Here is the essence of successful trading … reduced to a simple 1, 2, 3 strategy.
- Only trade liquid instruments
- Use a trading system
- Make it automatic
The above is deceptively simple, but may not be ‘easy’ to practice. Let’s examine why, and allow me to give you the rationale behind the above statements.
First, let’s deal with a few ‘truths’ …
- The only reason an investor/trader is in the market is (or should be) ‘to make money’. If this is not the case for you, then investing & trading can be a very expensive hobby!
- The biggest hurdle against one making money is generally oneself! ‘You are your biggest enemy ’ is a phrase I read and heard more times than I care to remember. Now, I know this may come as a surprise to many, especially the uninitiated, who would contend that big institutions or market makers are out to ‘get the little guy’. The simple truth is that the harm we inflict on our portfolios far exceeds any possible damage big institutions or market makers could do to us. Here’s the reason why – We are, at our core, emotional beings – driven by GREED, FEAR and EGO. We tend to get emotionally attached to our investments/trades, and, when they do well, we either ‘root for them to do better’ (We get greedy), or, if we’ve suffered many losses and then ‘win’, we can’t believe we have a winning trade, we see too quickly (we get fearful). Conversely, when our trades don’t do well, we ‘bury our head in the sand’, and pretend that it isn’t happening, and hold on to losing trades longer than we should (We cannot accept that we were wrong – it would damage our ego).
- Most newbies wander into the stock market without a (trading) plan! They buy something and hope it works out well – as an instructor in one of my classes stated ‘Hopium can be very addicting’! Be warned – if you fail to plan, you plan to fail!
Enough of the ‘Doom and gloom’, fortunately there is a solution, and it’s easy as 1, 2, 3 listed above!
My goal is to empower you in your trading, so I’m going to explain the rationale of my trading strategy. This time, I will begin with no. 3 first, and then work my way up.
‘3. Make it automatic’ – Here’s how and why …
- How: Currently, virtually all online brokers have trading platforms that allow you to place ‘GTC’ (good till cancelled) orders and ‘Limit’ orders. If you are not currently using them, or not trading online, you should seriously consider both. An online search query for ‘Best online brokerage firms’ will give you many reviews to different brokers to compare.
- Why: Using GTC and Limit orders essentially removes one’s emotions from driving trading decisions – it allows you to sit and ponder when the stock market is closed about your trading plan, where to ‘take a profit’, and where to ‘take a loss’. Once placed, the orders stay in effect until either the market triggers them, you modify them (preferably not during the trading day), or they expire at their scheduled expiration date.
Once I appreciated the power of such automatic trading, I have often wondered how I/we survived without it. Of course, the technology just wasn’t there earlier to make this happen. One of the successful traders I know stated that he only routinely checks on his portfolio twice a week at scheduled times when the market is closed, and modifies his orders to ‘take him into the market’ and ‘out of the market’ depending on what Mr. Market does. If one desires it, the current technology can send you alerts via email, pager or text to inform you of completed trades, whereupon you may access your system to place other GTC/Limit orders to be carried out when Mr. Market deigns to favor you.
‘2. Use a trading system’ – Here’s why and which one(s) you should consider …
- Why: The most important reason for using a trading system is that it helps control your emotions while you trade – as opposed to picking stocks at random, or based on what is mentioned on TV or by the current market guru, you can make an informed decision of which stocks/options to buy, when to buy, when to hold (despite apparent downturns in the market), and when to sell (despite apparent euphoria in the market).
- Which one(s) to consider: Now, I know some of you would wish me to name ‘THE’ trading system – one that is fool-proof that will always work to generate profits quickly. Unfortunately, I cannot fulfill such a wish or request. In my opinion, there is no ‘one size fits all’ answer to this question – the right trading strategy for one person may not be the right one for another – the right trading strategy for you is one that you UNDERSTAND, and have tested for yourself sufficiently to believe that it works, and will work in the long run. All trading systems will have losing trades, sometimes more than one in a row, and for the system to work; you have to believe in it sufficiently to stick with it through the losing trades to be able to reap the rewards of the winning trades. Here are some criteria that I recommend you look for to find a system that might work for you – you may have to test more than one to find the right one for you, but time and money spent initially will be well worth the frustration and money lost later if you do not do your due diligence up front.
- ‘Understandability’: Find a system that you understand the explanation of how the system works, as opposed to a system whereby you merely follow buy/sell recommendations from a newsletter.
- ‘Testability’: Find a system that stands the test of ‘back-testing’. Although past performance is not a guarantee of future profits, if a system cannot perform well in the past, it is doubtful that it will perform well in the future.
‘Individual’ vs. ‘Hosted’: Decide whether you wish to design a trading system yourself (this is hard to do well) or wish to adopt one created by someone else. At least initially, it might be preferable to follow someone else’s system and back-test it for yourself to make sure you understand it. Later, you can modify it to suit your needs, or begin experimenting with creating your own system. When picking a hosted group to follow, find one that has sufficient support with training, whether written (books or web pages) or videos (DVDs or online links) that explain the system sufficiently for you to understand it. It helps to have ‘live’ support people who can respond to you by phone or email and answer questions you might have. Some such groups have online user groups, and some even have local groups who meet every few weeks to discuss their strategies, celebrate and share their wins and look for counsel for their problems with losing trades. I have listed some such trading systems to consider on another webpage (See ‘Trading Systems’)
‘1. Only trade liquid instruments – Here’s why …
Why: Liquid instruments have ‘tighter’ bid-ask spreads.
One of the most universal reasons (though oft ignored) that traders lose money is at the bid-ask spread, and the key to making money is not losing money! This may seem obvious, but is an essential concept.
Warren Buffet is often quoted as having said that there are only two rules to making money in the markets –
“ 1. Never lose money, and
2. Never forget Rule No.1”
In brief, the bid-ask spread is the difference between what we buy an instrument (stock, future, etc) at, and can sell it at if we decide that we immediately want to do so. The wider the bid-ask spread the more we lose immediately when we buy anything. Explained another way, the bid-ask spread represents the minimum we must make (the instrument must gain) for us to ‘break even’ (get our money back).
The more liquid the instrument, the ‘tighter’ the bid-ask spread – and, the less we lose immediately.
See ‘Why Liquidity is Important‘ for a more detailed explanation, and to learn how to find stocks with highly liquid options.
Another universal reason traders lose money is in commissions (although this is becoming less of an issue with discount and online brokers nowadays with commissions at less than a $1/per contract). Losses in commissions are invariably is a result of overtrading – which is a strong argument for having a trading plan and making it automatic.