Chapter 21

Ten Killer Rules to Keep You Sane and Solvent

In This Chapter

bullet Relying on chaos, capital, and patience

bullet Putting your trust in the trends, charts, and diversification

bullet Going small with losses, trades, and expectations

bullet Getting real about trading goals, and knowing your limits

Trading is 90 percent head games and 10 percent money. If your head isn’t screwed on straight, you’re going to lose a lot of money in a hurry. So in this chapter, I help you keep the old noggin atop your shoulders by providing you with a road map to ten of the best trading rules I’ve discovered during my 17 years of trading. These rules can help you keep your mind and money where they’re supposed to be — between your ears and in your pocket, respectively.

Trust in Chaos

Chaos theory rules the markets. By definition, chaos is nonlinear order. In other words, what some describe as random actually is orderly in its own peculiar way. Look at the basic tenets of chaos, and then look at a market chart. It isn’t hard to see a connection.

Prices follow a nonlinear order. They tend to stay within defined channels or trading ranges. When they rise above or below the range, they enter an area of disorder, but when they enter a new price range, they go up, down, or sideways, again seeking and eventually finding nonlinear order.

Big money can be made when you figure out how to spot the limits of chaos and the transitions from chaos to disorder and back to chaos. By making this concept the basis of your trading, you’ll find that working the market is much easier than buying and holding something forever, hoping its price goes up, and much better than having the market work you or (more precisely) work you over.

When you trade with chaos as your guide, you find it easier to accept that the market will do whatever the market wants to do and that your job is to do your best to be on the profitable side (the right side) of the trade and to correct your mistakes as soon as you can.

Avoid Undercapitalization

If you don’t have enough money, don’t trade, period. It’s as simple as that. Many people open futures trading accounts with $5,000 and lose half of it within a month only to run with their tails between their legs back to something safer. I know. That’s what happened to me the first time I tried to trade futures.

How much money do you need? Most pros say that you need $100,000 minimum to open a futures trading account. If you whittle at them long enough, they’ll come down to $20,000 to $50,000, but few will tell you that you need anything less than $20,000.

More important is the fact that your $20,000 to $100,000 needs to be money that you can afford to lose.

Why do you need so much money? Bluntly, it needs to last long enough for you to endure all the bad trades until you can finally make a good trade that makes you plenty of money.

Be smart with your money. Don’t be one of those fools who maxes out his home equity just to be able to trade oil futures. Sure, you may get lucky and make it work, but the odds truly are against that. You can lose your money, and you’ll probably lose your spouse, your family, your home, and your shirt.

Be Patient

The two times when you need patience in the financial markets are when you’re becoming a good trader and finding good trades.

The problems with today’s markets are that you have access to so much information that you can fool yourself into believing that you must trade all the time. That can get you into big trouble.

In fact, trading for the thrill of it, or because you’re bored, is a recipe for disaster. I can remember periods where I didn’t trade for days or weeks at a time. These periods of market inactivity occur more often as I develop my trading skills. When I first started, I overtraded, and I paid the price for it. Luckily, I don’t make my entire living by trading and can afford to take my time picking and choosing the right times to trade.

Exercising this kind of patience can be to your advantage, too, because you can pick and choose when and how you trade.

Take time to think about your trading life. Some tough choices await you. Here are some important questions to ask before you jump in to the chaotic fray:

bullet How much of my livelihood do I intend to make by trading futures and options?

bullet How much time am I willing to put into analyzing the markets to improve my chances of delivering profits consistently?

bullet How much money am I willing to spend to educate myself and obtain a good trading setup?

bullet How long will I give myself to fully develop my trading talents?

bullet When will I trade?

Trade with the Trend

Investors are obsessed with the fundamentals. Futures trading isn’t investing; it’s speculating, so you need to be interested in technical and fundamental analyses. But the key here is that technical analysis tells you the direction in which the market you’re trading is headed — how it’s trending — and that’s something you need to know from the get-go.

When trading futures, the market trend, your time frame, your entry and exit points, and the protection of your capital in between are all that matter. If preservation of your capital jibes with the fundamentals of the market and you make money, you can take a few minutes to celebrate and then go right back to worrying about the following:

bullet Keeping an eye on your charts

bullet Following your trading rules

When trading with the trend, never lower your sell stops just because you think the market will turn around and that you were too tight in setting them. Likewise, when selling short, never raise your stops if the market starts going against you.

Believe in the Charts, Not the Talking Heads

The ultimate truth about trading is the price action. Few sources offer a better view of price action than price charts, especially in the fast-moving world of the futures markets.

Opinions are numerous. Some are going to be right; some are going to be wrong. However, the majority of commentators have their own self-interest in mind. In other words, their goal is to look good in front of the camera or in print so they can keep their jobs. If they traded, they wouldn’t have time to talk so much or to write reports.

That isn’t to say that when I’m on CNBC, I won’t be giving you the benefits of my experience, though, or that CNBC and other television channels don’t provide access to good guests and good timely information. My point is that you always need to look at all information through the jaded eyes of a trader, and that means looking at the market’s response to a story or an opinion and trading on what the market is doing, not on what the story is telling you.

Remember, Diversification Is Protection

In the stock market, diversification means spreading your risk among a large number of stocks and asset classes. Asset allocation models therefore have become quite handy. An asset allocation model is just a way to divide your investment portfolio and is often depicted as a pie chart. A common asset allocation model calls for a 60 percent exposure to stocks, a 35 percent allocation to bonds, and a 5 percent allocation to cash.

In the futures markets, however, diversification is different. It has more to do with how much cash you have on hand and how you allow seasonal tendencies of the market to affect your trading. Futures diversification boils down to your ability to manage your capital, your time, and your experience.

If you have more than one or two positions open at the same time in the futures market, you may find yourself in a dilemma because you have a hard time keeping up with what’s happening when the markets move so fast. The way to get around this problem is to limit the number of markets that you trade at any one time. For some of us, it’s one, or maybe two. Much depends on which markets you develop a knack for trading as you progress.

Limit Losses

Limiting your losses while trading is a simple rule that should make sense, but it’s a rule that bears repeating. The 5 percent rule is commonly used by traders and is easy to see and remember. Don’t risk any more than 5 percent of your trading capital on any given position, and limit your losses to 5 percent of the value of any given trade.

Get used to limiting your losses early on in your experience so you become disciplined in your approach to trading.

For a futures trader, a 5 percent loss is probably as much as you’ll ever want to handle. If you’re day trading, you can use period moving averages to identify where to place your stop-loss orders.

Make it a rule never to get a margin call. You’ll sleep better.

Trade Small

Trading small goes along with limiting your losses. But above all else, trade within your means. If you have $5,000 equity, which is way too little to think about trading futures, you should never trade contracts that require a $5,000 margin. A bad day can wipe out your entire equity position, and you’ll soon be getting a margin call.

For most beginning traders, trading one or two contracts at a time is a good rule of thumb. If you’re trading crude oil, your margin is somewhere near $7,100 per contract, which means that, in a perfect world, you need to have at least $142,000 total equity to be able to trade one contract. See the previous section about how much to risk in any particular market. Your loss limit from that starting point is $355, or 5 percent of $7,100. See the preceding section with regard to limiting losses to 5 percent. (Check out Chapter 3 for more about margins and the futures markets.)

A perfect, or nearly perfect, contract for small accounts is the Chicago Mercantile Exchange (CME) E-mini Eurodollar contract. Margins for the Eurodollar contract tend to be less than $1,500 per contract, so you’re thus at least closer to following the 5 percent rule.

Have Low Expectations

Most good traders are right a third of the time on average and half of the time during periods when they’re hot. The way you stay in business is to manage your money so that you cut losses short.

Good traders are masters of the low-expectations game. That’s where you think that if you come out even or a few bucks short, it’s a good day. Pros readily admit they tend to make a lot of trades just on either side of breaking even. Known as scratch trades, they’re the most common experience that you’re likely to have while trading futures.

Having enough money and the sense to be able to continue to trade are key. The longer you stay in the game, the greater your chances of making the occasional big trade.

Set Realistic Goals

After you become well funded, develop a good money-management system, and set your expectations at the right level. The next step is to set realistic goals.

Here are a couple of ideas:

bullet Some pros shoot for a three-to-one reward-to-loss ratio. If you choose this strategy, that means when things are going well, your goal is to double your money twice over, while (of course) setting prudent stops and managing your money correctly.

bullet Take profits when you’ve made 20 percent. I like to take at least partial profits when I make 20 percent on anything. In futures trading, applying this rule is not always possible when you have only one contract, because commissions and fees can eat away at the profit. However, my 20 percent rule works well in the stock market, when I’m trading several hundred shares of stock.