The bulls have been good to us so far in 2012, despite a hiccup in April; but May has started on a positive note. The stock market continues to show optimism, with the key stock indices displaying a golden cross, with the 50-day moving average (MA) above the 200-day MA. There were several moves recently to below the 50-day MA, but this was met with good support buying and a stock market bounce. All of this buying bias is encouraging, but the continued light trading volume signals that we should be cautious, as there are numerous threats that could drive fresh selling.
Bullish investor sentiment in the stock market continues to drive buying interest, albeit the readings in April were mainly neutral, as investors became increasingly hesitant.
You need to understand that being prudent is important for success in the stock market. Too greedy and you will likely see your capital sink.
The reason why I want to briefly talk about risk management in the stock market is my sense that there are some of you who probably fail to incorporate any sort of risk management strategy. If you do, that’s fantastic; if you don’t, read on.
Let’s look at the case when a stock rises. When this happens, you should always think of a potential exit strategy. This does not mean, liquidating profitable trades, but rather protecting your unrealized gains.
Take the mini stock market rally as an opportunity to take some profits.
If you have a price target for your stock, you can sell the stock when it reaches that target. Alternatively, if the gains are significant, you can take profits on a portion of the position and let the remaining portion ride. For instance, if a stock rises by 100%, you can liquidate 50% of the position and keep the remaining 50%. Under this simple strategy, you take some profits, but, at the same time, create a zero-cost trade, as you have recouped your initial investment. You can view the remaining 50% stake as risk capital.
Another stock market strategy that needs to be considered is the use of mental or physical stop-loss limits. But you need to be careful when the volatility increases and wild swings in the stock market materialize that could take you out of your position prematurely.
Stops should also be used when a stock is trending higher. These stops are referred to as trailing stops and are constantly adjusted as the price of the stock rises. Adopting trailing stops helps to protect your gains as the stock rises.
One of my favorite fast food restaurant stocks is McDonald’s Corporation (NYSE/MCD), which you can read about in McDonald’s & this Other Stock Feasting on Fast Food Profits.