TRADE SAFE, TRADE SMART

“Trading? Invest in the stock market? ME??"

Sure! why not.

There’s hardly a single investor who didn’t hear that admonition at the start of his career, a single person with some extra money who wasn’t tempted to let a bank clerk do the heavy lifting for him.

But luckily, things have changed.

Financial trading is no longer a matter of calling a bank clerk you do not trust to invest in an asset you do not understand and (hopefully) make a profit you will never see, thanks to high commissions and questionable execution.

“But they’re the pros. The members of the club – the ones who know where the opportunities are. Surely, I can’t compete with them!”

Of course you can!

Today, almost anyone can access the economic news that hides the market action, and a trading platform to monetize that information. The question is, how not to fall into the pitfalls of ‘fear’ and ‘greed’, but rather understanding that these are the passions that move the markets.

In order to trade, we simply need to read the signs and act upon them. How do we know when the market is panicking and why? How can we take advantage of the herd mentality without becoming a member of the herd? In short – how can we bank wisely on the trends that fear and greed create?

Subduing natural instincts isn’t easy, but it’s worth money in the short run, and self-assurance later on. Strangely, though, the steps you can take are – in themselves – quite simple.

LEARN YOURSELF – LEARN THE MARKET

Let’s begin with the market. What is it?

Simply put, financial markets incorporate a huge number of people around the world just like you, watching what happens, hoping to make a profit, panicking when they don’t. Examples of market failures are abundant, and what most of them portray is public mayhem leading to market chaos.

In 1929, the greed of private investors caused a boom and panic caused the crash; in 2008, bankers monopolized on human greed, then crashed on their own personal fear. In short, and despite accepted theories regarding so-called “efficient markets” – if anything rules financial markets, it’s human emotions.

But haven’t computers taken the herd out of the mentality?

OK, yes. You’ve obviously heard about the algo-trading going on between emotionless computers, but remember who programs them. Computers may be impassive, but their programmers make mistakes, cause flash crashes and more.

Well, you ask yourself, with algos and the masses out there, how can I compete?

The answer is: Easy. You don’t.

You find out what motivates the markets, learn to anticipate it and go with the flow – hopefully staying at least one step ahead. While you probably can’t afford an algo-trading mainframe, you can learn about your emotions, how to identify them, and extrapolate that to the market.

Begin by trading extremely small amounts. This will put you in the correct mindset - keeping the risk of losing funds but without bankrupting you.

Keep a journal.

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Write down every single position you open, why you opened it and how (what opening and closing orders you used, how you decided where to place these). Alongside, keep a journal of your emotions. Are your palms sweaty? Do you find it hard to concentrate? Time to take a break? Afterwards, read your journal and analyse your feelings. Is there any correlation with the market?

Guess who else was panicking when you were? Who was jubilant? Who missed their exit point due to greed? (yes, it all goes in the journal).

RISKY BUSINESS

Won’t I simply lose my pants by the time I’ve learned?

Not if you’re careful.

You’ll lose at first – all beginners make mistakes, no matter what they’re undertaking. Ever heard those first recordings by the Beatles? Seen the kiddie movies Spielberg made with his first Super-8? But everyone learns, and mistakes are a part of the learning process.

The first rule of trading is “never risk more than you can afford to lose”. This is not to say that financial trading is a losing endeavour (after all, why are all those traders into it?), but one must be prepared to lose almost constantly at first. Just like any other kind of occupation, nobody comes into it fully fledged and bursting with potential.

Markets must be learned, and that is a time-consuming occupation. Thus, besides making sure you can afford to lose any pre-determined amount of money at the beginning, it is also a good idea to know how to spread that amount out.

Is there a formula?

Roughly, there are 2 rules to determine the ratio of capital to total open trades and investment per trade. These are the 2/10 rule and the 5/20 rule, usually ascribed to Warren Buffet. The 2/10 rule is for beginners, and it quite simply states that no more than 2% of one’s entire portfolio should be invested in any one position, and no more than 10% in all open positions at any one time.

Thus, if you have invested $1000 in your account, no position should have been initiated with more than $20, and your entire sum of assets invested in open positions should never rise above $100 (5 open positions, more or less). The 5/20 rule is aimed at more experienced traders. Second, place your take-profit and stop-loss orders at a ratio of 1:3 – for every dollar you risk losing on an open position, your take profit should be triple.

Thus, if you stand to lose your $20 investment, your take profit level should ensure you a $60 profit.

INVESTING & GAMBLING WHAT’S THE DIFFERENCE?

You’ve heard this cliché again and again; the answer, in a word, is ‘homework’. Returning once again to every investor’s guru, Mr. Buffet, always remember his secret to success: “I never invest in a company I do not understand.”

But Buffet has a huge organization doing research for him. How can I even begin to keep up?

The more you know about an asset, its fundamentals, what makes it tick and what influences its value, the less your position becomes a blind gamble, and the more it becomes an informed investment.

Think of those scenes in movies about horse-racing and boxing: they’re always about the “inside tip”, “taking a fall”, the hero trying to maintain the grace of sport in a world of (albeit dishonest) businessmen. The producers may want to tell you that honesty pays; but the reality is, that in the world of business, the more you know, the better positioned you are for success.

So what can I do?

Before investing in an asset, study it for an extended period. See how its value changes with every new bit of information. Find out who are the faces behind the decisions. Only when you completely understand the asset should you begin formulating a plan for its monetisation.

You may find a company that is making a lot of money, but diverts most of its capital to wages rather than development; you may find one whose stats are impressive, until you compare it to others in its sector; you may find a company that fulfils your dream requirements, but whose CEO has been charged with fraud. In short: don’t invest in what you do not know!

Whether you’re a fundamental analyst, studying the news and financial reports, or a technical analyst, verifying technical indicators against one another, it’s always best to investigate the interplay of the two – see how the technical reacts to the fundamentals and (quite often) how often the fundamentals are a reaction to the market.

But whatever your approach, stick to it until you reach a point where you see your predictions bearing out. Investigate the past until you understand it, then try to apply what you’ve learned to the present/future.

That way, when you lose on a position, you won’t see it as a personal failure but rather a new direction to investigate – another learning opportunity. Search for the point at which your prediction and the market diverged and study it. Only when you learn to put your mistakes to good use will you finally be profiting from them.

Good luck and welcome to the most fascinating endeavour, ever!