Think Like a Trader to Limit Your Risks and Pocket 28% Weekly Gains

When most “Main Street” investors think about traders, they envision people taking massive risks and churning their accounts constantly to eke out small gains over and over again. In reality, though, that mental image isn’t very accurate; for real world traders, minimizing risk is everything. Whether you’re a long term buy-and-hold investor or a short-term speculator, thinking like a trader can substantially limit your risks – and increase your potential portfolio gains this year.

When it comes to investing, people like to talk about the risk/reward ratio, the idea that the more risk you take on the greater the rewards you stand to reap. It’s a concept that plays out all over the industry: safer investments like bonds and CDs pay a lower return than riskier investments like stocks. Essentially, you’re being paid to take on the added risks of investments that aren’t a “sure thing.”

But the risks of even the most volatile investments can be limited by taking on the trader’s mentality…
One of the best ways to do that is by using a technical analysis concept called “resistance”. In short, resistance is a sort of price ceiling for shares of a given stock – it’s an area that shares have difficulty moving above.

Resistance may sound complicated in technical analysis parlance, but the guiding principles are easy enough to understand. Basically, areas of resistance are pockets of excess supply that exist for shares of a stock. Maybe it’s an area where investors see shares as “expensive” or a previous level where shares failed to move above, prompting current owners to attempt to unload shares. Either way, resistance is a price level where available shares outnumber buyers and put a halt to a stock’s move higher.

While there are a number of ways to spot key resistance levels, one of the most powerful is also the most obvious: look for past price levels where shares peaked.

By placing your mental target price just below resistance, you can often unload shares of a stock before buying starts to languish. A good example happened earlier this week in shares of US Oil Fund (NYSE: USO), an oil ETF that I recommended my Penny Momentum Trader readers unload on Monday.

We’d been shooting for a pre-planned trade as shares moved from one area of resistance to another. Here’s a graphical glimpse at how our trade panned out:

We bought shares of USO just above $39, as shares cleared a previous resistance level, and unloaded before $42, where they’ve since stalled. That $42 target price came from the previous highs that this ETF hit back in March and April 2010 – so it came as no surprise that the rally has fizzled out since we hit the “sell” button.

Ultimately, we ended up banking 27.5% gains on USO options within a single week. That’s a solid move given the limited risk and pre-set price target that we entered the trade under.

Obviously, putting resistance-based price targets to work isn’t something that’s easy to implement from the get-go. That said, with practice, careful analysis of the markets could have you pinning strong levels of resistance (and realistic price targets) in 2011. As anxious investors take their toll on the market this month, new and experienced investors alike are facing a challenging environment – that’s why there’s no time better to expand your trading toolbox…