Turn conventional investing wisdom on its head and don't do what countless others have tried before you. Good habits and knowing what not to do are a must.
We know you trade. You’re reading this magazine. But what about your millennial friends who are landing their first jobs and starting to save a little? How many of them trade? Or invest? Do any of you talk or text or chat or tweet about the market? Ever? The fact is, trading today isn’t some super-esoteric lifestyle that means you become a math nerd who talks exclusively in market-speak and kinda never gets invited to parties. Do your friends want to learn? What may be missing from all that when you’re starting out is the wisdom of experience that dictates what not to do, which can be as crucial as what you actually do. Were I talking to my 25-year-old self, here are the two cents I’d give.
Even if someone’s interested in the market, people are busy. They only have so much time to learn about trading and would have to make that time count. Be honest—if you spent six hours perusing research reports and company financials, what could you possibly learn that 1,000 market analysts don’t know already? But if you spent six hours studying vertical options spreads, and learning how to estimate potential profit, you’d start to learn something a lot of analysts don’t fully grasp. (Starting out your education with options would be ambitious but might be well worth it.)
Once you got verticals down, for example, you’d own that knowledge for the rest of your life. The fundamentals of verticals—buying one option and selling another option at different strikes in the same expiration—don’t change. Yet, company financials do. Knowing how options make and lose money, where they’re profitable, what’s at risk, how they respond to time and volatility, and how to apply it all for a particular directional speculation may not only be more practical than knowing what the company financials tell you; it could be critical.
And there are just a handful of strategies you’d need to be competent: short puts and covered calls, vertical call spreads, vertical put spreads, iron condors, butterflies, and calendar spreads, to name a few. That’s pretty much it. You can employ an options strategy for just about any market condition over the next 60 years—high volatility or low, market rallies or black Fridays. Even for a beginning trader (for all options traders, really), it’s never about perfectly predicting the next big market move or hot stock. It’s about learning, absorbing, and applying the right strategy.
A first instinct when we earn money is not to lose it. In the world of trading, naturally we hate seeing a winning trade turn into a loser. Seeing our investment go up in flames. And as hearty traders, we have to train our hearts and minds to fear less and trade more confidently.
If we teach our friends fear, we keep them from potentially earning a better return on their money. Risk often presents itself as a scary monster under the bed to the uninitiated. It can make otherwise skilled traders resist, back off, back out, and more. Those kinds of traders and investors have mythologized risk. They hold onto images from the 2008 crisis and market meltdown. More recently, they tremble in the face of the Greek economic crisis. China, Iran, Russia. After all, they worry they could lose their money because of events out of their control. Events out of everyone’s control.
Perhaps the antidote for trembling is science. Teach your friends how to quantify risk. “Implied volatility” (vol) is the market’s way of informing us of how much risk is built into a given trading move. In our less-fear science experiment, for instance, vol times a stock price gives you a one-standard-deviation price change for a year out. And plus-and-minus that standard deviation change suggests a range where, theoretically, a given stock or index will land 68% of the time at the end of a given trading year.
EXAMPLE:Stock at $50; vol at 30%. (0.30 X 50 = 15)$50 – $15 = $35$50 + $15 = $65
So, 68% of the time (one standard deviation) over the next year, the stock will theoretically trade between $35 and $65 per share. That means a lot fewer sweaty palms. A lot more sensible evaluation using the market’s own data. (Of course, it’s entirely possible it could trade more than what the standard deviation suggests, which could also increase your risk.)
Converting volatility this way starts to effectively quantify the risk for newbie traders. Instead of managing their money in a world of absolute uncertainty, they can start to manage their money based on numbers.
And while you’re at it, show them which options strategies have “defined risk.” What’s that, now? No matter where a stock price or index lands over time, it’s possible to estimate and predict the maximum possible loss if a trade has some defined risk built in. Quantifying and defining risk is how traders sleep at night.
Equipped with your trading wisdom, your friends may start to see potential opportunities. Some will seem so good, and a big win could impart so much confidence to the new trader, it might create some early reckless behavior.
Quick success has its dark side. Top of the list: stop your friends from trading too big, no matter how good an opportunity seems. Larger trade sizes naturally mean more risk. And if a single trade moves against them, their small accounts could be wiped out. Distributing risk equally across all trades by limiting the size of any one trade is one way to survive.
Any single trade can be a winner or a loser. Make sure the loser doesn’t happen on a trade that has outsized risk—a trade that could take all the others down with it. And because you can’t predict which trades will be successful, modulating position size may help avoid early catastrophic losses.
All traders have losing trades. It’s part of the business. Your friends will learn all about that just like you did: the hard way. Through a lot of trial and error and honing instincts. For your part, you have to help make sure a losing trade doesn’t end their career.
Collectively, all this advice is timeless. These ideas and recommendations will be true for just about every earnings cycle and Fed announcement for years to come. The goal of the young trader should be to build a healthy trading account and a foundation of knowledge and good habits. That’s what they can rely on through many cycles of fear, hope, hard work, and patience as they become the successful math and strategy nerds who are the envy of all.
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Financial Communications Society 2016
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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
Tom Preston is not a representative of TD Ameritrade, Inc. The material, views and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.
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