RULES OF THE GAME
This article was one of my very first blog posts (published September 3, 2015) and it needs revising for sure. I will be working on it off and on over the coming months so check back for updates!
There are a few fundamental rules of trading that I believe every beginner should know. It has taken me a long time to really understand and accept a few of these and it takes even longer to become disciplined enough to live by them. The act of trading stocks and options is easy. The act of controlling yourself and your emotions in the heat of battle is something else.
The objective of this article is to set the foundation for the beginner. To provide a concise, detailed, and definitive explanation of what you should and should not do when learning how to trade. How do I know these things? Experience. I am no master. I have simply survived and learned along the way. So let’s get started…
RULE # 1: EDUCATION
People ask me all the time how much it costs to trade? How much is required to make “x” amount per month? I will get into that in another article, but I can tell you the “cost” of my education is upwards of $70,000.00. This is how much I lost in the very beginning (over a six month period) having no real idea of what I was doing.
As it often goes with me, I was successful out of the gate. My “gut” has always been absolutely spectacular with most things in life. It’s a gift I suppose, but listening to my gut is the hard part. I am often successful initially in everything, but as my “gut” gets pushed aside by greed, ambition, pure adrenaline or a host of other things I begin to lose it. At least, as I approach 40 (quickly) I can now recognize this problem and try to manage it.
The bottom line is: I think too much. In the beginning I don’t know enough about something to over think it so I’m really good at it flying mostly by the seat of my pants. The more I learn the worse I get because I start calculating variables. Bad idea.
Much like any education worth having you must spend big bucks to obtain it. I consider the $70,000.00 I have lost the cost of my education. I am now MUCH wiser, much more aware of how Wall Street works and I understand a great deal of things I never even thought about just a couple of years ago. I learn by doing. Some learn by reading. The most important thing is that you learn everything you can before you dive off into the market.
I strongly recommend the thinkorswim platform for learning how to trade with paper money. Do NOT think that trading the real market with fake money is stupid or a waste of time. Trust me, it’s THE most important thing you can do.
RULE # 2: LOOK IN THE MIRROR
The problem is not the market. The problem is not the volatility. The problem is not the uncertainty. The problem is YOU. The faster you come to accept this fact, the faster you will make money. This is a game yes. It can be unfair and not make logical sense. It can be stupid and fascinating at the same time. It is what it is so stop bitching about it.
Your ability to trade successfully is completely centered around your ability to control yourself, your emotions and, most importantly, your FEAR. If you are scared to death all the time to lose money you need to close your web browser right now and go mow grass (that’s really a joke I love to mow grass – actually I’m a hellofa trimmer I let Hillary mow).
If you do not have the means to fund your trading education and make mistakes quit now. If you are not a risk taker and have a tendency to panic quit now. Your greatest enemy will not be a sudden downgrade of Starbucks or some software scandal with Volkswagen. Your greatest enemy will be how you handle said events and whether or not you can sleep at night knowing you’re down $40,000.00 at the closing bell, but come tomorrow morning everything may be just fine. This happens all the time and you need to be able to sleep.
Look in the mirror and have a long talk with yourself and if you’re married talk to your spouse as well. This game affects everyone in your life, not just you.
RULE # 3: MONEY TO BURN
This rule is pretty straightforward. If you plan to take risks with your money and day trade or trade options you need to use only money you would literally set on fire.
This rule is no joke and should not be taken lightly. You never use your rent to trade. You do not pass on buying pencils and bread for your children to save money to trade. I have heard horror stories of people losing large (very large) sums of their retirement trying to trade the market.
Let’s get something clear: you (and me for that matter) are not a professional trader. You would be considered an amateur or retail investor. You are an outsider, a sucker, at a disadvantage to the rest of the investment world and when it comes down to it you really have no clue and never will of what is really going on in the background. That’s the game for those of us who do not work on Wall Street.
There is an extremely high probability you will lose every dime you initially inject into your trading account. In fact, I would recommend you lose it all playing around and doing things you would never normally do. It’s how I learned. I was a rookie and buying 1000’s of option contracts at a time. I made $42,000.00 in a single day with only $100,000.00 in my account. Don’t you think I was hooked then? The adrenaline pumping? You bet your ass. Then I lost every dime of that $42,000.00 in a single day because I was foolish and kept pushing. This leads me to the next rule…
RULE # 4: KNOW WHEN TO FOLD’EM
One of the most important things I’ve learned is how to exit a position. Seriously, my biggest problem was greed. I’ll admit it. You think you’re any different? The first time you’re up $12,000.00 on an option trade within a few hours of execution let’s see how you react. Would you sell it immediately? Of course you would…or so you think.
Greed is the most powerful emotion we humans must deal with. It is all consuming and it has brought down empires, destroyed continents and put many, many people on the street (homeless, not Wall Street). Greed kills and you will experience it first hand. Prepare yourself.
One of the first books I read discussed in great detail the importance of having a plan. To know before you ever make the trade what you’re willing to accept. What price do you want in and what price do you want out. This is crucial.
I ignored it, of course, as you will, but having a plan and knowing in advance what percentage gain you are willing to accept and exit is so very important. In the heat of the moment, you will not be thinking rationally. This is the part the books forget to tell you and why I started this blog. To tell you the truth with real world experience.
Emotion kicks in, adrenaline flows and in the moment you will be incapable of making the correct decision. Trust me. The best thing you can do is set an auto-limit order where you believe the stock or option is heading and let it ride.
I am an instinct trader. I happen to be very good at instinctively knowing what will probably happen one way or another. It took, literally, years for me to realize that I was right more time than not and to just listen to my gut. If I thought a Starbucks option was going to $1.00 I now set my limit-order at $1.00 and come hell or high water I will not adjust. I run about 80% right, but trusting yourself is difficult. How did I learn? I started writing down where I believed the option was headed upon execution of a trade. I then let it play out and typically sold it too soon against my own advice. I would then watch it hit the number I wrote down time and time again.
Have a plan. Know when to get in and when you want to get out. In other words, know when to hold’em and know when to fold’em.
RULE # 5: CUT YOUR LOSSES
This rule is related to # 4, but I’m making it a separate rule. Why? Because it’s my blog asshole! No really, because it’s that important.
Sometimes you will simply be wrong. I know, it sucks and can be hard to accept, but it’s true nonetheless. Sometimes you must sell a losing position and live to fight another day. I typically do this when I’ve been fighting a trade for a few days and it just hasn’t performed the way I expected it would. It will take some time to learn how to “see” this phenomenon.
One of the hardest things I had to learn was the “reset” procedure as I call it. There comes a moment when it’s best to just liquidate all positions and “reset”. Calm down. Take the stress off – go completely into cash and relax.
Cut your losses and start over. It’s ok to do this and you should not feel like a failure. It happens to the best of us and looking back there were moments when I really needed to step away. Dump it all to cash and go for a run…or have a stiff drink.
RULE # 6: IT TAKES MONEY TO MAKE MONEY
You need capital my friend. I promise you this: it is much more difficult to make money (good money) with $10,000.00 than it is with $100.000.00. Sounds obvious, but the reasons aren’t so much.
First, you need enough money to always keep at least 20% in cash no matter what and yet have enough to make a difference. Make a difference? What does this mean? It means when you’ve got $30,000.00 worth of Starbucks CALL options and Starbucks stock takes a nose dive for no apparent reason you need to be able to double-down not bail or panic.
Second, you need enough money so that making 10% on a trade warrants the time and effort involved in making that 10%. Let’s say you buy a CALL option on Starbucks after watching it for weeks. You know that sucker backwards and forwards. You know what it’s worth and where it has been and where it is going. You are the man! You buy it with $1000.00 and you’re right!! Yay! You just made 54% gain on that trade (this happened to me last week actually it’s why I’m using it as an example). That’s great and all, but that’s only $540.00 profit before commissions. Now, had you bought $100,000.00 worth of that option you would have made $54,000.00! A single trade makes enough money for most people to live on for an entire year. This game and the stress involved is simply not worth it unless you have the money to play.
Third, and most importantly, you need enough money to buy your way out of a problem. This happens a lot. It’s a fact of being a trader. You’re going to screw up and buy something too soon or too late. Let’s say you bought that same Starbucks CALL option a hair too soon and paid .90 cents per contract. Starbucks underlying stock falls and that CALL option is now trading at .75 cents per contract. Now let’s say a few days go by…you know what? Starbucks underlying stock must go higher than it was when you first purchased that option for .90 cents per contract for that option return to .90 cents per contract. In other words, if Starbucks was trading at $60.00 per share when you paid .90 cents and the stock went down and the option decreased to .75 cents for a few days then the underlying stock would have to move above $60.00 per share to get back to where you started. Why? Time decay for one, but that’s for another article. This is a simple explanation to a very complicated event so don’t email me with all the bullshit about implied volatility and what might or might not happen.
You must have enough money to buy your way down. You purchase some at .90 cents and when Starbucks drops and the option hits .75 cents you buy more. Don’t panic. Don’t bail. You believed in the option (and yourself) enough at .90 why not at .75? See, emotional control is important.
By buying down, you’re lowering your cost basis and Starbucks underlying stock price doesn’t have to move up as high for you to break even or even exit profitable. The closer you can get your cost basis to the current trading price of that option the more likely you can get out even or profitable. The slightest bounce up and you can bail.
RULE # 7: GOOD COMPANIES MAKE GOOD STOCKS
Again, common sense. You are much less likely to lose money if you stick with good companies (at least initially). I’m not saying you can never speculate, but wait until you’re using the houses money to do it.
Ford, for example, is a good company and a slow mover. If you’re a seller of options this is a good one to get your feet wet. Starbucks loves to move and typically in an upward direction. If you’re a buyer of call options Starbucks is a good one to play with. Netflix loves to get hammered. If you’re a shorter or buyer of put’s start here. Nordic American Tanker is a good company, good CEO and good stock to own. It is also a slow mover (lately) so if you want to play with selling cash-secured put’s this is a good choice. If you’re assigned no worries…it’s a good company with an excellent dividend.
As long as you stick with good companies you will rarely lose money. When people lose money on good companies, typically, the entire market is getting hammered. So many bail at this point guaranteeing their lose. Never do this. If you have a losing position in a good company just double-down. You’ll be glad you did. Ask anybody who owned Home Depot, AT&T, Verizon, GE, Alcoa at the end of 2015…the list goes on and on.
All of these companies were in the toilet and so many panicked. Looking back is easy, being the moment is hard so I understand, but had you simply doubled-down you would be quite wealthy right now.
RULE # 8: THE HOUSES MONEY
Upon making your first real money – liquidate everything into cash. Why? Because you’ve just done it. You’ve made $20,000.00 on a trade and you’re feeling confident. Stop! Liquidate everything and reset. Now, trade only with the $20,000.00 you just made. No excuses. No arguing. Just do it.
By trading only with your gain, you are now trading with the houses money. You have zero risk. The pressure is off, there is no stress and you are free to screw up as much as you want. This is typically when people start really making money because they’re no longer worried and scared. They’re no longer proving to themselves or their spouse they can trade.
Did I do this? No. That’s why I’m making it a rule. My first real gain was on a Ford call option. I remember it like it was yesterday. I was up 102% on a Ford call option – yeah, Ford! Ford never moves enough to make 102% gain, but it did that day. I was a rookie and had no idea how rare that really was. Did I sell it? No. Greed took over and I late lost it all the next day. I could have sold, liquidated everything, been up 20k and started only trading with the houses money. Looking back, I was a fool and let the emotion of the moment control my actions.
RULE # 9: BUY IN SMALL INCREMENTS
Whether you’re buying stocks or option contracts start slow. Even when you know what you’re doing and have the money start slow. Don’t worry about the commissions of multiple trades. If you’re right, those commissions will be meaningless.
Let’s say your budget is $30,000.00 and you want to trade (not invest there is a distinct difference) Netflix. You’re all excited, your heart is pumping and you can smell the money already. What a glorious day!! Netflix dips to $100 a share and you blow your entire $30,000.00 budget on 300 shares. Whooo! That felt good right? Who else can say they blew 30 g’s this morning…so you sit back, sip your coffee and BOOM! Netlfix is now trading at $96.18. You spit your coffee up, sweat pouring down your neck, what do you do? Will you be divorced before the end of the day??
With the above scenario yes, you will be divorced if Netflix never hits $100.00 per share again. You were too eager and too excited about the potential gains and jumped in too quickly. All you can do now is wait, pray and try to save yourself (and your marriage).
What you should have done is easier, less stressful and will keep your marriage together longer. Upon Netflix hitting $100.00 per share you purchase 100 shares for a total transaction of $10,000.00. I’m using round numbers to keep the math simple. However, if you need math to be simple I would turn off your computer now and go mow grass (there’s mowing grass again). I digress.
So you just purchased 100 shares for 10k and Netflix dips to the aforementioned $96.18 what do you do? Scoop that sucker up with another 100 shares. Now, not only do you have 200 shares, but you’ve paid less overall for those 200 shares as you would have had you just bought 200 @ $100.00 per share. What does this mean? It means your cost basis is now lower than the initial $100.00 per share. It would probably be in the $98.00 range. Your cost basis is your break even point. Netflix will need to go back up to $98.00 for you to get out unscathed.
Netflix is very volatile so it makes for a good scenario. As the day progresses and things change another dip occurs and Netflix is now trading at $91.60 per share. What do you do? You guessed it. Scoop that sucker up! You have to be willing to take a risk with this game. You cannot get scared and panic. I once heard Jim Cramer say that it takes great discipline to continue buying into a stock that is falling. Yes, yes it does. So you just scooped up another 100 shares @ $91.60. Now you have 300 shares with an average price per share of around $95.93 and you’ve only used $28,778.00 of your kids college fund. Sweet! Hopefully you can buy him or her a car with the difference. Maybe a used Honda. They’ll be fine.
Here comes the fun part! The next day or evening (if you’re trading after hours) Netflix explodes! What’s going on?? Earnings report? New contract with Disney? Apple finally blows up leaving only a smoldering pile that once was Apple TV? Who knows and who cares it’s just going up! This is the moment in which you must make a decision. Do you hang on to it, turning it into an “investment”…I get nauseated at even the idea! Do you sell it and, if so, at what price? Think – quickly! If you are adhering to the rules you would already know at what price you want to exit – duh!
You decide to sell at $105.00 per share clearing a reasonable $2,692.00 profit after commissions. Using the first scenario you would have only profited $1,470.00 and lucky for you, your marriage and the college fund it actually came back up. Now go buy that used Honda with your profit and call it a day.
In the real world, you could have sold everything at $96.00 per share and broke even. If you had spent your entire $30,000.00 @ $100.00 per share you would require $100.00 per share to break even.
RULE # 10: NEVER VIOLATE YOUR COST BASIS
This is also incredibly important. I would go so far as to say it is just as important as number one. Once you decide to pull that trigger you either buy the amount you really want if the dip is strong or you wait. You rarely chase a stock or option. I say rarely because there are moments when you can get away with it, but they’re indeed rare and not for the rookie. Chasing will bite you more often than any other trading mistake.
You will get excited I understand. Stocks can jump 4% and 8% in a few hours and your first thought is how you’re missing the ride. Options can jump 100% and you will think man if only I had bought it yesterday, maybe if I…STOP! DO NOT DO THIS. You’ll be screaming later I promise after you down that bottle of Grey Goose.
Going back to our original example: upon your initial purchase of Netflix at $100.00 per share you will have just created your CB or Cost Basis. CB is often used in stock forums and online to look cool so be sure to used proper acronyms and jargon. It’s important you look cool at all times. The cost basis has been set and you continue to monitor the days trading.
Netflix eases up to $100.68 on heavy trading and you hear they’re releasing the new Star Wars before it arrives in theaters. You are tempted to buy more. DO NOT DO THIS. Well, ok maybe if they’re releasing the new Star Wars before it goes to theaters. That was bad example. You may violate cost basis only if there has been some unexpected and life altering (company altering) event. Otherwise, you hold your ground soldier!
That same day Netflix falls below your $100 initial purchase price (Cost Basis) to $98.76…if you want more now is the time to buy. You are below your cost basis so you can feel good about pulling the trigger. Your cost basis or average purchase price per share has now lowered to the difference between $98.76 and $100. This formula is actually somewhat complicated and there are many good calculators on the web to determine the new cost basis after purchasing more shares at a given number / pps (price per share).
RULE # 11: PATIENCE
This should probably be number one, but regardless this game takes patience and a lot of it.
There are days that will be naturally down. They will start down and stay that way. I call these “buy days”. When things crash I start buying. There are days that will be naturally up as well. They will start up and keep going sometimes for what seems to be no reason whatsoever. These are, you guessed it, sell days.
Waiting for each type of day takes patience. They will come no matter what. The market will not continue in one direction (up or down) forever.
You wait for the days that go down to buy the stocks you love on the cheap or sell cash-secured put options. Stocks you never thought would be cheap again.
I’ll give you a “real world” example: I love Starbucks (SBUX). I frequent Starbucks almost everyday and believe the stock is one to own, not trade. However, I do trade it. I purchased 500 shares at $55.75 before last quarter earnings and sold at $58. I was happy and when it went to $59.32 I felt sure it was headed straight past $60 as so many predicted. I felt bad and figured I would never see it again around $54-$55 and almost took it off my list. Then the big crash came and it fell all the way to $42.00 per share. I’m not sure if anyone scooped that sucker up at that price, but I did see it there for a second. I was lucky enough to grab it again at $49.51 and rode it all the way to $56 with 1000 shares making a nice profit. I told several people to purchase at $47.00, but I missed that number due to a funding problem that day and the fact all hell was breaking lose. Luckily my wire arrived just in time to catch $49.51. You try wiring money to an online brokerage the morning of the largest crash in history and see how well you do!
My point is: you wait. Be patient. Wait for the mornings you can wake up and see all RED. These are great days indeed. Do not think the day will never come when you can buy Ford (F) at $13.50 again. It will happen sooner than you think. Patience.
Funny, I wrote that last paragraph in September 2015 and boy was I right! Ford hit $11.02 during the holidays and the end of 2015 was a FIRE SALE for stocks. Another prime example why you always keep cash available.