You may not have noticed…………….but, this trading stuff is risky.As a student of trading, I have to admit, publicly, that I found the truth to the above statement the hard way. (Is there any other way?)

Here’s what I was recently told, by my mentor:
“Winners focus on RISKS.
Losers focus on PROFITS.”

NOW he tells me! (In Texas, we call it closing the barn door after the horse has gone.)

As I look back on my beginning trading and as I speak with many starter students of trading, I see a definite pattern: They are thinking of making a PROFIT, they look at how much they could MAKE on a trade and they are not REALLY aware of the full RISKS that they are taking on, especially in relationship to their portfolio size.

How does this happen?

Here’s my take on the matter:

Many students want to make more money than is reasonable for their portfolio size. Likewise, they want to make it faster than is reasonable and realistic.

Thus they make several mistakes:

1. They ignore the fact that there are PORTFOLIO MANAGEMENT RULES which are well-documented, established and proven thousands of times to hold true.

They make the common error of thinking, “I’ll be different” or “Yes, but my situation calls for more aggressive action.” I’m sorry to say, ladies and gentlemen, but both are death knells and lead to NON-survival of the learning curve. They lead to action and attitudes that are more gambling than trading. They somehow, deep within their minds, rationalize that those rules do not apply to them. But they do. They DO!

2. They don’t know how to correctly analyze a potential trade for the true risks involved.

They don’t consider the fact that ‘anything can happen…and will!’ They don’t learn how to place the trade on a risk graph and to SEE, not just LOOK, at how much exposure they’re taking on. And, worst of all, they don’t consider the ‘Black Swan.’ The Black Swan is defined as being the worst possible thing which can happen, the thing that no one believes will happen and that, when it happens, pundits say, ‘It was easy to see it coming!’

As another example, suppose the trader forgot about a put option he had sold and it ended up, on expiration day, in-the-money? Would he be shocked if the next Monday morning, he looked at his screen and found that he owned hundreds of shares of stock and his account had been debited for thousands of dollars?

3. They attempt to fix a defined risk trade with an unlimited risk ‘adjustment.’

This is where they might place a spread, for example, a short call vertical (bear call), the market rallies, so they sell a put to offset the loss in the vertical. What happens, in this case, is that they have UNLIMITED downside exposure that could lead to ‘sudden death’ to their portfolio.

Here’s my trading psychology on placing a trade:

a. Ask what the Black Swan RISK is and EMBRACE that odiferous bird, i.e., be sure you’re financially, mentally and emotionally comfortable with that much loss.
b. Define what your MINIMUM profit level is so that, when that’s hit, you can GET OUT and take your RISK off the table as soon as possible.
c. If the trade goes against you, FIRST consider simply reducing your RISK in the play.

The committee of ‘they’ says, “Focus on RISK reduction, avoidance and minimization. Eventually, you’ll actually start to see some profits!”

I concur.

Let’s survive our learning curve together by watching our risk at every turn!

Is trading easy?It can be categorized as ‘simple,’ but, of course, that doesn’t mean that it’s easy. Simple is herein defined as being CLEAR.

You see, my dear fellow students of trading, there are two kinds of simplicity.

The first attracts the trading students who might be looking for easy, quick, pat answer to all of their trading questions. This person is of the opinion, consciously or subconsciously, that if he takes enough courses, reads enough books, finds the right trading system, does enough market analyses he’ll be able to solve the puzzle of successful trading and reap huge financial benefits, multiplying his current portfolio size.

While each one of those items is worthy of our attention, he might overlook the fact that all of those are OUTSIDE OF OURSELVES.

The second kind of simplicity includes all of the above activities but BEGINS with these four crucial ingredients:

a. A deep journey within OURSELVES to look objectively at how we think, how we perceive the world, how we react to people, events and things around us,

b. A forgiveness of OURSELVES for past shortcomings and a true acceptance that we are worthy of success,

c. A total release of any attempts to CONTROL people, events and things around us, and

d. A total release of any TIME CONSTRAINT or expectation of how long it will take to become a successful trader. (This means denying our ego that is begging for quick gratification.)

Then, when the day comes when we have reached that elusive level of financial, mental and emotional wealth that we have desired, we can consider ourselves as having earned the right to return to viewing trading as ‘simple.’

Then we’ll know that seeking simplicity directly is not the right path.

It’s only simplicity on the other side of complexity that is of true value and fulfillment.

BTW, after it becomes ‘easy’ to us, then we’ll say, ‘It was simple!’

All students of trading, especially those that are serious about surviving their learning curve, need a trading manager.This is a person whose brain is a like a Montana bear trap, whose blood is cold as Texas tea and who walks around, in the office, wearing a steel- faced helmet and shield. Also, she has a machete hanging from her belt.

Her job is simple:

1. Disallow you to trade until you have a written set of trading rules on each and every strategy that you employ. You must write them, but they must be passed through a Review Board of her sisters. The board will perform a critical review of these rules and must approve them before you can trade with real money.

2. Disallow you to place a large position size. This includes not only the size of your long trades (debits), but the risk you accept on your short trades (credits), the size of your margin requirements and, finally, the Black Swan risk you take on any single trade or any group of trades within the context of your portfolio. (She will also enforce, under most cases, the rule that only defined- risk trades will be allowed.)

3. To look over your shoulder every moment that you’re executing a new trade, making an adjustment to an existing trade or exiting a trade. With checklist and red pen in hand, she’ll watch to see if you do all the above in the exact same sequence and manner that you did on the last ten such trades.

The services of this trading manager from Hades are invaluable to us traders because she forces our EGO and our THINKING to get out of the way of our trading success.

So long as we dutifully and cheerfully comply with her ‘suggestions,’ she’s as sweet as a Southern Bell, with a flower in her hair and a soft, honey-dripping demeanor.

But if you dare cross her on any of these rules…… Well, it’s not a pretty picture. You don’t want to KNOW what she’ll do, all for your own good!

My fellow trading students, you cannot trade successfully without this trading manager!!

Hire her.
Marry her.
Adopt her.
Be her.
Do whatever it takes to bring her on board.

Yesterday, as I walked into a store, I saw the sign in the window the words, “Applications Accepted.”I think back to the time when I first heard about a trading school and I thought to myself, “Maybe I should look into it.” It was as if I had seen a sign with those same words on it and I decided to go for it.

Now, in retrospect, I offer the world’s first (I think) “Trader’s application.”

Position: Trader
Salary: You determine
Hours: You don’t want to know
When to start: Immediately

Requirements:

1. Be over the age of 18 (that includes be so physically, mentally, financially and emotionally)

2. Know who you are (Many applicants would wash out right here! Most of us stay just busy enough, in life, to avoid ever having to truly look in the mirror and see who we really are. This shows up when students of trading are asked to tailor a set of trading rules that fit their personality. They have a tough time with that and flit from one strategy to another and another. The reason: They understand the strategies. What they don’t know is who their personality is!)

3. Know what you want in life (Many of the still-standing applicants would wash out here. “What do you want?” is one of the toughest questions in life because in order to answer that question, we must spew out, in public, before God and everyone, that which is truly of VALUE to us. What we value in life, you see, defines us!)

4. Be resourceful – This means that the person must have the drive and ambition to seek all the items needed for technical trading skill. That skill comes from finding the answers to all the ‘who, when, where, how, which’ questions. They seem tough, at first, but all of them can be found through hard work and determination. (This shows up when students are left to themselves to dig out the answers and not chase any quick, easy ‘Holy Grails.’)

5. Be highly motivated – This means that ‘who, when, where, how, which’ questions mentioned above, pale in comparison to the biggest question of all — ‘WHY.’ This ‘why’ must be deeply imbedded. (This shows up when the student loses money and suffers other setbacks. It’s when times are tough that one’s commitment to one’s self is tested.)

6. Be strongly self-disciplined – This cannot be taught by any trading teacher, mentor or pundit. You have it or you don’t. If you have it, you simply apply who you already are to trading. If you don’t have it and you’re not already displaying it in other areas of life outside of trading, it’s not just going to fall out of the sky and suddenly allow you to become a disciplined trader.

7. Must have the ability to focus – This is a tricky one because most of the plethora of things that will distract you from a focus on trading are good ideas! Even a mediocre trader can distinguish between good ideas and bad ideas as to how to manage your time and energy. But making a decision to cut out a lot of good ideas for the sake of trading is tough. Self-rationalization is the enemy of focus.

8. Be self-confident – Again, this cannot be taught. But this one item, in my estimation, will make a HUGE difference on your chances of success.

By the way, if you’re a visual learner, here’s a thumbnail sketch of the job description:

a. Take a sheet of graph paper.
b. On the left, start a line near the very bottom and crawl it near the bottom to almost the right hand side. Then, a couple of inches from the right, start a steep ascent and finish, on the right, near the top.
c. Then, again starting on the left, start another line, this time near the top and crawl it near the top to almost the right hand side. Then, a couple of inches from the right, start a steep descent and finish, on the right, near the bottom.
d. Then, on the left, mark the starting lower, left-hand line “MONEY.”
e. On the left, mark the starting higher, left-hand line “WORK.”

What you’ve drawn is a picture of the learning curve to which this column is dedicated. That’s because I believe that in many cases, the first years of studying and practicing trading the serious student will work like heck for little, no or loss of money. But when she sticks with it and pays her ‘due diligence,’ she’ll end up with less, easier, and more joyful work along with more money than she ever imagined!

Webster’s definition of a DECISION: a determination made after a consideration.Trading has been described as simply a long series of decision-making events. If this is true and following this logic, of those who are attempting to ‘make it’ as traders, the good decision-makers have a best chances of success.

Therefore, here are a few comments about decision-making, in general, and about the specific characteristic that is unique to TRADING decisions.

The decision-making process is a simple, sequential process:

Step 1 – Gather the facts
Step 2 – Weigh the pros and cons of each one, as objectively as possible
Step 3 – Select the best choice
Step 4 – Commit to it

One of the first things we traders must do is to decide which strategy to adopt.

We look at the facts as best we can, speak with others, see the various examples, see the strategy demonstrated, etc. We weigh the pros and cons, either logically or emotionally, then, finally, select a strategy which seems to fit us.

OK, fine. But here’s where the challenge begins. When trades that are done in that strategy begin to ‘not work out’ and start costing us money, we start questioning our judgment on that decision. Then what?

One of the most common sins that I’ve noticed in myself and in my fellow traders is to then say, “That strategy didn’t work!” and to switch to a different one. The problem is that one can easily fall into the quicksand of having ‘tried’ so many different strategies and having lost so much money that one is now feeling depleted and discouraged.

What has happened, here, is that this trader, rather than truly making decisions, is stymied in INdecision.

Here’s my version of the real life decision-making process:

Right decision
I
Wrong decision
I
INdecision

We all begin at the point of indecision, standing there, peering, with lust in our hearts, at the desired ‘Right’ decision. We tend to look at the ‘Wrong decision’ point as an alligator swamp. Thus we wish jump from the Indecision point, high in the air, and land safely on Right decision point without falling in the swamp of Wrong decision.

HOWEVER, ladies and gentlemen, what we sometimes forget is that INdecision has short theta! (That’s floor trader parlance for the paying of time decay in an option.) In other words, there’s a TIME LIMIT to our decision-making.

Our learning curve experience and our trading career have a time limit before they expires worthless on our day of expiration!

We can be wrong just SO many times. We can lose just SO much money, before we QUIT!

This is because constantly moving from strategy to strategy, trading system to trading system, indicator to indicator, etc. keeps us spread out over a large WIDTH of choices and is actually a form of INDECISION, the worst alligator pit of all! This is because all the while, time is taking its toll and pretty soon we get to a point where even a WRONG decision is better than INdecision!

Better to choose ONE strategy, ONE system, ONE set of indicators and bore into it in DEPTH and stick to it to the point of mastery.

Then, one bright day, we might find ourselves actually making money!

The Holy Grail is not in the choices we make as much as it is in what we make of ourselves within the depth of those choices!

In previous posts, in this series on options portfolio management, we spoke of portfolio and trading SIZING and how all beginning traders should trade SMALL amounts.Now let’s turn toward a method of trading that almost all professional trader use and which does wonders to ensure that we survive our learning curve: partialling.

Partialling is to incrementally ENTER and EXIT any trade.

Here’s the procedure:

a. We find a trade that we truly like, that meets all of our rules and is of the DEFINED risk variety; we time it perfectly, according to what the market gives to us.

b. We enter ONE contract or any amount that equals to, say one fifth of our total risk allowed according to our trading rules. In this example, let’s say that our limit of .5% of our portfolio amounts to $500. Then we begin to BUILD our trade by placing $100 at risk in this initial trade.

c. After a short time, IF and WHEN the market starts to move in our favor, we add a second contract or two and, then give it some more time. Say, now our risk is up to $300. After another amount of specified time or market movement that is yet in our favor, we add enough contracts to get to our .5% limit or, in this case, $500.

d. The trade proceeds to the target profit level OR it begins to turn against us.

e. At the FIRST sign of it turning against us, we CLOSE one or two contracts, say leaving $300 still in the trade.

f. With another sign of it turning against us, we close the rest of the trade and are finished with it.
The THINKING behind partialling IN is that it gives us a chance to TEST the market a bit before we risk too much money. By the time we are fully invested (to our pre-determined risk level), we have SOME assurance that the market is moving in our favor on this trade. We then begin to partial OUT of the trade at the FIRST sign of trouble so as to reduce our risk quickly.

Does it always work that way? OF COURSE NOT, but it does enough that almost all professional traders use it to give an extra assurance that they can ‘let the winners run’ and ‘cut the losers short.’

Recall that trading is a PERFORMANCE game and all that matters is the BOTTOM LINE: Do our winners outnumber our losers and are the amounts of those wins larger than the amounts of the losers.

A serendipity of partialling is the mental serenity of not being fully invested in a losing trade. Yes, times will come when we will WISH we had been in a trade that truly ‘took off’ and we will miss out on some profits, but the pain of losing is always ten times worse than the discomfort of missing out.

More on managing an options portfolio, yet to come…

In our continuing discussion of proper management of an options trading portfolio, the next topic is one of the most crucial in the entire trading process – how much of our portfolio will put at risk in any trade that we do.The reason for this emphasis is that this is where the largest percentage of traders, especially beginning ones, make their fatal mistakes.

The trading rule is simple: Never place more than X% of your total trading account at risk in any one trade. It’s my suggestion that learning traders attempt to keep this maximum at .5%. Certainly never risk not more than 1% of the account.

Again referring to our discussion in an earlier post, this should eliminate ever placing any type of UNDEFINED risk strategy or trade.

Remember this: The Number One reason that traders lose their money and must drop out of trading is that they place too much money, in comparison to their portfolio size, in single trades.

Why, in the world, do they DO this? Here are some common maladies:

a. They suffer (or will soon suffer) from the idea that trading is easy. “All you have to buy the stock when the price is going up!” is a key thread of thinking of many beginning students.

b. They’re in a big hurry. They want to start making money as soon as possible that that they can quit their job, pay their bills or advance to a higher lifestyle. But they want to do it in short order. (More on this, later!) A friend of mine says, “Don’t be in a big rush to lose your money! Instead, go slow, but sure!”

c. They’re focused on making PROFITS before they’ve fully learned and understood the PROCESS of trading.

d. They feel their portfolio is too small and want to increase its size quickly (and easily)

Now, to back up a bit…. We said, ‘How much to put in a single trade,’ but what IS a trade? What constitutes ONE single trade?

That to which I refer is the fact that, as all traders quickly realize, a trade seldom consists of a simple entry and exit. What will REALLY going to determine the final outcome of most trades are the ADJUSTMENTS to that initial entry.

Here’s what happens: A trade is entered. Things go along well for a short time. Then, with changing market conditions, the trade begins to get ‘into trouble.’ Any good options trader then seeks an adjustment to the trade which can take the form, many times, of what is really a new trade being placed on top of the initial one. While this new trade is an attempt at getting the first one ‘back on course,’ it also has its own RISK.

One of the most fatal mistakes for traders is to place a defined risk trade one, then, when it gets into trouble, place an UNdefined risk adjustment onto it. This makes the entire trade an UNdefined one.

This trader has jumped from the frying pan into the fire.

More on the next post.

The third section of our discussion of management of our overall options trading portfolio involves the sectioning of each of the two or three portions of the pie into various types of strategies and, more importantly, into the risk levels we will accept in each one.Strategies can be of two varieties: non-defined risk and defined risk. The non-defined risk strategy is one in which while trading may have a profit target in mind, he’s taking totally unlimited risk on his money. In this strategy, he can lose ALL of the money, perhaps in his ENTIRE TRADING PORTFOLIO. (Can he place ONE seemingly small trade and lose ALL of the money in his portfolio so that he’s OUT, he can no longer trade at all? YES, absolutely!)

In case you haven’t yet gathered, I am NOT a proponent of any new student of trading using any undefined risk strategy, e. g., a single call or a put option.

In the defined risk category, there are many relatively simple strategies that one can learn wherein the risk is totally defined, i.e., the amount that a person has on the line is specifically delineated. Losses cannot go beyond that point.

Therefore, the first step in proper management of the strategies is to make a commitment to do ONLY STRATEGIES THAT HAVE A DEFINED RISK. (Sometimes, people ask about stops. Aren’t they defining a risk in a trade? The answer is NO because price gaps can shoot past it.)

Next, in addressing the risk in any trade or strategy which one is considering implementing, the first and foremost question is always, ALWAYS: What’s the ‘Black Swan’ risk on this trade?

The Black Swan event is one which was totally unforeseen and is of such a magnitude as to be shocking and held as incredible by traders. Normally, they are to the downside. It might take the form of a ‘crash’ where the overall market suddenly and unexpectedly takes a huge hit (almost or literally overnight) or the form of a specific event that strongly affected a specific stock, e. g., a news event.

At any rate, one must look, then, at a potential trade from the viewpoint of a total PESSIMISTIC, asking all the ‘What if’ questions, even those of which a person wouldn’t normally think. For example: A trader buys 500 shares of a tech stock that is selling for $60. His investment is $30,000. That night, the CEO of that company is arrested for fraud and the company announces that it might be going out of business. The next morning, the stock immediately drops to $3. At mid morning, our trader looks at the market and is shocked to see that his $30,000 has shrunk, overnight, to $1500 for a loss of $28,500 in less than 24 hrs!

Perhaps this was the trader’s retirement account and it had taken him 30 years of hard work to save up that money? How would he feel?

Imagine that feeling and then know what is meant by a ‘Black Swan’ event on your portfolio.

As a side note, while we are discussing RISK assessment, many strategies, in addition to the risk involved, also have margin requirements. Margin is the amount of money in our account that, while it’s not DIRECTLY involved in a strategy or play, it does TIE UP monies in our account so that should they become necessary, the broker will have legal access to them. Thus margin requirement is another crucial factor in selecting a strategy.
Next, how much SHOULD we risk in every strategy and in every trade?

After we’ve properly planned and regulated our overall trading portfolio, the next step is to divide into in segments and plan what we are going to do with each one. Again and as always, the driving motive behind this is RISK assessment.Overall, any portfolio should be divided into at least two sections, often three or more. In trading, the portfolio proportioning is described as being akin to a pie and each one of the sections is referred to as a slice of that pie. The key is to size them according to our RISK TOLERANCE LEVELS. Here’s an example:

I. Income portion – 60% of our entire trading portfolio – These dollars represent the most conservative portions of our trading monies and of our mind. This is money that we are LEAST conducive to losing. An example would be our retirement fund, such as an IRA.

Placing this in the context of the big picture, recall that we took a portion of our overall net worth and placed it in a relatively discretionary fund (money that we can afford to lose) called our trading portfolio. Now, we are going to the next level of conservativeness by dividing it further into risk tolerance portions. In this ‘income’ portion, we want to use strategies that have three characteristics:

a. Slower moving, i.e., using longer time frames (this is where ‘investment’ has more of a role, i.e., placing money for long term sitting, say three months to a year or more.
b. Less volatile money, i.e., less likely to be erratic in its increases (profits) and decreases (drawdowns)
c. Higher probabilities of making a profit, albeit a relatively small one.
II. Strategy portion – 30% of our entire trading portfolio – These dollars are those with which we are not quite as conservative and for which we have a slightly increased risk tolerance. In other words, we are more willing to take a higher chance of losing this money, in ‘payment’ for the possibility of making a higher profit percentage. This portion of our portfolio might be……

a. A bit faster moving, using shorter time frames (say a week to up to about three months; this is called ‘swing’ trading)
b. More volatile, i.e., more erratic and unpredictable in its increases and decreases
c. A less likelihood of making a profit, albeit with more possibility that when we DO make a profit, it will be a higher percentage of the money invested.

III. Speculative portion – 10% of our entire trading portfolio – These dollars are those which we are the most willing to TOTALLY LOSE. We have the highest tolerance of risk. Thus its characteristics would lean more towards being………..
a. Of the shortest time frame (day trading, i.e., in and out of trades during the same training period, or in a trade fro up to a few days)
b. Of the highest volatility, where it is highly unpredictable and can move very fast in either direction
c. Of the lowest probability of making a profit, but with the goal of a high amount when it IS struck.

In our next section, we’ll delve into the various types of strategies to be used in each pie slice and the amounts of risks to be allowed in each of them.

We’ve discussed, a bit about the topic of our trading portfolio, the quality of the money therein and its size, in comparison to our overall net worth.Now, a word about its trading rules. Yes, that’s right; every dollar of our trading portfolio must be regulated by strict management rules to which we have fully committed. From the viewpoint of the overall portfolio, there are three considerations:

1. At what point do we STOP trading because of the damage of losses?
2. At what point do we WITHDRAW some of the profits from this portfolio?
3. What, exactly, are we going to do with the PROFITS from trading?

First, recall that we’ve discussed the first and foremost consideration of any trader at any level of money management discussion – RISK. Even at the level of the overall management of our trading fund, we must pre-set LIMITS on how much damage we’ll accept before we take a break from trading. There is nothing shameful about doing that! Some beginning students of trading seem to believe that there’s a stigma about taking a hiatus from trading, when, in fact, it shows good money management on the part of the trader, it shows that he has the self-discipline to do it and that, in fact, his intention is to survive his learning curve and live to trade another day.

Take a break from trading can be a very good thing if the market is such that one is overwhelmed or if he simply is in a ‘losing streak’ and needs to refresh and wait until he can take on a new mental perspective.

The point is that we all should have a pre-determined point where we commit, in advance, that if our ‘drawdowns,’ as the losses are called in the trading world, reach a certain point, we will, in fact, pull back from the market, continue to do our research and perhaps do paper trading for a while until we ‘get our swing’ back. No stigma is attached. It’s simply part of the plan.

Secondly, withdrawing money from the trading portfolio does represent a financial and a mental setback because not only does it remove dollars but it removes the potential dollars that those dollars could potentially bring in.

Most professional traders attempt to ‘let them ride’ and bring in more and more dollars until they are at such a point that they want to start placing some of them elsewhere, to make money in some other venue, e.g., real estate or other business venture, or to live on.

Finally, there is the stuff of which dreams are made – profits that can be removed without hurting our trading style AND that are not needed in any other business venture AND that are not needed to live on. These are strictly for pleasure or for philanthropy (same thing).

These dollars are pleasant to imagine and to think of, but should NOT be the focus of any new student of trading! The reason, as we have discussed in another post, is that being driven by the idea of PROFIT is very BAD for a student when it takes the place of what he really needs to be thinking about – the PROCESS of trading.

Next, we’ll move on to the slicing of the portfolio pie.