Top 11 Trading Lessons
With the last big week of earnings season ahead and plenty of news expected, not to mention the many other things weighing on investors minds, next week promises plenty of volatility. For stock traders, this is actually a great setup and gives them opportunities to make more money than possible in a market that has little to no volatility. So while volatility can be nerve racking for a long term investor, for a trader it's a opportunity to profit. Of course, it's also an opportunity to lose money if you don't know what you are doing.
Trading stocks is really about taking calculated risks and managing your risk. I wanted to use this post to talk about some lessons I have learned over the past few years trading stocks and options that I think might be helpful to some newer traders. These lessons have been painful and costly, but I feel like they have been very valuable and have made me a better investor. I'm generally a pretty risk averse investor, so my approach to trading stocks and options, while certainly aggressive, has a definite tilt toward my inherent conservatism. This approach may not work for everyone and as usual, I'm not recommending any particular approach - you'll have to figure out what works for you.
Here's a rundown of my top 11 trading lessons learned:
Portfolio Size - Keep trading portfolio allocation modest relative to overall portfolio size (Financial Fortress) - It's important that when you are trading, you want to make sure you isolate the money you are using from other life savings and asset "buckets" to insulate yourself from trading losses, should your risk management strategies fail
Position Size - Keep individual position sizes small relative to your trading portfolio - 2-3% for individual options positions and 10-12% for stock positions
Company Size - Stick with the large cap stocks - the markets for these stocks are generally more liquid than smaller cap names and bid/ask spreads are generally tighter which means it's easier to buy and sell positions and to get better pricing; also if you do suffer a temporary setback in a particular trade, you can always hold the stock until it recovers especially if the long-term trend has been positive (this does require some patience, of course)
Margin - Don't use excessive leverage - if using margin, keep the percentage low to avoid triggering a margin call in the event your portfolio value drops (I like to target 30% or less since most brokers will let you margin at most 70% depending on the stocks in your portfolio); when trading options, always use cash
Earnings Season - Unless you are "long" in the stock or option or are selling covered calls (to capture the elevated premium and you don't mind continuing to own the stock post-earnings), avoid earnings week trading of calls and puts (especially the ones that expire that week or the week after) - that's basically gambling and while you can make 10x sometimes, you can lose everything and in my experience, that's what happens most of the time - the sellers of those calls and puts are banking on it
Risk Management - Remember that options trading is a zero sum game - there is one winner and one loser in every trade - try not to be the loser by focusing on risk management
Risk Management II - Understand your break-even point for each trade and the maximum loss you are willing to take - sell when you hit that point to keep your losses small (remember that with options, the price goes to zero at expiration if they are "out of the money," so selling early for a loss may be better than waiting for a miracle)
Risk Management III - If a trade is not working, close it out - don't wait and hope for a rebound, your money can be better deployed somewhere else
Don't Sell too Soon - If a trade is working, let it continue to work and set a reasonable profit target to exit
Trades that Work - My favorite trades that have most consistently worked: selling covered calls on "household name" stocks (I found a great free webinar on Barchart here that you might be interested in that does a good job of explaining this strategy), and also buying long-term call options (3-6 months out) and taking small profits along the way - 10% to 30%
Trades that Don't Work - My least favorite trades that have not worked: selling short term put and call credit spreads - these are difficult to risk manage if the stock moves in the wrong direction, since there's not much time to recover and they are costly to exit and mitigate losses; to make money on these trades, you have to be right about 80% of the time, which is not easy to do; longer term put credit spreads can work, but generally the further out they are, the lower the premium relative to the risk of loss you take, which is not appealing
The Financial Fortress approach would ensure that you are broadly diversified across asset classes and your stock trading portfolio should not be a large component of your overall financial picture, so even if you suffered heavy losses (which shouldn't happen if you are managing risk appropriately), the impact to your net worth should be minimal. The diversification in your stock trading portfolio need not include other asset classes like bonds or real estate, unless you don't have exposure to those areas in other parts of your Financial Fortress. I'm not recommending any particular stock or strategy. Stay safe, healthy and positive.
I hope you find this post useful as you chart your personal financial course and Build a Financial Fortress in 2020.
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