10 ‘Prudent’ Rules of Thumb for Hobby-Traders

With the increasing prevalence of online stock brokerages such as TD Ameritrade, TradeKing and the like, come a slew of individuals known as hobby-traders.  Hobby-trading involves the part-time trading of stocks as a hobby for supplemental / consequential income.  It differs from day-trading in that day-traders trade stocks as a full-time career with the chief goal of earning a primary source of income.

Characteristically, hobby-traders research their stocks at night and place automatic buy/sell orders through their online stock brokerages.  This allows individuals to hobby-trade in addition to working their regular full-time job.  I’ve been hobby-trading for a little over a year now and have enjoyed it immensely! Last year, I earned close to an 80% return on the money I invested – not too shabby for a beginner exerting relatively little effort!

Of course, positive returns are not guaranteed and it is recommended that an individual have at least a moderate understanding of the stock market before dabbling in hobby-trading.  For those with little to no knowledge of the stock market, I would strongly recommend utilizing one of the many free resources available to help bring your level of market knowledge up to par before engaging in hobby-trading.  Most online brokerages offer free online trainings and courses for beginning, intermediate and advanced traders.

Regardless of your stock market knowledge level, I wanted to share a few simple prudent rules of thumb that I adhere to when hobby-trading.  Keep in mind that I still consider myself a beginner as far as hobby-trading goes.  As such, these rules of thumb are by no means meant to be the basis of your trading strategy; rather, they represent my experiences as my knowledge of investing in the stock market grows.  If you would like to add to the list, please feel free to post a comment with your own personal rules of thumb.

RULE 1:  ONLY HOBBY-TRADE WITH NON-ESSENTIAL FUNDS

The most important rule of thumb for hobby-traders is to only trade with non-essential funds, or those funds not required to cover monthly expenses or those expenses resulting from the occurrence of an unforeseen event (e.g. job loss).  The income from hobby-trading should be considered consequential income – or a mere consequence of your hobby.

Before becoming involved in hobby-trading, establish a savings account with enough cash to hold you over in the event an unforeseen expense were to arise.  The reason being is that your stock may drop in value after purchase, meaning you would take a financial loss if you had to liquidate it to cover unforeseen expenses.

RULE 2:  DON’T RUSH TO BUY

Don’t let your money burn a hole in your pocket!  You will find that when you start turning a profit as a result of your hobby-trading, you will experience a ‘high’.  You become excited and anxious to reinvest your money with the hopes of turning yet another profit.  Many investors will do so at their own peril.  Always stick to your rules of thumb for hobby-trading or you might end up purchasing an overvalued stock whose value will drop after purchase.  If this happens, you might find yourself having to hold the stock for an extended period of time just to break even!

RULE 3:  DON’T FORGET ABOUT TAXES

Keep in mind that brokerages generally do not withhold taxes on the gains you earn from hobby-trading.  That means you will be responsible for paying your capital gains taxes when you file your tax return for that year.  Make sure to set money aside in your hobby-trading account to cover any taxes you might owe.  What’s more, if you anticipate earning enough profit through your hobby-trading to lift you into a higher tax bracket, you may want to consult a tax professional before engaging in hobby-trading.  A tax professional should be able to provide you with tips and tricks to help minimize your tax burden.

RULE 4:  SHOOT FOR A HIGH VOLUME OF SMALL GAINS

This is more of a personal preference rather than a general rule of thumb.  I personally aim to make a 5%-10% profit on every stock I purchase.  It doesn’t take a whole lot for a stock to drop or jump 5%; therefore, I’m able to buy and sell stocks fairly rapidly.  Often, you will find that you can buy and sell the same stock several times in one day when you adhere to this strategy.  The converse of this strategy is to hold on to a stock for an extended period of time in an attempt to gain a large profit (e.g. 100%).  Both have their downsides, but it has been my experience that the greatest upside can be realized with the small gain/high volume strategy.

Of course, your adoption of a trading strategy should depend on your consideration of several factors, including the amount of the brokerage fee and the amount of the purchase.  In other words, if you are only investing $1,000, then aiming for a profit of 5% on each sale would only leave you with about $30 after you pay the average brokerage fee.  That is hardly worth the risk.  In the end, you must develop your own trading strategy to fit your particular risk tolerance, involvement level, desire for liquidity, and investment amount.

RULE 5:  AIM FOR CURRENT RATIOS GREATER THAN TWO

As I mentioned before, I am relatively risk averse.  As such, I set my stock screeners to pull companies with a lower default (bankruptcy) risk. One of the measures I use to gauge default risk is current ratio.  A current ratio measures a company’s ability to pay short-term obligations and is equal to a company’s current liabilities divided by current assets.  The ratio is mainly used to give an idea of the company’s ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory and receivables). The higher the ratio, the more capable the company is of paying its obligations. A ratio less than one suggests that the company would be unable to pay off its obligations in the event they came due.  Therefore, my rule of thumb is to invest in companies with a current ratio greater than two, meaning they can cover twice their current minimum obligations and still have funds remaining.

RULE 6:  AIM FOR COMPANIES WITH A MARKET CAPITALIZATION OF $50M OR GREATER

Market capitalization represents the total dollar market value of all company’s outstanding shares.  It is calculated by multiplying a publicly traded company’s outstanding shares by the current market price of one share.  The investment community uses this figure to determine a company’s size.  A market capitalization of $50M or greater is important to me because, for the most part, it infers that the company is relatively substantial and secure, and will likely be actively traded.

RULE 7:  BUY NEAR THE 3-MONTH LOW

When determining an ideal price at which to purchase a stock, I generally look at the stock chart for the previous 3-months and select a price near the lowest point.  Assuming the market is relatively stable (meaning not jumping or dropping 500 points a month), this is a good rule of thumb to abide by.  This is one of the factors I consider in picking many of my buy positions.

RULE 8:  EARNINGS PER SHARE (EPS) GREATER THAN ONE

Earnings per Share (EPS) serves as an indicator of a company’s profitability and is equal to (Net Income – Dividends on Preferred Shares) / Average Outstanding Shares. To illustrate, lets assume that a company has a net income of $25 million, from which it pays out $1 million in preferred dividends and has 10 million shares for half of the year and 15 million shares for the other half, the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from the net income to get $24 million, then a weighted average is taken to find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M). A little confusing, I know.  In addition to some of my other rules of thumb, I like to see an EPS greater than one.  This tells me that there is at least $1 in net income to cover each outstanding share.  Granted, if your stock price is $50/share, an EPS of 1 doesn’t mean a whole lot, but at least it means the company is in the positive relative to the number of shares it has outstanding.

RULE 9:  STAY ABREAST OF LATEST NEWS FOR YOUR STOCKS

One of the most detrimental things any trader can do is overlook relevant news articles, both for a particular stock and in general for the market or industry.  Thankfully, most online brokerages show recent articles for a particular stock when you pull up a quote.  You will have to keep an eye on financial news dispensaries (CNN, Yahoo) for general market and industry news.  It is up to you to review the news articles and consider how the value of the stock may be affected as a result.  The value of your stock may be affected either positively or negatively as a result of the story.

A personal example of when I was positively affected by a news article involved a purchase of shares in Energy Conversion Devices, Inc (ENER).  I read an article that had just posted seconds earlier stating that ENER had received an offer for purchase.  Generally, an offer for purchase of a company will result in the increase in price for shares in that company.  I purchased some shares, turned around and placed an automatic sale order for my 5% profit, and when the market opened the next morning, my automatic sale order took.  If only all transactions could happen that way!

RULE 10:  RE-EVALUATE YOUR BUY POSITION EVERY 2-WEEKS

As stated, I often use a stock’s 3-month low (and occasionally 1-month low) price to help me determine my buy position for that stock.  I will then mark my buy position in a spreadsheet next to the relevant stock symbol.  I keep an eye on the stock, waiting to see if it gets close to my buy position. Sometimes, a month will pass and the stocks price still hasn’t moved close to my buy position, in fact, it may have moved even higher. It is for this reason that you should re-evaluate your buy position every 2-weeks to ensure you don’t maintain unrealistic buy positions and subsequently miss out on potentially profitable opportunities

Stay tuned to the Prudent Penny blog as I’m going to implement a new blog series entitled “Prudent Stock Picks.” The series will offer readers a look at all the stocks I happen to be watching at a given time, as well as my buy positions! Of course, there are no guarantees that any of my “Prudent Stock Picks” will, in fact, turn out to be prudent. Only time will tell!

2 Comments for this entry

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  Charlotte Ulm

  February 12th, 2011 on 11:35 PM

  Found this very informative- not sure I would hobby trade as I find the process very time consuming if done with due diligence.
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  Nathan

  February 16th, 2011 on 3:00 PM

  umm, I will leave the trading up to you!