Today’s Trading Lesson From TradingMarkets

“All of life is the
management of risk, not its elimination.” — Walter Wriston, former CEO of
Citicorp

Trading wouldn’t be
trading if it were not for risk. Someone always has to step up to the plate,
sell when nobody else will, or buy when there are only sellers. That person, in
my estimation, is a trader. A trader in the truest sense of the word. Keep in
mind that being a trader doesn’t mean you stick your neck out so far that you
can’t come back and play tomorrow. People that do that are referred to as former
traders. My responsibility as a trader is to make a fair and orderly market and
to make money for my firm. Your responsibility is to make money. Period. You
don’t carry my baggage of SEC and exchange-mandated responsibilities. You are
just supposed to trade when the odds favor your long or short position and then
to take profits or cut losses.

I’ve been there in the
pits, during the crash of ’87, through the mini-crash of ’89 and for the past 12
months when the world suddenly became allergic to the US stock market. I can
tell you first hand how chilling it is to hear twenty brokers shouting in unison
various call offers and put bids. Keep in mind that these same brokers have been
slamming us with enough stock to choke Warren Buffett, but they expect us to
still keep on bidding for calls and offering puts. It’s pretty much like hitting
yourself in the head with a hammer. It feels so good when it stops!

The reason we have to keep
on buying on the way down and selling on the way up is because the SEC compels
us to do so. For being there to facilitate entry to or exit from the market, we
don’t have to put up margin. None, nada, zip. All we have to put up is enough
money to cover the risk of our overnight positions. So, while a customer can buy
1000 shares of IBM on margin and put up 50% of the $96,000 it would cost to
fully pay for that amount of Big Blue, professional pit traders like me have to
put up just $250! Not $48,000. Just $250. That kind of leverage can swing both
ways, so you can imagine the cowboys have pretty much been wiped out of our
business. Those are the former traders I referred to earlier in this section.

There are countless books
and seminars that purport tell you how to make money without taking risk. They
are all full of crap. Even an arbitrageur takes risk. They reduce their exposure
to risk by timing their entry and exit, but even the best arb firms on Wall
Street take risk in the establishment of the first leg of their trade. What
if the stock is halted before they can buy or sell the second leg? What if the
company extends the deadline for proxies? What if another bidder comes along?
Each could negatively impact what would have otherwise been a riskless
trade. 

Most successful traders
will tell you one of the most difficult and important lessons to learn about
trading is discipline. Without discipline, the best system, most accurate
technical studies and fastest access to the market is all wasted. Without the
discipline to take your profits and cut your losses, you will never know whether
it was your system, trading methodology or bad luck that was to blame for your
loss.

On the floor we have an
expression that perhaps you’ve heard; you can’t eat like a bird and defecate
like an elephant. (Ok, in the pits we don’t say defecate, but you get the idea!)
Put quite simply, you can’t take $.50 profits and let your losses run against
you by $2. All too often, I see investors and occasionally professional traders
let their losses run, which is the quickest way to ruin. Lack of discipline is
the most commonly blamed culprit, but I would place improper planning at a
strong second. A plan for your investing means you set entry and exit points
before you commit capital.

When I said that at the
www.TradingMarkets.com conference
in Las Vegas last October, you’d think I had three heads. I just think you can’t
establish a short position without knowing where you expect the stock or index
to go. You have to set a mental stop, or cover with a call option (against a
short position), to keep your position from trading you. Proper risk management
means you have to cut your losses at the same percent you would take your
profits.