8 Simple Rules for Trading

The market's recent winning ways have had a lot of investors returning to the market. There are, however, also plenty of folks taking their inaugural dip into the trading pool. These are exciting times, but that doesn't mean they will all be profitable.

As we unroll the "Welcome" banner to those discovering what the stock market has to offer, I'd be remiss if I didn't point out the meaty asterisk dangling there. It leads to fine print -- warnings in Latin I believe -- that appear to spell out Dick Cavett Emperors and Carpet Dion. So let me try my best to translate for my friends whose knowledge of the market and the classical language of Latin is little more than Uybay Ockstay in its romantic piggy dialect.

I have 8 simple rules for trading:

1. Buy what you know.
It seems like obvious advice, right? Stocks are priced perpetually by the prevailing consensus so your best chances to make money lie in companies -- or sectors -- that you feel you understand better than the masses.

One of the first stocks I ever bought was Amgen (Nasdaq: AMGN  ) back in the early 1990s. I cashed out a few weeks later. At a loss. Yes, I'm that guy who lost money on Amgen. Go figure. But what was I doing there? I didn't know my Neupogen from my Epogen. Biotechnology was just a word that oozed with glazed momentum. While I'm sure there were more than a few investors who felt they knew Enron well when it imploded, how many, to this day, still have no idea what the company did for a living?

2. Learn from your losses.
I've stumbled plenty on Wall Street's cracked pavement over the past dozen years. Thankfully, I have always learned more from my failures than my investing successes. It's natural to miss. It's healthy, too, as long as you learn from the burn.

Don't just take a loss and shrug it off. Be your own portfolio detective. What were your assumptions going in and why didn't they pan out? How did the stock stumble and could you have seen it coming? More importantly, would you recognize the pattern if it happened again?

3. Avoid stop orders.
Earlier this month, someone asked me about Netflix (Nasdaq: NFLX  ) . The stock has had a spectacular run since I profiled the company last year in TMF Select (now Motley Fool Hidden Gems). This guy had gone along for the ride but got nervous once the stock closed just over $40 a share. He decided to put a stop-loss order at $40 to lock in his gains.

Now, I'm not in the business of handing out personalized advice, but I did explain the Fool's policy on stop orders. A volatile stock -- and clearly most stocks that have you chewing your fingers to the bone to the point of considering stop-loss or stop-limit orders will fall into this category -- will fluctuate. If you want to sell, go ahead and sell. Setting a stop a few ticks lower is only asking to cheat you out of what could have been your ultimate reward.

4. Yield to the yield signs.
One of the most dangerous things about these rock-bottom rates is that income investors who are disgusted with the ankle-high interest rates being paid on their CDs and savings accounts are flowing into higher-yielding stocks.

There is big money to be made in income-producing investments. Our new Income Investor newsletter will hopefully bear that out over the next few issues. But for those who are just buying into companies that are providing generous payouts for the sake of the dividend alone, come on now. Don't skimp over the fundamentals. Companies such as Schering-Plough (NYSE: SGP  ) and Kodak (NYSE: EK  ) have recently shaved their payouts because their dividends were making promises that their companies couldn't keep.

5. Respect your investing horizon.
If I were to pose two scenarios, one in which a conservative investor buys a risky stock or one where a risky investor buys a conservative stock, which is more problematic? The former, of course, and that's why it's important for those with a short-term investing horizon to recognize that risks are magnified when the investing window is narrowed.

No, I'm not suggesting that every stock you buy be a lifer. However, if you are investing money that you need in a few months, do recognize the downside. In the market, patience is a virtue while an egg timer is a disaster waiting to happen.

6. Lean on free.
While you may eventually find yourself paying for quality high-end research, there is no shame in devouring the plethora of free primers out there. You didn't pay for this article, right? If you did, I'm sorry, go back to that man hanging out at the corner peddling Fool.com articles out of his trench coat and ask for your money back. By the same token, you won't find a tollbooth on the way to our excellent Investing Basics area.

There may come a time when you will want to pay for quality research over wasting your time on following up on penny stock spam, Excellent. Until then, treat yourself.

7. Know your broker.
How well do you know your broker? No, I'm not asking in the social sense. I've been trading online since Schwab (NYSE: SCH  ) set up shop on the ancient GEnie online service and I have gone months, if not years, without carrying on a conversation with my discount broker. But I have switched brokers as my needs have changed and through better understanding of which brokerage house will meet those needs the best.

Don't just settle for what appears to be the cheapest commission or the company with the nearest branch. Compare all the costs and variables. Our Broker Center has a great comparison table so you can see how your broker stacks up against the competition.

8. To be continued.
What? You really thought there were only eight simple rules for trading? No. They keep going and going. Accept that. Evolve. Follow the bouncing asterisks. Learning? It's forever.

Rick Aristotle Munarriz has never seen a complete episode of 8 Simple Rules for Dating My Teenage Daughter, but he misses John Ritter already. He happens to own shares in Netflix. Rick'sstock holdingscan be viewed online, as can the Fool'sdisclosure policy.


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