Trading Tenets

My Philosophy of Trading

Traders at their desks
Traders at their desks. Tetra Images/Getty Images

There is no guarantee that you will earn money as a trader. Just believing that simplistic rule is the first step towards finding success in the trading world. Why? Because those who appreciate the truth of the statement know that much hard work is ahead of them. They also understand that becoming a consistently profitable trader is a task that is difficult to accomplish. But it is far from impossible.

Those who expect to earn lots of cash without much effort must depend on 'good luck' for success.

When you, as a trader, have a winning mindset and understand reality, then your chances of coming out as a winner are significantly higher than if you just take tips from other people or follow advice from a newsletter.

I began trading options in 1975 (and as a professional, beginning in 1977). I have leaned many lessons. Based on that experience, today's post contains nuggets of information that I want to share because I believe that every trader can benefit from being aware of these ideas -- even those of you who may not agree with all. I offer them with the hope that they will help you make more money over the longer term -- and more importantly -- save you from self-destruction during the beginning phases of your career.

 

  1. Always know how much money is at risk for every position in your portfolio. Consider the worst possible scenario and be certain that any potential loss is never more than you can afford to lose. This is especially true for anyone who sells naked options or buys and holds individual stocks, ETFs, or mutual funds. 
  1. Hope is not a strategy. Prayer will not help. Protecting your assets trquires careful risk management. 
     
  2. Compare the potential reward and loss for each trade. Be certain that seeking that reward is worth the risk. For each trade, establish a profit target AND know the maximum sum that you are willing to lose. Remember, it is possible to lose more money than your plan specifies because there are times when nothing can be done to hedge risk -- for example when the markets gap higher or lower. Thus, know your financial liability if the worst possible scenario occurs. As a compliment to that rule, have the discipline to get out of any position when your profit or loss target is met.
     
  1. When you are short an option, or when you sold an option spread, allow someone else to collect the last few pennies by covering the short position -- before expiration -- at a low price.
     
  2. Define your comfort zone. Do not blindly accept the risk tolerance of another trader. A trade may be suitable for someone else, but that does not mean that it is suitable for you. Trade within your comfort zone -- especially as a new trader. Later, you will probably (slowly) expand that zone.
     
  3. Greed is not good.
     
  4. Confidence is necessary for success. Fully understanding what you are doing leads to confidence. However, overconfidence may result in blowing up your account.
     
  5. Always know how much money is at risk. (Worth repeating). This applies to when you initiate the trade as well as to every day that you continue to hold the position.
     
  6. Unlikely events do occur. Do not seek tiny rewards, despite the high probability of success, unless the worst case scenario results is a small loss. Translation: Do not sell far-out-of-the-money options @ $0.05 to $0.15 with the belief that they will always expire worthless. If you ignore this piece of advice, every once in awhile, something bad will happen. That is how careless traders go broke.
     
  1. Examine positions every day and decide whether they are worth owning at current market value. This has nothing to do with whether the position is currently underwater or profitable. The trade should pass the simple test: Do you want to own this position today?
     
  2. All trades involve risk. Any profit that you already earned represents your money. It is not "house money." Please be as careful with that money as with any other money. Translation: Do not take extra risk just because you currently have an unrealized profit on any given trade.
     
  3. Understand that a loss does not have to be locked in (position closed) for the trader to know that he/she has lost money. When the market goes against your position, money has been lost. Sure, you have an opportunity to earn money going forward (i.e., recovering the loss), but make no mistake. Money already has been lost when a trade is underwater and there is no reason why that loss cannot increase further. Do not hold onto a bad position seeking to get back to even.
     
  1. My number one tenet: Risk management is the key to every trader's success. It is so easy to fall into the trap of believing that you have become an expert after a series of profitable trades. It is easy to believe that the market will behave as you predict that it will. Trust me: It is important to remain vigilant and never complacent. If you take some unnecessary losses while protecting your assets, that is not a bad thing because you will survive and prosper over the long term.

    Choosing a reasonable (for your experience, skill, and comfort zone) position size is the single most important factor governing how much risk you are taking as a trader. But do not forget that  the ongoing risk of every position changes as time passes and the market moves. Be ready and willing (i.e., be disciplined) to modify positions -- as needed -- to prevent losing a significant sum. Manage each position as well as the entire portfolio. 

I wish you good trading!