Steve's note: Today's essay is a bit different than we normally feature in DailyWealth. It's by my friend Jeff Clark. Jeff is one of the most successful traders in the world. If you ever make short-term trades, his advice below is priceless...
This Is How Millionaires Really Trade
By Jeff Clark, editor, S&A Short Report
June 7, 2008
Joe is the financial version of a suicide bomber.
He's a veteran trader with great instincts and a sharp, analytical mind. And he'd be worth millions today if he'd just stop blowing himself up.
I hadn't seen Joe for a few months until I ran into him yesterday. He didn't look good. His face was pale and drawn, and sported the remnants of a three-day beard. His eyes were bloodshot. And his breath reeked of alcohol.
It was 10:00 a.m.
"I just got rolled by the market," he said. "Everything was going so well. I was having a great year scalping profits on small trades. I mean, I was really making some money. Then I bet big on this one trade and – BOOM – it blows up on me."
"I always make money," Joe continued, "when I bet small – ALWAYS. But whenever I bet big, I get killed. What am I supposed to do?"
It was a rhetorical question, and Joe didn't seem to be quite in the right frame of mind for a constructive answer, so I just nodded sympathetically. But the answer seemed obvious... and it's a lesson you can use immediately to become a better speculator: Bet small.
Big trades are emotionally difficult to handle. When a trader has the rent money on the line, he's more likely to second-guess his strategy. He'll watch over every tick on the stock and wonder if he should get out, add more, cut back, or whatever. That's when emotion takes over. Trading on emotion is never a good thing.
The thing of it is... every trader has blown up. Pain is part of the learning process. It's like how a toddler learns not to touch a hot stove. A big loss teaches a trader to minimize risk.
Some traders learn their lesson after one blow-up trade. Others, like Joe, turn explosions into a habit.
Personally, I've blown up three times. The last time was about 15 years ago. I took such a spectacular loss, and suffered so much pain, I swore it would never happen again.
Since then, I've adhered to three simple rules that minimize my risk, yet still allow the potential for spectacular gains...
1. Take 90% of your investable assets and lock them up in safe, low-risk investments with the objective of earning 8%-10% per year.
Of course, 8%-10% returns in today's market environment might seem difficult to do. But really, it isn't. Several strategies work well in a volatile market. In fact, selling covered call options against low-risk value stocks is hugely profitable right now.
2. Take the remaining 10% of your account and speculate with call and put options. Understand, I'm not talking about gambling here. I'm talking about speculating.
Proper speculating involves only taking on trades where the potential reward far outweighs the potential risk... and where the odds of success favor the trade.
The combination of 90% conservative investment and 10% speculation makes it hard to actually lose money. Think about it... If you can earn a 10% return on 90% of your money, then you can just about lose everything on the speculative side and still break even at the end of the year.
The real benefit happens, though, when you earn 10% on the conservative account and then knock the cover off the ball with your speculative trades.
3. Never, ever overleverage a trade. Keep your "bet sizes" small.
Remember, the real purpose of options is to reduce risk. Options allow you to put up less money and still control the same number of shares. So, if you normally buy 1,000 shares of stock, then you can buy 10 option contracts and maintain the same exposure with just a fraction of the funds.
This is where most people make mistakes. They look at options as a tool for leverage. Instead of buying 1,000 shares of stock, they buy 100 option contracts, thereby gaining exposure to 10,000 shares – 10 times their normal position size.
The hope is they'll get more bang for their buck. Inevitably, leverage does create a bang. But it's usually an unwelcome explosion, like Joe's. For a rule of thumb here, remember that most of the greatest traders of all time won't put more than 1% of their investable funds into any one trade.
I've been trading stock and options for a living for more than two decades. So I know if you 1) keep the bulk of your money in safe, long-term investments, 2) use the rest to make intelligent speculations, and 3) keep your trades small, you'll always avoid the catastrophic loss that wipes out most investors.
And I'm sure these rules will keep you off the booze at least until happy hour.
Best regards and good trading,
Jeff Clark
Editor's note: Jeff Clark is a regular contributor to DailyWealth, a free investment newsletter focused on the world's best contrarian opportunities. We write with a simple belief in mind: You don't have to take big risks to make big money with your investments.
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