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Bull. Bear. Who Cares? How to Keep the Party Going

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January 1, 2015

TRADE MANAGEMENT PARTY TIPS

What does a wicked, strange-colored punch and ear-shattering heavy metal have to do with bull markets? Everything and nothing. Great parties don’t last forever. And unlike the night you wore the hula skirt on your head in the pic that somehow got to your mother-in-law, in the real world you don’t overindulge. You pace yourself.

Over the past few years, major U.S. indices have had strong rallies. If you bought an index fund five years ago you might be seeing strong returns. Profits are fun, right? But markets go down as easily as they go up. If you’re not ready for it, it can be a hard, nasty, punctured-balloon, torn-streamer kind of crash. The trick is arriving at the party dressed like a seasoned trader and knowing how to temper your investments. Consider three principals that could potentially help you let the good times roll no matter the market conditions.

1 // Kegs Are Funner Fuller

When the beverages run dry, guests head for the door. When it comes to your investments, keep money flowing in your brokerage account to make new trades or meet expenses. To buy a stock, call, or put, for example, you’ll need to cover margin requirements. If you use up all your funds on one or two trades that can mean two things. One, you won’t be able to take advantage of new trading opportunities. And two, you’re potentially putting your entire account value at risk.

For example, if you have $5,000 in a brokerage account and you buy 50 call options for $1.00 each, plus transaction costs, you’ve used up all available funds. If the stock or index moves lower by the options’ expiration, they might expire worthless. Your account is now worth $0. And that’s true of any trading or investment strategy. If you invest all or nothing on any one trade, you put your entire account at risk. No more fun. No more dancing under starlight and falling in the pool with your clothes on.

PARTY TIP: A smarter approach might be diversifying—trader style—by spreading a percentage of your trading capital over a variety of trades across sectors. That way no single trade can potentially wipe you out. And even if all your trades lose, you’ll still have money left over. Break it down like this. If you don’t want to risk more than 20% of a $10,000 trading account, then the total risk of all current trades shouldn’t exceed $2,000. Now, diversify that risk over many trades on stocks in different sectors, and possibly even different asset classes. If you expect to be managing 10 trades, each trade should carry less than $200 maximum risk. That way, if all 10 trades lose the maximum, you’re only potentially losing $2,000 plus transaction costs. So you’ll still have approximately $8,000 left over to trade with or blow on a lot of guacamole and party favors.

Once you evolve your trading method, and begin to feel more comfortable with putting more of your capital at risk, you might think about implementing various types of margin trading in your account. You may even qualify for portfolio margining (see “Portfolio Margins Made Clear,” below) Now, using margin isn’t an excuse to binge. It’s just another tool, like anything else. Use it wisely.

2 // Know When to Cut Yourself Off

While everyone’s guzzling exotic concoctions and slamming down hot wings, know your limit. The trading equivalent to passed-out-in-the-corner party fever can take a few forms. Like trading too big or sticking with a bad strategy.

Trading too big can happen even to veterans. You wake up one day and decide a trade is unusually attractive. You say to yourself, “this stock’s so low it can’t go lower.” Or, “the market keeps going up, it’s never gonna drop.” And countless other fantasies.

So you risk 2 or 3 times a typical trade allocation because you’re so confident. Pin the tail on the stumbling host, anyone? You know how this bloated party ends. The stock does go lower, or the market does crash, and turns your big trade into a big loser that that leaves you with empty pockets and a strange tattoo.

PARTY TIP: In addition to rule number one—keeping trades smaller—at a certain point, you may have to cut off a trading strategy altogether. If you’re using a certain logic to identify good spots that turn out not so good, put simply, reevaluate. You may be using a set of technical studies or fundamental indicators predicated on the market moving higher. No matter how well-researched or planned, if your research is yielding nothing but losses when the market stops rallying, it might be time to walk away.

Every strategy can have losing trades. But how many are you willing to take before you find a new one? That answer can depend on how big the losses are, and how big your account size. As a rule of thumb, if you’ve lost more than the max loss you identified in rule 1, say more than 20% of your account size, and haven’t had any winning trades in a while, it might be time to get that strategy into a Hefty bag with the soggy Twinkies and lukewarm pizza.

3 // There’s Always Another Bash

Ask anyone on the A-list. No matter how fantastic a given market extravaganza, there’s always tomorrow. So don’t try to cram a year’s worth of fun into one night. You need patience, a daily dose of responding sensibly to fast-changing market conditions, and make sure you have enough gas in the tank to make it to the next one.

PARTY TIP: If the market doesn’t rise, you’ll need to adjust long term because the market will naturally fluctuate. You already know the market doesn’t always go up, so what works today might not work tomorrow. What works in one set of conditions doesn’t always work in the next. If you only know how to trade a bullish market, but your bullish strategies aren’t working, it might be time to admit you’re in a bear, or a trading funk. To handle that, you’ll want to stay small in your trades, active, and engaged.

A trading career isn’t built in one expiration or in one earnings cycle. Successful traders look at longer horizons and rely on fundamental rules like these to make sure the end of a trading hangover is just a power walk and a kale smoothie away.

Do You Qualify for Portfolio Margin?

Find out more information on portfolio margin accounts.

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