Featured in this month’s Master Investor Magazine.
During my many talks over trading events, conferences and training sessions, I have always encountered the same question from people who are interested in dipping their toes into the markets or have just a couple of years of experience: what are the most basic and fundamental rules that one should follow when starting to get into trading and investing? Are there any very simple guidelines that will ensure that everyone and anyone has at least a fighting chance in this game or is it just for professionals?
And that’s exactly what I will do in this two-series guide, give everyone a shortcut to the lessons that I have learned through sweat and tears. So hopefully you won’t have to go through the same experiences to learn these rules the hard way. And trust me, this saves time and, equally importantly, money, lots of money.
Win more and win bigger
A trader should always focus on winning more times than he loses, and making sure that his winners make him more money than his losers cost him. This sounds too simple and stupid to focus on, right?
But at the end of the day that’s what trading is all about and that’s why it is called trading. You will make choices – effectively that’s what trades are – and some of them will go well and some of them will go wrong. The key here is to try to make more good decisions than bad ones and also make sure that when a trade goes your way you will get paid more than what you’d lose if it went badly.
And then repeat this simple plan again and again. After all, if you could achieve a small edge in both these factors do you really need anything else? Suppose that you win 55% of the time on your trades and you make 1% on your winners and lose 0.5% on your losers. Doesn’t sound too exciting, right? However a sustainable performance like that will make you infinite profits if repeated forever.
Just think how casinos – yes, casinos, stay with me here – make their money: they have the odds stacked in their favour far less than 55% – most times only about 0.5% or 1% – and they just pay winners an equal amount to what they get from losers.
However, they simply repeat this process for an infinite amount of times because they know that this way they will make an infinite amount of money. That’s an easy rule to follow and it keeps the focus on the bigger picture – every single trade is just another choice, another step along the way.
Never fight the market, the market always wins
It makes no sense trying to go against a multi-trillion dollar market because you’re angry or “you know better”, the market will wipe you out. Understand when you’re wrong on a trade and get out as soon as your stops are hit, never move them or add to a losing trade.
What that means comes down to two lessons: first, that you should not get stuck to a losing trade more time than what’s needed to find out that your initial idea was wrong; and secondly, that trading is a game or a business where ego has no place.
What is really important to understand is that each trade is essentially a bet, an attempt to get a feeling of where the market is heading. And as such there are levels and indications that pretty much confirm the market’s intentions for the time being, so if your trade is towards the opposite direction, simply get out of it.
Don’t get fixated and try to stay in the trade “just a bit longer” only because “it might eventually reverse in your favour” – it rarely does. Most of the time you will lose more money than you should and also waste time waiting for your luck to turn.
So don’t try to outsmart the market or stomach supposedly “temporary” losses; the market will always outstretch you to a point where your account simply can’t take it. Instead, trying to understand what the market wants to do and calmly following it is much simpler, much safer and mostly stress-free.
Be adequately capitalised
Trading is like a small business, it requires starting capital. You wouldn’t want to fund your account with such a small amount that a few mistakes would wipe it out. You need to provide yourself with the opportunity to make mistakes and still have the chance to correct them and move forward.
Always keep in mind that making a loss means that you need to over-perform the next time to cover your loss and break even. It is crucial to understand that, for example, a 5% loss requires a 5.3% gain just to bring you up to your original capital and so on. So each loss hurts more than an equal win.
Hence having an adequately funded account means that you prolong the life of your trading career and allow yourself to make mistakes, learn from them and then over-perform to break into profits.
And that almost brings us to the end of the first part of this mini-guide, but I would like to conclude with something really important. Trading is one of the very few things in life where mistakes translate to an immediate loss of money. It’s not that you simply don’t make money; in fact, you immediately see your capital go down. So sticking to a few rules or “commandments” literally translates to preserving your capital and avoiding simple yet treacherous pitfalls.
Happy Trading
Alpesh B Patel
P.S. You can find my daily market commentary on InvestingBetter.com. See you next month!