Back in early 1982, I was a clerk for a big market maker on the floor of the Chicago Board of Options Exchange (CBOE). A year later, I had a seat on the exchange, was a market maker and was running a hedge fund.
My first day of trading – for my account – was a disaster.
There was a “fast market” in FedEx Corp. (NYSE: FDX), which means the pit was crowded with traders yelling and screaming, buying and selling options based on an unexpectedly positive earnings report that had just come out. I rushed into the crowd and amassed a position.
I walked back to my booth on the floor, right next to the Salomon Brothers booth, where Norman – the investment bank’s head trader, and without a doubt the smartest guy on the floor – asked what I’d done. I told him I got “long” a bunch of calls.
Norman quickly shot back: “What’s your exit?”
Of course, I hadn’t given that a second’s thought. I was too excited about getting into the position.
Just a few minutes later, a news story said the earlier earnings report was wrong – and that FedEx had actually lost money that quarter.
I lost $30,000 in a Chicago minute.
It took me a week to make that money back, but that’s how I “earned” the first of five trading rules that are the key to getting rich.
These aren’t made-up rules. I earned and learned them from experiences just like this one.
Five Steps to Riches
One reason most investors fail to become wealthy is that they don’t understand the single most important premise of investing.
It’s not the buying – the getting into trades or investments – that makes you money.
It’s selling to cut losses, selling to ring the cash register or selling because you’re buying a jet with your winnings that matters.
Maximizing your wealth is about managing your positions – it’s about trade management after you’ve put on your positions.
Here are the five rules I always follow that will guide you.
Rule No. 1: At First, You’re a Trader
Every time you put on a new position, it’s a trade – just a trade. You’re not an investor… yet.
If you think about it, that make a lot of sense. To become a wealthy investor, you have to start by putting on trades. If you manage your trades correctly – if they have the upside potential and you manage that potential correctly – your winning trades can grow into fabulously profitable investments.
It’s about duration. Not all trades evolve into investments. Some are losers… it happens. Some are just beautiful opportunities that net tons of money when you close them out.
So, think like a trader until your trades become investments. Then, think like an investor.
Rule No. 2: It’s a “Binary” World
If you’re like me, you engage in tons of analysis and preparation before you put on a new trade. But once you do – whether we’re talking long or short, in stocks, bonds, options or futures – one of two things is going to happen. Either the position goes in the direction you predicted. Or it goes against you.
If you adopt that simple “binary” mindset – understanding there are only two possible outcomes to think about – you’ll be comfortable making more trades. After everything you’ve done to analyze the opportunity, you’ll understand that the bottom line is the price either goes up or goes down.
If your trade-management strategy prepares you for either scenario, you’ll make a lot more money: With a trade-management plan, you won’t be hung up on being proved “right” immediately, even though being right – and right away – is the Holy Grail all traders seek.
Rule No. 3: Know Your “Pain Point”
Depending on your personal parameters – meaning how much capital you have, how much you feel you can lose on any one position and in your overall portfolio – you need to ask yourself a single question: How much can I afford to lose without becoming upset?
None of us likes to lose anything. But trading is a business, and businesses sometimes have to endure losses. (In fact, there’s an old maxim that says, if you’re not suffering any losses at all, then you’re probably not taking enough risk.)
The business of trading requires that you take small losses. At the end of the day, it’s not about how much you make – that always takes care of itself if you follow good trade-management rules – it’s about not letting losses distract you from growing your business. Know your “pain point” and make that your bailing-out point.
Rule No. 4: Understand Your Plan Before You Put in a Trade
Having a trade-management plan in place – meaning you intend to take certain actions at specific price levels – is the essence of successful trading and investing. The beauty of creating that plan is that, in order to pick the spots where you’ll take action, you must already have completed the analysis that led to those decisions.
No matter what your trade does – no matter which direction it heads – you’ll have a game plan detailing what you intend to do.
Rule No. 5: Cut Your Losses Short and Let Your Winners Run
It’s a simple rule, but few follow it. In fact, most individual investors do the exact opposite: They hang onto their losers, and let those losses mount in the vain hope the trades will turn around. And they take profits too quickly – then watch angrily as the trade they exited grows more and more profitable.
These mistakes harken back to rules 3 and 4: Such investors don’t know their pain threshold – and don’t have a plan.
When you get to your “pain point,” cut your losses short. Once you’re out, you’ll be able to reassess with a clear head.
Letting your winners run demands a plan. And that plan to manage winners should have short-, medium- and long-term outlooks. The short-term outlook is what’s happening to your position right out of the gate. What’s the position doing relative to your expectations, to your “pain point” and perhaps to peer investments?
The medium term is what you expect for the trade after you’ve traversed the short-term holding period. This is where a lot of individual investors lose their way. They panic because they’re afraid they’ll lose what they’ve gained over a short run and bail out. Or perhaps the trade seems to lose steam after generating a big short-term profit, so they bail out – only to find it was merely taking a breather and consolidating before it runs for new highs.
The long term is where your “trade” turns into an “investment.” You have to navigate that transition and then manage the position going forward.
In an upcoming column, I’ll expand on this trade-management planning strategy by showing you how to get ready for a trade.
I’ll use real examples and charts. And I’ll explain how to “find” levels to get in at and get out at, where to put your stop-loss orders, and when, where and how to raise or lower them.
And I’ll periodically bring you more of these strategy sessions – putting you on the path to wealth.