This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com
I started researching investments and how to trade in 2003 after I started working professionally, when I quickly found my ignoramus college-graduate dreams of riches dashed against the rocky coastline of reality. (Who knew that I couldn’t drive a Porsche and have my own island on an engineer’s salary? And what’s with the whole soul-crushing corporate behemoth thing?) After I had recovered my faculties, I realized that if I were going to be financially free and independently wealthy, I’d have to learn how to do it myself. What better way than trading? Besides, I’m a “brilliant” engineer, right? (I actually AM a rocket scientist by degree, and a jet propulsion engineer by trade.) I could learn this whole trading thing better than all the other pinheads out there. I’d have it figured out quicker than you can say “second-order partial differential equation”!
Riiiiiight…
I went on a personal crusade to learn the ways of trading. Where to begin? Well, who’s the greatest investor? I started by learning fundamental analysis and value investing a la Warren Buffett. The whole thing makes sense, but you have to wait about 5 years to find out if you’re right or wrong! Maybe value investing is rational if you can avoid the duds, but I needed results now! Plus, I didn’t have any real capital to speak of.
On to short term trading: technical analysis, exotic indicators and tea leaves. I hopped from one methodology to the next, and this is what I discovered: Predictive TA is amazing—it usually works unless it doesn’t! Great; this is nothing like science and engineering, which are full of laws and absolutes. Time to try to learn by “doing”, I guess.
I opened a virtual stock trading account to start paper-err… computer-trading. I chased the daily % gainers and losers, bought some options, rolled the dice on earnings reports, and lost fake money; but hey, it’s just a simulation, right? I’d do better when it was for real. My intention was to fully learn how to trade profitably before going live, but in the end I couldn’t resist and opened an online discount brokerage account with $1000 that was burning a hole in my pocket. This wasn’t money that I needed to pay living expenses or anything, and if I lost it all nothing bad would really happen. But I wouldn’t lose it all—only an idiot would do that…
My first trade was AAPL, based on some iPod news release. If you bought the rumor and sold the news, you sold to me. Thanks. :-P I carved off about $300 as a prudent risk management measure (LOL) and bought a whopping 6 shares. I was sweating bullets on every tick: Red, green, red, green, green, red… After a few days I closed out the trade for an incredible $3.50 in profit. Easy Street here I come! That stellar result also included two free trades as a promotion for opening the account! Still, I had survived my first trade without “losing”, though I got lots of “loser practice” after that.
Fast forward to 2006: My account is down big time. On top of that, the brokerage executives are rolling around naked in a big pile of commission money, about $300 of which was mine. Eww. The traders who lived by the mantra “If you can’t see the other side of the trade, it’s you” saw the other side of my trades. So what happened? What was my downfall—diving in to manic stock rallies and getting left as the bagholder? Allowing a short-term trade to turn into a long-term investment, hoping to get bailed out? Trading options as cheap proxies for stocks? Technical or fundamental analysis errors? Poor stop selection leading to whipsaws? Mixing trade timeframes during the trade? Skipping from system to system? Widening my stop loss points after the trade went against me? Position sizing errors and crappy risk management? Revenge trading? Trading with Regulation T / Pattern Day Trader restrictions in force, limiting my options?
Actually, all of the above and more. I started out as a classic adrenaline-junkie knee-jerk mouse-clicking sucker, and thanks to many great teachers, I have now progressed to the point of understanding risk management, position sizing, expectancy, trade plans and rules, investor psychology and the importance of having an edge. I’ve learned that the first, early loss is the best loss, and to not only let winners run, but to add to them. I’ve learned that in the markets there are no absolutes, only probabilities. But even after learning these valuable lessons, I continued to make these same mistakes until I realized the underlying cause of all of the above symptoms. If you’re a neophyte trader, chances are it’s affecting you too. My fatal flaw? Undercapitalization! (I know, who woulda seen that coming…)
To my thinking, the big problem for those who want to learn how to actively trade comes from three incompatible things:
- To really learn trading, you have to have real money on the line or you’re missing some of the most important lessons.
- While you’re learning and you have no clue what you’re doing, you don’t want to lose your precious trading capital!
- Speaking of precious capital, if I already had a lot of money, I wouldn’t really need to trade to generate capital, would I?
No experience + no knowledge + no capital = no margin for error. Remember my AAPL trade? When you factor in my commissions, equity and position size, I would have had to make almost 5% on the trade just to break even! Can you say “Negative Expectancy”? Basically, as a noob trader I had to be right in a big way just to stay alive. Yeah, good luck with that.
So what can a beginner like me do? How do you learn how to be profitable and trade the right way with proper money management if you have to risk ~5% of your account just to cover commissions? Short answer: You can’t, so don’t even try. Seriously. As I found out, it doesn’t take a rocket scientist to pull it off—it takes a fortune teller! You’re better off paper trading, studying and saving up until you have enough capital to go live.
How do you tell if you “have enough”? Rule #1 of trading is to immediately bail if your trade is not proven correct within your timeframe and criteria. If the trade transaction costs are influencing your willingness to punch out of a bad trade, you’re undercapped. Without adequate funding, this will happen when you have a few losses in a row and you need a win to get your commission/equity ratio back down. If you’re in this situation, you’re dead. Realistically, if the amount you risk per trade (no more than 2% of your equity!) is not at least an order of magnitude (10x) bigger than your commissions, you need more capital.
Here’s an example calculation:
- Assume a $10 commission each way, for a $20 round trip
- Your ‘R’ value should be at least $200, or 10x the costs
- $200 is 2% of $10,000. That’s your minimum starting equity!
This can be reduced to a simple rule of thumb:
Your starting equity should be at least 1000x the cost of a one-way trade!
Most retail “discount” brokers with ~$10 commissions will let you open an account with only $1000! That can only end in brokerage executive moneypile-rolling. Gives the term “Naked Put” a whole new meaning…
There are deep discount brokers out there that let you trade for about a penny/share with a minimum of $1 per trade. With this structure you could get away with a $1000 starting account, as long as your trade size is 100 shares or less. (To their credit, some of these same outfits require you to start with even more money than that.) This is actually what I’m going to do next.
The bottom line: Find a broker that charges commissions that your equity can afford according to the 1000x rule. If there isn’t one, save your pennies before you even think about opening that account. Undercapitalized trading will only get you even further undercapitalized. Now that’s not rocket science.
This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com