Chapter 18

Looking for Balance Between the Sheets

In This Chapter

Finding out what’s on your trading mind

Accounting for what’s in your wallet

Investigating what you’re worth

The futures markets are a zero-sum game. Someone always loses, and someone always wins. In other words, any money that you make trading is money that you’ve taken away from someone else who’s also trading.

Put the shoes on your own feet, and you get a better picture of the situation. Yup, out there in cyberworld or in some crazy trading pit, someone is waiting to take your money away from you. So before you decide to start trading, you need to figure out whether you measure up mentally and financially.

I’m not talking about your self-esteem or your intellect here, although good measures of both are required for success in trading. More important, you need to know how much money you have and whether you can manage it well enough for continued success in trading futures — that is, well enough to stay in the game.

In this chapter, I tell you about some basic issues that can help you decide whether you should be a trader or think about doing something else with your money until your finances are in good enough shape to enable you to trade comfortably.

In a sense, you need to keep track of two personal balance sheets: a mental one, from which you figure out why you want to trade, and a financial one, from which you decide whether you have enough money to finance your trading venture. Both are equally important, and ignoring one or the other is a recipe for disaster.

Exploring What’s on Your Mental Balance Sheet

Your expectations about futures trading shape the role futures play in your portfolio. As a general rule, futures need to be part of an overall financial plan that includes stocks, bonds, mutual funds, annuities, real estate, and other assets. Although not a mandatory component, futures and commodities in general can be useful in the portfolios of individuals with large net worths, especially as a hedge against risk. However, the central tenet of your mental balance sheet is understanding why trading futures appeals to you.

Why do you want to trade?

Most people look to the excitement often associated with gambling and equate it with trading futures. Unfortunately, trading futures or other assets is not gambling. Trading isn’t associated with glitz and shouldn’t be associated with liquor or other diversions. In fact, the more aware you are of the current global situation and the current situation in your market, the better off you’ll be.

Here’s how I answer the question: Trading is a hedge for my life. I have two full-time jobs: my medical practice and my financial business. On occasion, one or the other takes over as a major income producer. When my trading business isn’t going well, my medical practice still provides a relatively stable income and vice versa. (I’ve experienced periods when the opposite has been true.)

I trade for these two reasons:

It’s my business. Trading and the byproducts of trading, such as writing books, selling subscriptions to my Web site, and occasionally providing consulting services, are major contributors to my income. By trading, I’m not only making money, but I’m also testing strategies in real time that I eventually can pass on to my subscribers (www.joe-duarte.com) in the form of recommendations and insights.

Trading provides income diversification and enables me to maximize the total return on my retirement fund. I add as much to my IRA every year as is legally possible within my means, and I trade the hell out of it. I don’t miss an opportunity to contribute to it, no matter what. Most of the time I fund my IRA entirely from the income that trading and related endeavors produce.

For me, trading is an important source of income and income diversification that I derive from a tremendously enjoyable and agreeable mental and intellectual exercise.

When pondering the question that heads up this section, make sure that your answers are truthful. If you’re just looking for kicks or you think that trading will fix all your problems, don’t fool yourself. Trading is work that requires personal and financial commitment, even if it isn’t your primary source of income. If you take it seriously, you need to think about what you expect to get out of it. If you decide not to take it seriously, don’t trade.

Trading is a sporadic way to produce income. You can experience long stretches during which no matter how you feel or how accurately you follow your trading plan, you’ll still have few opportunities to ply your craft, or you’ll end up going through a long and steady string of losses. In a good year, I can make as much or more money by trading than I’m allowed to add to my IRA. By adding money every year, I increase the overall rate of accumulation in the account. But in a bad year, I may have to consider taking out a loan to cover my taxes and to fund my IRA. Fortunately, I haven’t had many bad years.

Trading is a serious game that should not be taken lightly. The key to being a successful trader is to be comfortable with yourself, your motivation, and your ability to formulate a plan and put it into action. Before you start trading, it’s important that you understand why you want to trade. You need to look at your own life and situation to make a decision that you can live with when it comes to how much time and effort you can devote to trading and whether you’re willing to stick to it.

Trading as part of an overall strategy

Trading futures needs to be put into proper perspective. After you’ve sorted out your mental balance sheet, you can consider where trading fits into your life.

Trading can be a part-time endeavor, or it can be a full-time job. If you’re like me, you consider trading as full-time work, but if you do it part time, it can be a useful source of income all the same.

Say, for example, that you’re a buy-and-hold investor in stocks, concentrating on income-producing preferred, blue-chip, and utility stocks. Trading futures can add a more aggressive element to your portfolio.

One ideal way for you to trade to your advantage takes place during times when a market is moving sideways, and you can improve your income by writing call options (see Chapter 4 for more about options). Another way is when a market is ready to top out, and you can either sell stock-index futures short or buy put options to protect your stock portfolio.

Trading for a living

On the other hand, when you’re trading futures for a living, you may want to consider moving to Chicago or New York and looking for a job in the industry. If that is your goal, it probably will take several years to master the craft and significant amounts of capital, guile, risk taking, and effort may be required on your part to accomplish it.

Regardless of what you decide, you can derive at least some benefit from figuring out your mental balance sheet.

The Financial Balance Sheet

The high-risk world of futures trading requires a higher litmus test of your finances than other forms of investing. In the same way that you took the time to explore the reasons why you want to trade and how trading is going to fit into your life, you now must look at your finances with the least amount of flattery possible.

The big question is whether you have enough money to take risks as a trader. If you’re struggling to pay your bills every month and your idea of being solvent is transferring your credit-card balances to a new card every six months to increase your credit line, you’re better off not trading futures. On the other hand, if you have enough money, you may want to find someone to do the trading for you. And if you’re somewhere in between having no money for trading at all and enough not to worry, you’ll probably have to do at least some of the work yourself.

Organizing your financial data

As elementary as it may sound, getting organized is the only place to start. But before you start adding and subtracting, make sure that you have the following matters under control and accounted for within your monthly finances:

Your living expenses, especially food, mortgage, rent, and car payments: If you can’t live the way you want to on what you make, looking to the futures markets to save you from your current situation is not prudent. You have to have enough money for the basic necessities, food, transportation, and rent before you do anything else.

Your life insurance coverage: The amount here is variable and needs to be based on your family’s expected expenses after your death. Some basic life-insurance calculators are available online to help you determine how much you need. I recommend a quick Internet search, using your favorite search engine.

Your health insurance needs: Again, the amount of health coverage you have is based on your family and your individual needs. You need to figure in a worst-case scenario, though.

Your retirement plan: This aspect of your finances needs to be one of your highest priorities before any kind of investing. Make sure that you establish one and that you fund it as fully as possible before doing any other kind of investing or trading. As I note earlier in this chapter, I trade my retirement account actively and successfully, and I believe that you can do it too if you master the craft well. Just remember, you should not put 100 percent of your retirement money into a futures trading account. Always diversify and time the markets based on your experience and knowledge of trends and indicators.

Your savings plan, including how you’re going to pay for your children’s college educations: Start by calculating your savings rate, which is the percentage of last year’s earnings that you didn’t spend.

Your emergency fund: Set up an emergency fund and don’t even think about using it to fund your futures trading. At least three to six months’ worth of living expenses is a good start.

When you have the essentials covered, you can turn your sights on reducing or restructuring your debt with a clear and concise endpoint in mind so you can pay it off and start thinking about accumulating money to trade with. One way is to set yourself up with an allowance every month or every paycheck.

If by some miracle you find that you have enough money left over, congratulations! You can consider trading.

A good place to gather information for preparing this kind of a budget is your tax return or any recent loan application you’ve filed. You can develop a good inventory of your assets and liabilities by reviewing credit-card statements, your checkbook ledger, and your monthly receipts, especially expenses that are recurring every week or month, such as grocery, cellphone, and utility bills, and car and house payments.

Don’t forget to include intangibles, such as car repairs and impromptu medical and dental bills, because they can add up in a hurry. Be sure to categorize your expenses according to their similarities, much like when you’re preparing your tax return.

Get a second opinion from a financial planner about the state of your finances. Be careful when you do because most will tell you that trading futures is too risky, and some will try to sell you high front-loaded and back-end-loaded mutual funds instead. If you visit a financial advisor or planner, make sure you tell him upfront that you’re interested only in him checking your work and your calculations.

Setting realistic goals

Set the bar on your finances high enough that you won’t be sorry later. Ideally, you need $100,000 or more as an initial trading stake. If you can’t come up with that kind of money, wait until you can at least meet the lowest trading threshold of $25,000. Again, these are guidelines. Stories exist of talented traders who’ve made millions after starting with as little as five or ten thousand dollars.

When setting your financial goals, consider the following:

Your age: How old you are is especially important whenever you’re not well capitalized. Make sure that you can make your money back if you happen to have a disastrous start or streak.

The size of your family: As with age, the number of people who rely on you financially is more important when you’re not well capitalized. If your income is a significant portion of the family’s well-being, then that takes precedence regardless of the circumstances. Never sell your family short.

Job security: Most traders and would-be traders need a steady infusion of income that’s provided by a steady job. If you decide that trading is your job, you still need to find a way to supplement your income during the times when trading won’t provide you with enough money.

Your family’s attitude toward trading: If your spouse is going to harass you about trading, or you lose contact with the family because you’re up at strange hours trading currencies, you’re going to have a major problem at some point.

Your own risk tolerance and emotional status: If you can’t stand the thought of what you’ll do if you get a margin call or you get wiped out, find something else to do.

Calculating Your Net Worth

Your net worth can guide you in making your final decision about whether you can actually afford to become a futures trader. The calculation is simple, but it requires attention to detail. Widely used financial computer programs like Quicken can help you do the work. A quick search on your favorite Internet search engine takes you to several Web sites that feature other programs that also can help. You can find a simple free calculator on the Web through a quick search, or ask your bank for a checklist.

You can also do the calculations by hand. If you need a major helping hand with this aspect of getting set up, pick up a copy of Eric Tyson’s Personal Finance For Dummies, 5th Edition (Wiley).

Figure 18-1 shows you a generic personal balance sheet that’s self-explanatory. First, you list your assets and add them all up. Next you do the same with your liabilities. Finally, you subtract the liabilities from the assets, and you get your net worth.

That bottom-line number, your net worth, is the amount you hope that you can get out of all the things you own after you pay off all the debt you owe if for some reason you have to sell everything. And that’s the number that can tell you whether trading futures is a good idea.

Pay special attention to the amounts you have in the following:

Cash: Cash means the amount of money you have in money-market funds, your pocket, and even stashed in your secret hiding place.

Real estate: Real estate refers to your home and any rental property, second home, or other real property that you may own. As a rule, if you can’t sell it tomorrow, it shouldn’t count toward this calculation.

Stocks, bonds, and retirement accounts: Most people hold stocks, bonds, and mutual funds in their retirement accounts, although some also own them outside of their retirement plans. Any money that’s in a retirement account will be subject to tax consequences and early withdrawal penalties, so you need to include those amounts in the calculation. However, you also need to be realistic. You’re not likely to cash in your IRA or 401(k) plan to go speculate on soybeans. After reading this book, you better not!

Business assets: Consider how many of your business assets are involved in cash flow and inventory. Be careful not to be too generous in this category.

Credit-card balances, second mortgages, and adjustable-rate mortgages: Pay special attention to these amounts under liabilities, and be sure to include the latest credit-card balance and make sure that the amount includes any big purchases that you’ve recently made. Don’t hesitate to check your account online for the most current, real-time statement on your credit cards.

Figure 18-1: A balance sheet can calculate your net worth.

After you do all the calculations, here’s a useful guideline: If your net worth is less than $200,000, you shouldn’t be trading at all, much less trading futures.

Differentiating between trading and investing is important. If you have $200,000 or less, investing in mutual funds is perfectly acceptable, perhaps even in a mixture of stocks and funds, as long as you’re careful to follow sound money-management and loss-management rules and have a long enough time frame to make it profitable. If you’re trading, which by definition means aggressively and actively deploying your money, keep the following in mind as a bare-bones set of criteria.

Never risk more than 10 percent of your net worth as a trading stake unless you have a net worth of at least $500,000 to $1 million or more and you’re a well-equipped, stable, and experienced trader. If you are, you may want to risk as much as 20 percent of your net worth to trade, provided your expenses and long-term investments are covered. However, risking more than 25 percent of your net worth in any trading venue is a crapshoot and will likely get you into trouble.