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By: Chris Rowe — September 3, 2013

Technical Tuesday: Follow This One Rule and Profits Will Come

Editor's Note:  Chris is working hard today to put the final touches on Thursday night's private Live Webinar for students in his Technical Analysis Mini-Course.  (If you're enrolled in the Mini-Course and haven't yet R.S.V.P.'d for the webinar, you can do so here.)  The following was originally published 2012 yet, as you'll see, is just as relevant today as it ever was.  Enjoy.
 
Tuesdays are typically reserved for Technical Analysis. 

But you can be the best technical analyst on earth and still get crushed. 

Once you establish a trading philosophy and a trading system, there are a few rules you absolutely must live by.

Today I'll go over the importance of the single most important rule you can follow.  If you follow this rule, the profits will come.

The two most powerful words you'll ever read about investing:

Don't overleverage!

Following this rule is much harder than understanding how to analyze the market, sectors, or stocks.  The smartest traders and investors on earth get killed because they can't follow it.

Just look at John Corzine from MF global.  Here's one of the smartest and most sophisticated investors on earth.  He overleveraged himself and it sank his entire firm.  Do you think you are a better trader than him?

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 fighting human nature.

Marketers know to play to a human's weak points -- mainly Fear and Greed -- because they know that these hot buttons can overcome rationalism and logic.

Overleveraging is something we do when we get greedy about a position we believe we are “sure” about, or when we feel like we need to make up for a past mistake (usually a past mistake that involved overleveraging!).

Does this sound familiar?

We are so overconfident about a situation, and all we can envision is a future stock chart that explodes in the direction we want it to, and the amount of money we will have if we are right.  Sometimes we don’t even consciously understand that we are playing a position too heavily until we see what we’ve done in hindsight, the way a person remembers something embarrassing they did when they had too much alcohol the night before.

Imagine starting with $50,000.00 in cash.

You decide to use a "stock replacement strategy" by trading call options instead of stock.  

This strategy involves the use of leverage -- a word that some people find scary.  But if the leverage is used properly, you will take a fraction of the risk you're taking with stocks and ETFs... and with a much larger potential reward.  That's why, for the most part, I only trade options.

Let's walk through a couple of examples...

First, understand that "notional value" is the total value of a leveraged position's assets. 

Typically, 1 call option represents 100 shares of stock.  So if I own 1 call option that gives me the right to buy an $80.00 stock, then the "notional value" is $8,000.00.  

(100 shares of an $80.00 stock = $8,000.00.)
Sure, my call option (that gives me the right to buy an $80.00 stock) might only be trading at $9.00 per option contract, which only costs $900.00.
(1 call option, which represents 100 shares, trading at $9.00 = $900.00.)
Thus, What I have done is used $900.00 to control $8,000.00 worth of stock.  If the stock price is cut in half, the stock owner loses $4,000.00, but the call option owner loses $900.00.

When you are overcome with greed or you feel, as most people do, that your current lifestyle is unsatisfactory, it can be tempting to use the power of leverage to control a huge position.  

Check out the table below. 

Starting with $50,000.00 you can use leverage to control $500,000.00 worth of stock (bad idea), or you can control $50,000.00 worth of stock by only putting $5,000.00 to work (only risking $5,000.00). 

We started by trading positions with a notional value of $10,000.  You might have committed $900.00 to the trade, or you might have committed $1,100.00 to the trade.  The point is, you control $10,000.00 worth of stock in each of the first three trades.

In the third trade, you made an 80% return on the position.  That caused your account value to spike 16%, which is actually a nice annual return for the average investor. 

But in the fourth trade, you felt overly confident about a trade.  In addition to that, you felt that because you made a nice profit, you could afford to risk a little more.  So you find a very volatile stock that just took a huge dive lower, and you felt the stock would climb much higher just on a "dead cat bounce".

So you used the power of leverage to control a much larger position (in terms of notional value).  You used $16,000.00 cash, but the point is you used it to control a position with a notional value of $80,000.00.   

But the stock fell further and you lost $15,000.00.  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, you felt like you should reduce the notional value position size to $20,000 for the next couple of trades.  It's twice the amount you originally intended on trading, but now you feel like you have to step the trade size up if you're going to make back your money. 

Instead of turning this into a horror story, I decided that in the next two trades you made 20% and then lost 20%.  But you and I both know the story can have a much worse ending than that.  

Let's look at the table below, which has the same exact percentage returns on the trades, but with an investment of $10,000.00 notional value into each trade. 

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 being up 34.25%, but I don't even want you THINKING in those 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 $10,000.00 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.  

The Takeaway

You can have the most successful system on earth, with the greatest track record, but overleveraging on just one single position deems that system null and void and it is 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 a stupid loss.

Be a disciplined trader when it comes to position sizing, follow a smart trading philosophy, and the profits will come!

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