By: Chris Rowe — May 15, 2020
The #1 Rule in Trading to NEVER Violate
I get emails all the time from people like you asking me what the most important trading rule is.
So here it is:
The smartest traders and investors on earth sometimes get killed because they can't follow this one simple rule. That's because sticking to this rule is much harder than learning to understand how to analyze markets, sectors, or stocks.
Think back to the end of the last decade...
Remember a fellow named John Corzine? From MF Global Holdings? He was one of the smartest and most sophisticated investors on earth. Yet he overleveraged himself and it sank his entire firm. Do you think you are a better trader than he is?
As simple as this critical principle sounds, it can be the most difficult to follow because, instead of dealing with analysis and logic, it deals with the never ending fight against our own human nature.
IMAGINE STARTING WITH $50,000 IN CASH
Say there's a stock we're interested in trading. We decide to use a "stock replacement strategy" by trading call options instead of trading the actual stock.
This strategy involves "leverage" -- a word that some people find scary. But here's what too many people don't know...
If used properly, leverage involves a fraction of the risk we'd take by trading a stock or ETF. And it offers a much larger potential reward.
Let's walk through a couple of examples.
First, understand that "notional value" is the total value of a leveraged position's assets. Typically, a single call option represents 100 shares of stock. So if we own one call option that gives us the right to buy, say, an $80 stock...
Then the "notional value" here is $8,000. (100 shares of an $80 stock = $8,000.)
Now, our call option (which gives us the right to buy that $80 stock) might only be trading at $9 per option contract. Our cost is only $900. (One call option, which represents 100 shares, trading at $9 per share of underlying stock in the contract = $900.) Thus, what we've done is used $900 to control $8,000 worth of stock.
If the stock price is cut in half, the stock owner loses $4,000. But the call option owner loses just $900. That's the benefit of using leverage the RIGHT way.
Of course, there's another side to this...
When you are overcome with greed or you feel, as most of us do from time to time, that your current lifestyle is unsatisfactory, it can be tempting to use the power of leverage to control a huge position.
Starting with $50,000 you can use leverage to control $500,000 worth of stock (a BAD idea)...
Or, (as we just saw) you could control $50,000 worth of stock by only putting $5,000 to work and only risking $5,000 (a very GOOD idea).
A PICTURE WORTH A THOUSAND WORDS AND A MILLION DOLLARS
The table below spells out a set of six hypothetical scenarios for this kind of trade. Notice that the trades represent different notional values (the first column).
We started by trading positions with a notional value of $10,000. Depending on the specific cost of the particular option, we might have committed $900 to the trade, or we might have committed $1,100 to the trade. In any case, in each of the first three trades, we control $10,000 worth of stock.
In the third trade from the top, we made an 80% return on the position. That caused our account value to spike 16%, which is actually a nice annual return for the average investor.But in the fourth trade, we were feeling overly confident (that is, overly emotional) about a trade. Plus, maybe we felt that because we made a nice profit on trade #3, that we could afford to risk a little more. So we find a very volatile stock that just took a huge dive lower. We felt that this stock would climb much higher just on a "dead cat bounce".
So we used the power of leverage to control a much larger position (in terms of notional value). We used $16,000 in cash, but we used it to control a position with a notional value of $80,000.
But the stock fell further and we lost $15,000. The prior stock advanced 80%, but the overleveraged stock only lost 18.75%. In dollar terms, you lost nearly twice as much as you gained on the prior trade!
As you can see above, your account value went from being up 16% to being down 14%.
That may not seem like a big deal. In fact, we felt like we should reduce the notional value position size to $20,000 for the next couple of trades. It's twice the amount we originally intended to trade, but now we feel like we have to step up the trade size so we can make back our money.
Instead of turning this into a "slasher movie", let's assume that over the course of the next two trades we made 20%, and then lost 10%. By the time the "smoke clears away," (the bottom entry in the last column, far right) our account is down 10% overall.
And you and I both know the story can have a much worse ending than that. That's the danger of overleverage.
Now let's look at a slightly different version of the same table, below. Here we have the same exact percentage returns on each trade (the fourth column), but with an investment of $10,000 notional value put into each trade (first column).
As you can see, instead of having an account that is down 10%, you have an account that is up 14.25%. I could have spiced up the story with more volatility and compared an account losing 76% to an account going up 34.25%, but I don't even want you THINKING in those do or die terms. Let's think about this realistically.
Also note that this is a VERY oversimplified hypothetical scenario. I don't think it makes sense to invest one "typical" amount of money into positions (such as the $10,000 in the scenario above). It makes sense, instead, to first decide how much you are willing to risk on a trade and then go from there. But that's another lesson for another day.
Bottom line - you can have the most successful system on earth, showing winner after winner...
But overleveraging on just one single position renders that system null and void. That is. it's no longer a system. It can open up a whole can of worms and cause a domino effect that can easily spiral out of control, where you’ll find yourself spending the next several trades trying to make your money back from one careless loss.
Be a disciplined trader. Follow a smart trading philosophy. The rest will fall into place!
I know this is true, as I get emails from readers just like you all the time testifying to just how powerful following a smart trading philosophy is.
Right now I'd like to share the most recent feedback I've received.
I think you'll find it very informative and inspirational...
Chris, thanks for all your teachings, really, man. I will tell you that there are very few people in this business who are genuinely concerned about average investors like us not only in terms of helping us make money but more because you foster self-reliance in us through knowledge.
Most people would want to foster “dependence” in us so that we would need more services from them. Chris, this is not flattery because I have already paid for the lifetime of your services.
I know a genuine, sincere, and a good teacher when I see one and it is because all through my life people have told me the same about me and so I know the psychology and motivation of such a person. Having said that, you can use the following remarks or any parts of them as testimonials. They are all truthful and I mean them.
1. Chris, you are a superbly excellent teacher and I see that in every seminar. Your seminars are very clear, practical, and full of sincere care for us. I take notes of each seminar in terms of the small nuggets of knowledge that I derive from them.
I believe you have excellent communication skills, which comes from your keen sense of listening to us to understand us. One of the most, if not the most important trait of a good teacher is his listening skills (which requires patience).
2. Chris, you sincerely care for your clients (us) and really want us to learn investment skills. This is so rare and genuine for such precious information! It is a life-changing gift to us.
I have been studying the TAM course for several years since I first took that program from you years ago. I have gone over the entire course about 8 times already and I am still going through it again. Yet, every time I make notes for myself, and each time I see myself evolving.
I thank you for the TAM course and seminars. I thank you not so much for making me money, but more for giving me the knowledge which now belongs to me and I use it in all trading I do, even with all other professional services.
3. Chris, originally and the very first time I came to know you (about 15+ years ago) was when you had written a series of three or four installment article on Yahoo website pages and the article was about what is now your Stock Replacement Strategy (Checkpoint).
I had been searching for you since then and tried for the longest time to attend the TAM (that name was not there yet)! I applied for TAM and a few years later I secured registration into that course as you had closed it down for some time then.
And that happened to be what you told us was the last TAM course you would teach. Ever since then I have been reviewing, analyzing, and testing the TAM in my daily trading.
Currently, my portfolio is about $400,000+ although your services only account for about $25000, as I feel I am still learning the skills you are teaching. During this time, I made some errors of execution, even when my ideas were correct!
Mostly I did not make money because I was unlucky and the trades I chose were some of the few that had failed.
So, I became cautious and doubted your trades. I did not participate in them, and so I lost many good trades but I did follow them and used them as learning exercises! Your trades are really superb especially the Check-Point ones.
I highly recommend your services to all but caution: you must put in your labor and study time to be a consistent money-maker. The market shakes you out if you do not have proper learning. It is not Chris’ fault! Seminars are a great help.
If I were to rank your services in their order of importance/ease, it would be like this: 1. TAM 2. SPP. 3. Check Point 4. Swing Tech 5. Option Soup 5. Deep market trades 6. Profit Skimmer.
4. Chris, I finally figured out the secrets of your short time (few days to a few years) and a long time (few years to lifetime) trading success! Short time success is due to your system, experience, patience, confidence, and hard work.
And a long time success is due to your “good-karma”! I and perhaps you also believe in “higher authority and purpose”. You are truly one of the good men on the Wall-street and good-karma will always follow you in what you do.
The good-karma of genuine and true guidance to help people and teach us a life-time of precious skill.
Kirit (Kris) Dave'
Getting letters like this is what keeps me in the game, and words can't describe how much I appreciate them.
Thank you for your support!
See you soon,
Founder, True Market Insiders