TO BE SUCCESSFUL YOU MUST CONTROL RISK!!!

The trader who is on this website is most probably all excited about making money, and also is probably not thinking about losing money. However, the key to success is building your trading model around your risk tolerance as its first principal. Let me hammer home to you one VERY IMPORTANT fact. Each time you lose money, it is harder to make it up. And the more you lose, the more uphill the road becomes.  Here’s why.

Start with $10,000

Lose 10%  to $9000  You need to make $1000 on $9000 or 11% to get back to even

Lose 15% to $8500   You need to make $1500 on $8500 or 17% to get back to even

Lose 20% to $8000   You need to make $2000 on $8000 or 25% to get back to even

Lose 25% to $7500   You need to make $2500 on $7500 or 33% to get back to even

Lose 33% to $6700   You need to make $3300 on $6700 or 50% to get back to even

Lose 50% to $5000   You need to make $5000 on $5000 or 100% to get back to even

As you can see, you MUST CONTROL RISK VERY TIGHTLY, because it takes a bigger profit to offset a corresponding loss. When I was a registered Commodity Trading Advisor (CTA) managing other peoples money, an investment firm who assigned accounts to me and to other traders had a rule of thumb. The account was pulled if it lost 33%, because the belief was that it was almost impossible to come back the required 50% in any reasonable amount of time, and the money was best placed somewhere else.

When you decide to trade, ask yourself how much money you have to open an account and how much of that are you willing to risk. The one third rule is a very good one. If you lose 33% or even 25% you should seriously consider stopping.  When you open an account, let’s say for $10,000 you don’t do it with the idea of possibly losing all $10,000. Do it with the idea that if you lose some predetermined amount, say $3000, you will stop and close the account. I strongly suggest at least an account of $10,000, so you can spread your risk, as we will discuss later. Success can be accomplished on smaller accounts, but you are at a larger risk, as you will only be able to sustain a small number of losses. Also, as an active trader, your commissions will be high. The cost of trading as a percentage of your equity goes up in a small account. (It costs on average $10 to trade 100 or 1000 shares). I make 20/30 trades per month in my accounts.

The process of growing profits in your account has it’s ups and downs. Let’s say over a year’s time you are very successful and double your money. What you will find is that there might be some months you made 20, 30 or even 40%. But there are always going to be months you lose money. Anyone who tells you otherwise is not worth listening to. We are talking real life here. Look at the chart of my Real Time Track Record. And there is no way of eliminating down months by not trading when market conditions are unfavorable, simply because you never know what tomorrow is going to bring. All you know is what happened yesterday. In my daily commentary to subscribers I discuss general market sentiment and use it to know when to be conservative or aggressive in trading.

Let’s say the markets have been running strong for the last two months. Perhaps they will do the same for the next two months. But tomorrow could be the top for the next month(s) as the markets correct down. You simply never know how the markets are going to trade. Even the so called experts have no clue. As a matter of fact, the bullish consensus figures use the collective opinion of the experts as a reverse indicator. When over 60-70% of the “experts” are bullish the indicator says that market is at the top. It that true? Kind of. Yes, it’s usually true at market tops, but those same numbers can be very high for months before the actual top – the same special months your account is growing 10, 20 or 30%!

I can hear you asking, “so what do I do?” Develop a plan to trade and then follow the plan without second guessing it. It may or may not work – no guarantees. What I can absolutely guarantee you is that if you have no plan, you will make many very bad decisions based on emotion, and you probably will not be very successful.

THE BIG RISK FACTORS IN TRADING

General Market Risk. Something happens and the market takes a dive. The classic was 9-11. A terrorist attack is probably still the greatest risk we have in being in the markets. Another attack and our stop loss orders will probably mean very little. Do you ride it out – NO. You get out if the stop loss prices are violated, regardless of price. If you have preserved capital, rare, cataclysmic market occurrences can lead to great trades. The morning of the Friday a week after 9-11 we jumped in with both feet, and it proved to be one of the great trading cycles in the great three year bear market.

In a market in consolidation or correction, some great news event can cause a great advance too. For example if Bin Laden is killed or captured, the market would probably explode. You do not want to be short that day.

Should you be afraid of general market risk? No. There is nothing you can do about it. It’s part of the game, and it’s the only game worth playing. There is no market risk in playing at the casinos, but realistically, there is no chance for gain either. Sure someone will hit it big every once in awhile – the casinos make sure it happens. It keeps the losers coming to lose their many millions of dollars. You like those odds? How about trying to win $60 million by playing the power ball lottery? Feel lucky at odds 1/250 million? Me, I’d rather enjoy a dollar’s worth of Peanut Chews and pass on the odds of winning the lottery.

Earnings Surprise Risks. When a company disappoints the market with their earnings and/or their guidance, a stock can get hurt big time. Analyzing the price action of the stock the day before, or the week before the earnings are announced tells you nothing in terms of that price action being a reliable indicator of whether the news will be good or bad. Sometimes a stock’s price moves up anticipating a good earnings report, gets what it wants or even better, and the stock sells off. It’s an emotional time. Sometimes they “sell the fact” and a week later after the stock sells off, the buyers come in and the stock moves up very smartly. My recommendation – DO NOT have any position in a stock the day it reports earnings. I would rather forego the potential for a big gain, rather than take a big loss. A good example is LeapFrog Enterprises LF. The stock had been moving up strongly during 2003. On October 20th, the day before the earnings were to be announced, the stock closed sharply higher around $47. The company announced their net income rose 25% for the quarter and 102% for the year. Sales increased 12% for the quarter and 23% year to date. On October 21st the stock opened at $32, down $15 per share or 31%!! If you had 20% of your portfolio in LF, you just lost 6% of your equity. There is a wonderful page on Trading Day.Com that gives earnings releases and dates.Type in any symbol and it will tell you the earnings release date, either if known or estimated. 

The moral is always limit risk and never roll the dice. Dice players have some great rushes, but all are all net losers.

Analysts Upgrades/Downgrades. Another similar, but often smaller risk, and one you can do nothing about, are analyst’s upgrades and downgrades. They can have a significant impact on a stock, at least temporarily. For example, a stock has been in a strong up trend and an analyst who has rated the stock a “strong buy” now feels the stock is “fully valued” (read “too high”) and cuts his rating to “buy.” This is known as a downgrade. Often the stock will take a 5-10%+ hit then continue up along its merry way. These so called “analysts” never make a call based on technical factors, i.e. reading the price/volume action, which is the only way to base exit points. Who are they, or us for that matter, to say that the market place is wrong and a stock’s price is too high? It’s just an opinion, but many large institutions follow these analysts. Therefore their pronouncements can have a large, immediate impact on prices.

Medical Trial Failures. Biotech stocks have another type of risk associated with trading them. Often stocks are bought on the come – stories of great new drugs in development, clinical trials, etc. When they do not prove to be effective, or simply if the FDA requests more data or delays a ruling, the stocks can get hammered. What often makes these stocks so profitable is that the reverse happens. They get some good news and the stocks explode, then settle back before roaring ahead again. Those factors are all shown in the technical price action I watch. But there is no advance warning, technically, for failure announcements. Biotech is volatile and often offers greater potential rewards but at greater risk.

Dishonesty – Fraud. This is something you can’t do much about. If the officers of a listed company lie to the investing community, there is not much we can do to protect ourselves. It is a potential pot hole in the road to success. Sometimes there is fair warning in the price action of the stock, as fraud usually is not committed by just one person, and reason for the fraud is for personal gain. All of which means the rats are abandoning the ship, while telling every one the ship is riding high.

A classic example was July 2005 with CAFE, which shot up from 1 to 12 on fraudulent press releases about a deal with Walmart. The stock pulled back to a little over 10 when the fraud was revealed and trading halted. In September the stock resumed trading - at 4 and is now a penny stock.

Buyout –Takeover.  If you are short a stock and some company comes along and decides to pay a 25-50% premium over the market price, you just got burned real bad. Think that high flying tech stock is overpriced and sell it short, know you face this risk. Some investors think it’s a good reason not to ever be short. Buyouts also can affect long positions. If you own stock in a strong, growing company and it takes over another company and if the market thinks it’s a bad deal, your company’s stock will sell off, sometimes significantly. That stock you thought you only had a 3% risk of loss in all of a sudden is down 10-15%.  What can you do about it? Nothing. Stuff happens. Not very often, but it can happen to you.

Small Company Stock Dilution. I like trading lowered priced stocks because they generally move in much larger percentages. Although many of these small companies are often on the cutting edge of technology, they are still struggling to be profitable and make ends meet. One of their options to raise capital is to sell more stock. By increasing the float, the real effect is to dilute stockholder’s equity, by adding to the total number of shares. This also has the immediate effect of lowering the price. For example, I was long INAP (new symbol IIP) and on the afternoon of January 13, 2004 they announced they had filed a registration to sell an additional 35 million shares, a 15% dilution, which of course dropped the price approximately 15% from $2.65 to $2.28

YOU! I’ve listed many of the things that can happen in the markets that can hurt you as a trader and what you can and can’t do about mitigating those risks.  But what is, by far, the biggest risk in trading is YOURSELF. Very few traders are disciplined. And to be successful you need to be disciplined, objective and unemotional. Whatever you construct as your trading model, however you define a trade, you MUST not deviate from your plan regardless of the results. If you get scared out, (selling out too soon) or deviate in any way from your plan, you really have no plan, and will, in all probability, ultimately lose.

If you have not done well as a trader up to this point, perhaps it’s a blessing in disguise. The worst thing you can do is place all your chips on the table, roll the dice and win big. I have seen it happen a number of times in my lifetime, and all the big hitters lost it all and then some. Take the kid I worked with in my summer job when I was in college. He hit a trifecta at the race track for $60,000. He put a down payment on a car and a house. He still had money in his pocket to play the ponies. Next summer when I returned to work, I asked my boss “Where’s Ed?” Sad story I was told – lost the cash, the house, the wife divorced him, and he was in rehab. Then there was my friend who bought soybean futures one spring and it never rained during a six week stretch that summer. Beans went up, up & up, non-stop to the tune of over $1 million in profits. My friend, a psychiatrist of all things, said he knew it was going to happen all along. Then he took the money and invested in things he also knew would make his fortune grow. A Canadian gold mine and the coal tar company were both stories that could not miss, which of course they did. And then there was the sweetest deal – sugar futures, selling at historic lows – a no brainer. Except after he bought them, sugar just got cheaper and cheaper. After all the margin calls and his subsequent bankruptcy which followed, sugar did indeed go on a bit of a tear and a lot of money was made, but not by him. If he would have cut his losses, been patient….  I remember an excerpt from Mark Twain from  “Roughing It” (purportedly his autobiography) when he remarked philosophically after the silver mines played out “I can say, unequivocally, that for one day, on paper, I was worth a million dollars.” I’ not sure how much of a consolation that was… So, before you start, my advice is to study carefully Building a Trading Model then stick to it!!!