Treat Trading as You Would a Business

Trading should be treated with the same discipline as a business. Producing a written trading plan is an important first step (discussed below).

Establish your own accounting system to track your trading results and reconcile brokerage reports. A simple excel spreadsheet with daily, weekly, and monthly results is all you need. You should include gross profit/loss, number of trades, commission costs, ECN costs, other costs, net profit/loss, equity (be sure it matches brokerage reports) and any other data that will help. Use this data to help improve your trading. Look for patterns in your results, and profit/cost relationships.

For example, you may notice that you are seeing gains three days in a row and lose for two. If this pattern repeats itself over time, then you can put in the correction to work towards more consistent results and more effective risk management. Maybe you find that you trade better in the morning and then give it back in the afternoon. Stop trading in the afternoon for a while, or implement tighter controls for that session. In regards to profit/cost relationships, let’s say you notice that costs as a percentage of gross profit is normally around 30%, but has been slowly rising. This may be an indication that you are overtrading and that you should slow down.

Keep a good filing system. You will want to keep your daily printouts from whatever trading platform you use. This will show all of your trades for the day and can be matched with brokerage reports. Mistakes do happen, even with the advanced software that is available. No one is going to watch your money like you!

Create a trading diary. A trading diary should include comments about what you did right and what you did wrong. Did you follow your plan and your rules? What changes should you make to correct for mistakes? Is your strategy working, is it not working? Should you change your share size? Maybe you should change your risk management parameters. These are the types of questions you want to ask yourself. A trading diary is also a good way to plot your progress and acknowledge yourself for what you have accomplished.

Capital Preservation

"Don’t lose money. If you do lose money, lose very little money."

In Jack Schwager’s book, The New Market Wizards, he interviews a number of very different, successful, world-class traders. Each of these traders have different trading styles, strategies, and trade different markets, but they all have one thing in common – a set of rules that focuses on losing, not on making money. Here are a couple important quotes from that book:

"If you have an approach that makes money, then money management can make the difference between success and failure…I try to be conservative in my risk management. I want to make sure I’ll be around to play tomorrow. Risk control is essential."

Monroe Trout

"The elements of good trading are: 1. Cutting losses 2. Cutting losses 3. Cutting losses"

Ed Seykota

Your trading rules and plan should be designed around preserving capital and avoiding a catastrophic loss that can empty your trading account. If you run out of trading capital, you can no longer trade and you are out of the game. This control is accomplished through a combination of money management and risk management. Your primary responsibility is to not lose money – not to make a lot of money as fast as possible.

You must learn how to control risk and keep losses small. We cannot overemphasize this point enough. At first, you might be saying to yourself, "of course, this is obvious." However, few new traders, and many experienced traders, do not take the time to develop proper risk management techniques. Stop looking for the "secret to high profit trading" and focus on controlling risk. It has been said many times that if you control your losses, the winners will take care of themselves.

A money management strategy will help determine how much to trade. For example, let’s say you have $25,000. Do you want to enter a trade using all of your capital? That probably would not be the best course of action. If you did, and the trade went the wrong way, you would be taking too big a loss on one trade. Decide on a dollar amount or percentage of your total capital that will be the maximum you will use for any one trade. This will help control the size of your losses.

Stop Loss

You should also have a maximum loss that you will accept on any trade. This is called your stop and is where you will absolutely get out of a trade. There are many ways to approach stops and it partly depends on your style and overall strategy (day trading vs. swing trading vs. position trading). Pick one and then you can adjust it as you go.

For example, you might want to cut your losses to a maximum of 5% per trade if you are a swing trader. Once the 5% number is broken, you are out of the trade – no matter what. You can always get back in! If you are a short-term day trader, maybe a $0.05 to .10 cent maximum loss would be appropriate. Also, if you are day trading, set a daily loss limit. This is the point where you will stop trading for the day. Remember, the objective is to keep losses small. You cannot lose money if you stop trading.

Some traders also use a maximum profit objective for the day. Once they reach their goal, they stop trading. Once again, if you stop trading you cannot lose money – and you get to keep your profits.

There are two types of stops - mental and automatic. A mental stop requires the trader to execute the trade to close the position. An automatic stop is programmed into your direct access system or online account. Automatic stops help take the emotion out of a trade.

Discipline

Lack of consistent discipline is the major reason for failure. When we speak of discipline, we are referring to strictly following your trading rules and plan. Are you religiously keeping your stops, following your game plan, trading only stocks that meet your criteria, etc.?

Why would a trader not follow these common sense rules? Usually, because they are focused on their returns, not on controlling losses. It takes discipline to follow a sound risk management strategy. Discipline sometimes means doing something you don’t want to do - but have agreed to do and know that it is the right thing.

Margin

Buying securities on margin is a form of leverage with borrowed money. Financial leverage enhances value without increasing your investment. When you buy on margin, you are borrowing capital from your broker. Your broker will charge you interest on the borrowed amount usually at the "broker call loan rate." Before using margin, be sure to check with your broker and fully understand their margin rules.

The use of margin is a double-edged sword. You can make gains faster than without it, but you can also lose money faster. If the securities you purchased on margin decline by a specified amount, you may be required to deposit additional cash. This is called a margin call. Under most circumstances, your broker will notify you that you have a margin call, and you will need to deposit more money into your account. However, your broker is not required to contact you and may sell securities in your account without notifying you. This is more likely to happen when there is extreme market volatility.

For specific margin requirements and parameters, please speak with your broker.

Trading Margins

Everything in trading is a double-edged sword. If you are an active trader and open and close several positions a day, then the following rules will be applied to you. Realize that this is an updated set of requirements as of September 2001, and is under continuous review and refinement. You must check with your brokerage to ensure that you have the latest changes in this area. The new rules give you more buying power, but they also can cost you dearly if you are not well-educated and completely understand the risks involved with trading of any kind.

Pattern Day Trader

A "pattern day trader" is defined by the SEC as those customers who day trade the same security, bought and sold or sold and bought in the same day, four or more times in five business days. A "day trade" is defined as the opening and closing of a position within one regular market day. If day trading activities do not exceed six percent of the customer’s total trading activity for the five-day period, the clearing firm is not required to designate such accounts as pattern day traders. The six percent threshold is designed to allow clearing firms to exclude from the definition of pattern day trader those customers whose day trading activities comprise a small percentage of their overall trading activities.

In addition, the amendments revise the current interpretation that requires the sale and repurchase on the same day of a position held from the previous day to be treated as a day trade. The amendments treat the sale of an existing position as a liquidation and the subsequent repurchase as the establishment of a new position not subject to the rules affecting day trades. Similarly, if a short position is carried overnight, the purchase to close the short position and subsequent new sale would not be considered a day trade.

Equity Requirements

Minimum equity requirement means that a pattern day trader must have deposited in his or her account, a minimum equity of $25,000 on any day in which the customer day trades. The required minimum equity must be in the account prior to any day trading activities; however, firms are not required under the rule to monitor the minimum equity requirements on an intra-day basis. The minimum equity requirement addresses the additional risks inherent in leveraged day trading activities and ensures that customers cover losses incurred in their accounts from the previous day before continuing to day trade.

Day Trading Buying Power

The rules limit day trading buying power to four times the day trader’s maintenance margin excess. This calculation is based on the customer’s account position as of the close of business of the previous day.

Day Trading Margin Calls

Under the amendments, in the event a day trading customer exceeds his or her day trading buying power limitations, additional restrictions are imposed on the pattern day trader that more adequately protect the firm from the additional risk and help prevent a recurrence of such prohibited conduct. Brokerages are required to issue a day trading margin call to pattern day traders that exceed their day trading buying power. Customers have five business days to deposit funds to meet this day trading margin call. The day trading account is restricted to day trading buying power of two times maintenance margin excess based on the customer’s daily total trading commitment, beginning on the trading day after the day trading buying power is exceeded until the earlier of when the call is met or five business days. If the day trading margin call is not met by the fifth business day, the account must be further restricted to trading only on a cash-available basis for 90 days or until the call is met.

Two Day Holding Period Requirement

The new rules require that funds used to meet the day trading minimum equity requirement or to meet a day trading margin call must remain in the customer’s account for two business days following the close of business on any day when the deposit is required.

A more thorough account of Financial Industry Regulatory Authority (FINRA) rules and regulations can be found here.