When you boil it down, there’s really only about 6 principles that traders and investors need to be successful.
The 6 Principles
- Choosing a Direction
- Knowing How Far It’s Going to Go
- A Safe Amount of Leverage
- Trade Location
Principle #1 – Picking a Direction
This is the toughest principle to master. I can’t stress that enough– it’s really hard to predict the direction that a Stock, Future, or Currency is going to move.
However, if you can master the other 5 principles, picking a direction isn’t that hard. In fact, if you master the other 5 principles, picking a direction doesn’t really matter that much.
Okay, I know what you’re thinking.
You’re thinking, “You don’t know what the hell you’re talking about! You idiot!”
Okay, maybe not that extreme… But just bear with me here.
If you can focus on mastering the other 5 principles, picking a direction will be the least of your worries.
Principle #2 – Knowing How Far It’s Going to Go
When I say “it” I mean a Stock, Future, or Currency– whatever you’re trading.
This is the second grandmaster piece of information. Knowing how far it’s going to go is key to preventing a winning trade from reversing on you, and turning into a loser. Knowing how far it’s going to move is also what helps you be a contrarian trader at the right spots.
And you know what? This piece of information is readily available to everyone! The sad truth is that nobody cares to look for it. Actually, it’s great because it gives those who know an edge.
Do you want to know where to find out how much something is going to move?
Do you really want to know?
I don’t think I should give away all of my secrets, but since you were nice enough to read this far…
The Options Market.
That’s where you find this piece of golden information. Knowing how to read the Options Market will tell you how far an underlying is expected to move over a given period of time.
By knowing the 1 Standard Deviation move of an underlying, we know that there is a 68% chance of an underlying moving that far.
Principle #3 – Liquidity
Liquidity is important. Trading and investing in liquid instruments allows us to cover our “assets” (see what I did there?) without getting burned as badly if what we were trading/investing was illiquid.
Liquidity is important because it allows for tighter Bid/Ask Spreads.
Let’s say you’re trading something that isn’t highly liquid. Let’s say XYZ Stock has a Bid/Ask Spread of $0.80.
If you were to enter a position, then immediately get out of the position for whatever reason, you would immediately lose $0.80. Now multiply that by however many shares of stock you were trading.
See what I mean?
Principle #4 – Volatility
This is key to making money in the markets. If it doesn’t move, you don’t make any money!
That’s why you’re trading right?
It’s not to fool around, and play the slots. You’re in this game to actually make money. Being cognizant of how much a Stock is expected to move can help you to make more money when trading or investing.
One way that you can make sure that you’re trading Stocks, Futures, or Currencies that have enough volatility is to check the daily percent move that it tends to make.
The daily percent move will tell you how much you will gain or lose (on a percentage basis) if you were to be long or short the Stock, Future, or Currency with no leverage.
If you are using leverage, then you simply multiply the percent move by the amount of leverage you are using.
- I’m long the /NQ Futures from the prior day’s close
- The /NQ Futures are up .25% the next day
- I’m leveraged 5x on each contract I’m trading
- Then I would have a total gain of 1.25% on my account
Knowing the volatility (or expected range) of what you’re trading also helps to identify reversal points.
It’s important to know if you are at the top of the expected range because it will help let you know if you should get out of your position when signs of weakness start to appear.
Knowing the expected range also help you identify turning points in the market that you may want to enter a position in.
This brings us to our next point on Trade Location.
Principle #5 – Trade Location
Trade Location is the single best risk management tool that we have available. However, it can be somewhat elusive.
Trade location is simply an arbitrary price point that you think would be a point of support or resistance. In other words, it’s the point at which you think the market might turn. Trade Location is very important because these turning points offer the best asymmetry in terms of risk-reward.
If you are wrong on your trade location, you will know it pretty quickly and have the opportunity to get out of your position sooner than later (hopefully).
The ability to know whether you’re right or wrong quickly also has a positive effect on your Emotional Capital. If you get into a position that doesn’t have great trade location, you’ll probably be panicking the whole way down as the market comes down and tests the zone you should have gotten in at.
However, if you just wait for your spot to get in, then you will do much better.
I’ll say it again: Trade Location is the single best risk management tool available, but it can’t quite be quantified.
Principle #6 – A Safe Amount of Leverage
At some Spot Forex brokerage firms you can get leverage of up to 50x.
That is insane!
You must really want to lose all your money quickly if you think trading 50x leverage is a good idea.
In fact, leave this website and never come back if you think 50x is ever appropriate.
Remember how we were talking about volatility earlier? Here’s another example, except with 50x leverage.
- I’m short the /NQ Futures from the prior day’s close
- The /NQ Futures are up .25% the next day
- I’m leveraged 50x on each contract I’m trading
- I have a loss of 12.5%
Your risk of ruin is so high that you most likely will not be able to recover.
Check out this article for more on the topic of leverage.
In most cases, anything about 10x leverage (definitely anything above 20x) is considered way, way, way, WAY too risky. When you’re trading with that much leverage you’ve crossed the line from trading to gambling.
Keep in mind there is a misconception out there that you should trade bigger size as you become a better trader, or have more winning trades.
You get to trade more size as your account gets built up and you can afford to trade more of what you’re trading with your predefined level of leverage. In other words, don’t think that you should start using 30x leverage just because you’re on a hot streak. But then again, do what you want. You’ve been warned though.
As you can see these are 6 pretty simple principles that you can follow no matter where you’re at in your trading. Hope this helps and is valuable to those of you who checked it out.
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Thanks, and have a great day!