self-control is a limited resource, diminishing with overuse. This means relying solely on willpower to overcome trading impulses is unsustainable. Instead, develop a disciplined trading plan and stick to it, especially when under pressure, to mitigate the impact of greed and fear.

Mental toughness matters. Successful traders possess mental toughness, characterized by:

• Resilience: Bouncing back from setbacks.
• Composure: Handling pressure without panic.
• Focus: Maintaining concentration.
• Self-confidence: Believing in your abilities.
• Motivation: Trading for the right reasons.
  Continuously assess and improve these traits, and remember that even the best traders experience losses and exhaustion.

8. Rigorous Risk Management: Preserve Capital Above All Else.

Don’t forget our first aim is to preserve capital and our second aim is to make money.

Capital preservation first. The primary goal in trading is to protect your capital; making profits is secondary. Every trade must be evaluated based on its risk-to-reward ratio, ideally aiming for at least 3:1. This means for every £1 risked, you should expect to make £3.

Cut your losers, run your winners. This fundamental rule is essential for long-term survival. Set a "stop loss" level before entering a trade—typically 5-10% below your purchase price—and adhere to it strictly. Conversely, for winning trades, continuously raise your stop loss to protect profits as the stock price climbs, ensuring a profitable exit.

Money management rules. Implement strict rules to control your portfolio:

• Position Sizing: Never more than 3% of capital in one stock, 10% in one sector/theme.
• Exposure Limits: Never be long or short more than 50% of your capital.
• No Leverage: Avoid borrowing money to trade, as it amplifies losses rapidly.
• Trading Diary: Document your reasoning, entry/exit points, and lessons learned to foster discipline and self-awareness.

9. Diversify and Hedge: Don't Put All Your Eggs in One Basket.

If there is less correlation between the different stocks, the more likely it is that your portfolio will be less volatile, and your returns more stable.

Diversification reduces risk. A balanced portfolio with numerous ideas and stocks is crucial for long-term success. Concentrating too much capital in a single stock or sector exposes you to excessive risk. Adding more stocks and sectors, especially those with low correlation, reduces overall portfolio volatility and stabilizes returns.

Hedging protects positions. If you like a stock but are concerned about broader market movements, hedge your risk. This involves buying your preferred stock while simultaneously selling a market index ETF or a less favored stock in the same sector. This strategy, known as a "pair trade," aims to profit from relative outperformance rather than absolute price movement.

Alpha and Beta. Understand that a stock's return is influenced by:

• Beta (50%+): Overall market movement.
• Alpha (25%): Sector performance.
• Alpha (25%): Individual stock-picking skill.
  If your conviction is primarily about market direction, buy an index ETF. If it's about a sector, buy a sector ETF. Only accept single-stock risk when you have strong, company-specific reasons.

10. Understand Currencies and Commodities: Expand Your Trading Horizon.

If your view is that you don’t like any of the currencies you might decide to just put your money in gold.

Currency as a macro play. Currency trading offers a direct way to bet on a country's economic success or failure. Capital flows—demand and supply for a currency—drive its value. This allows for diverse macro plays:

• Commodity currencies: AUD, CAD, BRL strengthen with commodity booms (e.g., China demand).
• Safe haven currencies: USD, CHF, SGD appreciate during global crises.
• Carry trades: Exploiting interest rate differentials (e.g., AUD vs. JPY), though highly leveraged and risky during shocks.
• Pegged currencies: Opportunities arise if a peg is expected to break (e.g., HKD vs. USD).

Commodities: demand and supply. Commodities (energy, metals, agriculture) are driven by economic growth and secular trends. Their prices reflect future supply and demand, often expressed through "forward curves" (contango or backwardation). Trading commodities requires understanding these curves and market dynamics.

Beware of complexity. While attractive, commodities and currencies can be complex. Futures contracts require "rolling" to avoid physical delivery, and many structured products carry hidden fees or underperform the underlying asset. For beginners, indirect plays—like investing in mining or fertilizer companies—might be safer than direct commodity trading.

11. Learn from History: Bubbles Burst, Valuations Matter.

Markets are the result of human behaviour and people never learn. Human greed is infectious and we must resist getting involved in investing during stock market bubbles.

History repeats itself. A deep understanding of economic and stock market history is crucial. The last two decades, with their relatively benign business cycles, are an anomaly compared to the last 200 years. Major recessions cause significant stock market declines, and booms lead to bull markets, but these are not perpetual.

Valuations revert to mean. Experts often claim stocks always go up in the long run, but this depends heavily on your starting point. Historically, expensive markets (high P/E ratios, low dividend yields) tend to produce below-average returns over the next decade, while cheap markets yield strong returns. The market's valuation in 2000, at the peak of the Internet bubble, was a historically terrible time to buy equities.

Bubbles are inevitable. Financial markets are prone to bubbles, where prices detach from underlying reality due to speculative fervor. Examples include the car industry in the early 20th century and the dot-com bubble of the late 1990s. While new technologies can change the world, the companies involved don't always make profitable investments. Resist the infectious greed and avoid participating in unsustainable rallies.