Learn how to trade the way most successful traders that I know have become financially independent. This guide is the beginning of a series of articles that show you the most common path I know of to successful trading. There are a lot of people who want you to learn how to trade using their new discovery of a secret way of trading. I have seen many of these secret trading methods come and go over the last 14 years which I have been trading. The principals shown here worked 14 years ago and they work today.
Trying is not gambling although some of the Game Theory mathematics that applies to gambling can be of some use in trading. Non-professional gamblers will generally not make good traders unless they approach trading differently than gambling. Professional gamblers sometimes approach gambling with a careful study of the game they are playing and Game Theory mathematics to get consistent results; these gamblers can be good traders. Trading may trigger some of the same addictive reactions that gambling does in some people but not for me. I hate to gamble but I love to trade. I view most forms of gambling as a waste of money but I view trading like a great game of golf. When I go to Las Vegas I see a lot of people putting their money on bets without really knowing much about what they are doing. They are untrained in the proper techniques that are needed to win at what they are playing. The casinos take their money without much difficulty. If one of these Las Vegas gamblers turns to science and becomes skilled at it then they will be permanently thrown out of the casinos. People who approach trading the way they lose money in Las Vegas are just throwing their money away. Being a trader is being a skilled professional.
However, trading is like being a skilled sports professional rather than a typical skilled craftsperson. A skilled craftsperson gets it right nearly every time in that his success rate is near 100%. If you play a professional sport you would not expect to achieve such high success rates, just having a winning season is often cause for much satisfaction. Once you know how to trade you can expect to achieve 57-59% winners. However, learning how to trade is learning how to accept your losses as well, which are 41-43% of your trades. Losing 41-43% of the time is not always easy because the losses are not always distributed evenly. There are times when you will have nine losers in a row and you still need to keep your cool and be confident that you know how to trade the next trade. You need to trade with careful risk management so that when you have a string of sequential losers you don’t blow out your account. We will discuss proper risk management many times in this how to trade series because it is very important to your ultimate success. Most people who are unfamiliar with risk management strategies such as the Kelly Strategy will risk too much. Forty PH.D’s were asked to play a gambling game where they would be guaranteed to win 60% of the time but at the end of 100 rounds only two had more then they started with because of poor risk management. You can get everything else right and still lose money unless you manage risk correctly.
Learning how to trade is easier than many highly skilled professions but you will need to do your homework before you trade real money. Paper trade first and only after you have mastered paper trading should you slowly transition to real money (mixing some paper and some real). Paper trading today is done in an electronic simulation environment, not with real paper. When you trade you must do what needs to be done even though you may not want to do it. Human instincts are often wrong and you must learn to resist these feelings that will lose you money. The way probability works is important to trading but is different than your natural instincts will lead you to believe. The Gambler’s fallacy, also known as the fallacy of the maturity of chances is the belief that your odds improve when an unusual series of losses occur or that your odds of winning rises when you have a losing streak. Some slot machine players will prefer slot machines that have not paid out in a while in the belief that the chance of a payout has now improved. Let’s look at a coin flip example: if you are flipping a coin and you get “heads” four times in a row then your chances of getting “tails” on the next coin toss has improved. However, each coin toss is an independent event that is ignorant of every previous coin toss. Since the coin does not remember the previous string of heads it is not biased in the next toss. If fifty different people toss a coin in the air eight different times then the probability of at least one person getting all heads or tails is 32.44%. That person with all heads (or tails) probably had difficulty accepting the outcome but it is no less probable that the person who had exactly 25 heads and 25 tails which were evenly distributed.
Another example of how human intuition is wrong is the Monte Hall paradox and Bertrand’s box paradox. You are in a game show, and you’re given the choice of three doors: Behind one door is $1,000; behind the others, $1. You pick door No. 1, and the host (who knows the right answer) opens door No. 3, which has $1. He then says to you, “Do you want to pick door No. 2?” Should you switch your choice from Door No. 1 to Door No. 2? Most people would say no because their chance has not seemingly changed and Door No. 2 does not seem to offer any improvement in their chance of winning. People are more inclined to stay with their choice once made. Staying with your choice leaves you with a 1/3 chance of winning but changing to door No.2 increases your chances to 2/3. It is surprising and not at all intuitive but it has been shown to be true (hence the term “paradox”). As a trader you should learn what is true and re-train yourself to these truths while avoiding use of your natural human instinct. Why something works in trading is unimportant, that is an academic exercise for the curious; the fact that it works is all you need to know.
For many people it is hard to exit a losing trade and accept defeat. People who have been reasonably successful in their life would rather hang in there and work that defeat into a victory. This is a recipe for disaster in trading. After several disasters the aspiring trader then over reacts and starts exiting to soon. They want to exit a trade if there is any loss showing at all because the pain of past disasters puts them in a panic. Knowing how to trade means limiting your losers and giving your winners room to run (we will discuss this more later).
For this discussion “being long” means to own a stock, bond, or whatever. If you are “short” then you have sold it after borrowing it from your broker such that you can only profit on it if it drops in price.
How to trade your Opportunities
At this point I am assuming that you want to learn how to trade so we won’t extol the virtues of the independent private trader. You need to pick what kind of trading you would like to do. This is very important because you need to match your circumstances and interests to one or more of the various trading opportunities.
Do not assume that anything you think you know or anything anyone has told you is accurate, because it often is not with new traders. Carefully weigh each trading opportunity listed below with an open mind before deciding. People sometimes get into trading on the wrong instrument or method for their financial situation, time schedule or personality and then they struggle to make it work.
The instruments of trading
There are four asset classes that are commonly traded:
Trading stock shares is the most familiar and most commonly traded of the asset classes. This does not mean that it is easier or safer or better than the other asset classes to learn how to trade; do not confuse familiarity with safety or ease. Stocks trade during the Eastern Time business day and in some cases for a few hours before and after the regular market hours. Part time west coast traders can usually get a few hours of trading in before going to work due to the time zone differences. Stocks represent indirect ownership of a business, including the most familiar ones in our daily life. Do not confuse a good stock with a good trading stock. For trading purposes you must be emotionally indifferent to the stock; just trade the facts of the situation. Beginning traders often have a false sense of security when they trade a stock that they have researched because their stud gives them a more comfortable feeling of familiarity. Familiarity is never the same as less risk. If you drive a Harley Davidson motorcycle and are in love with it then do not trade the stock because you are too biased.
If you have more than $25,000 to trade then this is probably a good asset for you to begin to learn how to trade. Stock (and option) trading has the drawback of requiring an account size of more than $25,000 to trade more than four times in five days in a margin account (“pattern day trade rule”). To trade you need a margin account or you will need to wait three days after closing a trade before the the funds are cleared so you can trade again. Even if you hold your trades for longer periods of time, like weeks at a time, sooner or later you will want to make more than four trades (entering or exiting trades) within a five day period because stocks tend to move together 70% of the time and you may need to exit or reverse several positions in your portfolio in the same week.
A sub-category of stock trading is penny stocks. These are “pink sheet” stocks which are essentially worthless empty shells. If a stock selling for five cents goes up to fifteen cents then you could tripled your money. These stocks are worthless and none have ever emerged (to my knowledge) to become a real company. This market is ruled by pump-and-dump schemes where someone puts out false information via email/fax spam that some penny stock is about to take off and become a real stock with some new positive development at the company. The distributor of this information buys the stock ahead of time and then sells into the suckers who are reacting to the false news by purchasing the stock.
Options are very popular and can be very profitable. I recently made $8,000 in four days on some S&P 500 ETF option trades using just $12,000 of my account balance, but that doesn’t happen very often. My options had lower risk because they were deep in the money and several months out in expiration. It was a synthetic stock position with a lot more leverage than a normal stock trade would give me. This is called a stock replacement strategy or a synthetic position (depending on how it is done). We will discuss this more later. Options can be the most complex of the assets to trade. Options are based on another asset, like stocks or futures so you need to understand both the option and it’s underlying asset. Its best to learn how to trade options after you learn how to trade the underlying asset first. Options are also subject to the $25,000 requirement of the pattern day trade rule.
This is an area best left to specialty brokerages. Any one corporate bond issue is thinly traded and not suitable for independent traders working from home. These bonds should not be confused with US Treasury bond futures, which are futures contracts -not the bonds themselves (see below). For long term investors it is better to buy bonds than to buy bond funds. As long as you own a real bond (not a fund), you will get all your money back with interest (unless they go bankrupt). You may permanently lose money in a bond fund no matter how long you invest in it.
Forex trading is the trading of the exchange rate of currency pairs, like the Euro vs. Dollar. This seems easy to understand and is not subject to the pattern day trade rule so you can open an account with $100 and start trading tomorrow. However, currency exchange rates change rapidly and these pairs can cause your trade to swing wildly in value, which I find difficult to trade successfully. In my unscientific sampling of traders I have found fewer people being successful with forex than stocks, options, or futures trading. If your trading budget is tight then you may need to go this route, in which case you need to follow the lead of someone who is successful, like Todd Gordon of Aspen Trading.
I’ve saved the best for last. Futures trading is usually the last asset to be considered by novice traders. I’ve known people who have traded stocks for more than ten years and have never seriously considered futures trading. A big part of the reason is that it is unfamiliar and mysterious to most people. I did not make my first futures trade until five years after I had started trading stocks and then found that it was a lot easier than I thought. Like any type of trading, you need to know what you are doing. Futures trade 24 hours per day from Sunday night to Friday afternoon and are not subject to the pattern day trade rule.
Tom Grisafi (pictured at right) makes his living trading agricultural futures, primarily in grains, in his house in Indiana.
Futures are a contract for future delivery. For example, if you own a German car dealership you can buy a futures contract that will lock in the price of the Euro vs. Dollar for next quarter’s car purchases to protect yourself from an adverse change in the exchange rate. The leverage in futures contracts is very high so a little money goes a long way. Over use of leverage can lead to excessive losses (remember the 41-43% of your trades will be losers). Futures contracts can be had for stocks, stock indexes, commodities (corn, wheat, soybeans, etc.), US Treasury bonds, and much more. Futures offer a wide range of uncorrelated instruments to trade but caution should be exercised when holding contracts overnight as their value can change dramatically while you sleep. Futures contracts are rarely traded outside the United States but foreign investors who have US trading accounts will kick up the action around 4am Eastern Time. Novice traders often gravitate to the S&P 500 futures electronic contract (ES), which is not the best choice most of the time due to the relatively high tick value and narrow daily range (more on this later). My favorite futures contracts are NQ, YM, EMD, and RUT. I know some traders who swear by the FDAX (German stock index) but I would have to wake up too early to trade that one.