PRESERVATION OF CAPITAL

If you had asked many traders and investors during the Internet and Technology bubble of the late 1990′s what was the effect of risk on their investments, you would often hear, “The greater the risk you take, the greater the reward you will get.” If you ask the same question now (and after the 2008 bear market), you will probably hear “The greater the risk, the more you can possibly lose.” There are many reasons people lose money in the markets. One easily avoidable mistake is putting too much capital at risk in a single position.

Start to think of your investing/trading account as a business. Good business people look to cover their expenses and make a steady growth in earnings, rather than striving for the big hits. Not surprisingly the big hits come along, but they come along without excessive risk. Excessive risk is the killer of many good traders and investors. In today’s world we might add the killer of banks and other financial instituions as well.

Preservation of Capital, therefore, becomes the cornerstone of any good trading plan. Remember, to trade you must have capital, and every time you trade you put that capital at risk. To survive, to prosper, you must preserve your capital. Before asking yourself, “How much can I make” ask yourself “How much can I lose” This is what risk/reward really means!

STEADY, CONSISTENT PERFORMANCE

Anyone entering the market expecting to be right on even a majority of his or her trades is in for a rude awakening. Think of it this way. In baseball, who are the all stars? Would you agree anyone with a batting average of 300+? Looking at this statistic in reverse, it means that this individual makes an out 7 of 10 times at bat and a hit in only 3 of 10 trips to the plate. The good player, however, knows that the hits help more than the strikeouts hurt. The reward is greater than the risk. To gain capital you have to be consistently profitable, but to do that you must limit your losses while allowing your profits to run.

THE PURSUIT OF ENHANCED RETURNS

While I have talked a bit here about risk, there is a time you may take additional risk to enhance the overall return of your portfolio. You accomplish this by only risking accrued profits not your original trading capital! This does not mean that you abandon your risk / reward ratio. It means that with accrued profits, you may take a larger position, or you may utilize the increased leverage afforded by the options market. A discussion of options is beyond the scope of this tutorial. To learn more visit The Chicago Board Options Exchange site at CBOE The important point to be made here is this: you only pursue enhanced returns with profits made, not your original trading capital.

COMMITMENT TO MAKE IT HAPPEN

I am quite sure most of you are familiar with the word commitment. Hopefully, you are committed to your family, and your profession. To be a successful trader you must be committed to the task. The following is an excerpt from Victor Sperando’s book Methods of a Wall Street Master.

To trade well you must:

• Establish goals
• Acquire knowledge of the markets
• Define your rules of trading
• Execute in strict adherence to your rules

Only by establishing these rules will you be able to adhere to the discipline needed to insure your Success.  The nature of this business requires a set of personal attributes without which I doubt anyone can be a successful trader, speculator, or investor.

• First is a soundly based self-confidence, a realization that our mind can learn the truth and apply it with positive results in every realm of life.
• Second a self-motivation and commitment, the ability and willingness to put the time and energy into learning what to trade and how to trade it.
• Third is intellectual independence, the ability to stand on your own judgment based on the facts as you see them and in the face of countervailing opinion.
• Fourth is a fundamental personal honesty, a total commitment to identifying and dealing with the truth about yourself, the markets, and your decisions.
• And finally is a sincere love of what you do, the recognition that the greatest reward comes from the process of the work itself, not the money or fame that may come with it.

These attributes are fundamentally important in every area of life, but the rapid pace and volatility of the financial world make them even more critical. Without self-confidence, you will live in constant fear of making a wrong decision and sooner or later the fear will paralyze your ability to think and make decisions. Without intellectual independence, you will be swept away by the changing tides of opinion into the whirlpool of financial ruin. Without fundamental personal honesty, your wishes will become claims on reality, and you will find yourself making choices based not on the facts, but on your wishes and hopes. And without love of what you do, your work will become stale and uninteresting; you will lose your motivation and drive to continue.

All of these attributes are attainable, but only through a complete commitment to understand yourself and your relationship to reality.