Rule 18. Never Meet a Margin Call
This important rule applies only to leveraged traders. Margin calls arise for two reasons. First, the market may have gone against you, which means that the equity in your account has fallen below the required level. Second, the margin requirement for the commodity or financial futures in your portfolio may have been raised. When your broker calls you with a margin call, you have two alternatives. The first is to send in sufficient funds to bring your account up to the required equity level. The second is to reduce the margin requirement by selling all or part of your position.
To make the correct choice, we have to examine why your account is in this unfortunate condition. If the call is being made because the market has gone against you, it means that either you have too much leverage and will therefore be on emotional tenterhooks with each twist and turn or your original premise for getting into the position no longer holds. Either way, meeting a margin call will have the effect of increasing your emotional commitment and is therefore undesirable. If your original decision was based on a false assessment, then the margin call should be viewed as a gentle reminder that you should deal with this problem by liquidating all or part of the position. The margin call may also arise not so much because your current position has gone against you but because the account has been allowed to dwindle slowly. The call then follows in the wake of a string of losses. In this type of situation, the prognostications are worse because the call does not reflect an isolated incident but the culmination of a deteriorating trend. A stronger dose of medicine is then called for. The best thing to do is to exit the markets completely for an extended period so that your emotional wounds can heal and objectivity can return. The length of the period will differ for the individual and the seriousness of the losses, but in general, a "vacation" of at least three weeks is appropriate.
Alternatively, the margin call may arise because you have just added some new positions. This implies that you have been overtrading or at best that you have not taken the new riskreward potential into consideration. Whatever the reason, the finger points to poor money management.
Sometimes the equity in the account rises a little from the initial balance, but a margin call is still generated because the exchange minimums have been raised. You may think that such calls should be met because the market has moved in your direction and you were, in fact, correct. The raising of margin requirements is merely a technicality. This type of reasoning is incorrect, because margin requirements are raised for a reason. Ideally, the exchanges prefer to set low margin requirements, because this encourages more trading and therefore more commissions for the members. However, when conditions become more volatile, they must also take into consideration that traders are more likely to run into financial difficulties. The raising of the requirement is therefore a hedge against such losses. If conditions become more volatile, then it makes sense for you as a trader to take some more precautions. Quite often, a raising of the requirement is a signal itself that the prevailing trend is in the process of reversing.
Consequently, whatever the reason for the margin call, the rule remains the same: Never meet it by sending in more money.
Rule 19. If You Are Going to Place a Stop, Put It at a Logical, Not Convenient, Place
Traders often follow the discipline of predetermining where their downside risk might lie and place a stop-loss order slightly below that point. If the stop point has been determined with resort to some sound technical or fundamental analysis, this represents an intelligent method of operation. However, if you initiate the trade on the basis that you cannot afford to lose more than $300 and so place the stop at a point that limits the loss to $300, your odds of a winning trade will be greatly reduced. In this instance, you are not making decisions based on price action, where the market has the opportunity to tell you if you are wrong. Instead, you are picking an arbitrary point based on your own assessment of how much you can afford to lose. If the stop is triggered, it is not a vote by the market that you misjudged the trend, for quite clearly the market was not given enough leeway to come to such a verdict. Such stop points represent nothing less than a gamble that the price would not slip to such a level. The chances are that, having been stopped out, you would then see the market reverse direction to a degree that the trade would have ended up in the profitable camp.
Even traders who recognize this fallacy can be drawn into complex mental games where the sheer degree of their optimism causes them to rationalize incorrectly that their stops are in fact logically placed. It is not a bad habit therefore to ask yourself, "Is this really the best place to put the stop, or am I placing it here as a convenient place to limit my losses?"
SUMMARY
We could add a 20th rule, which would be to follow the other 19 rules without question. It makes little sense to learn about and develop a set of rules if you fail to put them into practice. You would forfeit any sense of objectivity, independent thinking, perspective, and risk control that the rules are designed to deal with. To make sure, let's add a 21st rule: Follow the other 20 without question at all times!
13
Making a Plan and
Sticking to It
If you have studied the ideas in this book, you now have a good understanding of the underlying psychological forces that drive markets and the kind of pitfalls you can easily stumble into if you are unable to master your natural emotional tendencies. All the reading in the world, though, will be of little use unless you can put it into practice. That's the difficult part: Execution involves tremendous effort. Starting out is often relatively easy because you gain strength from the initial enthusiasm gained from fresh ideas. The really hard part is the continual application of these ideas as the novelty wears off and some losses develop. The struggle to maintain newly learned disciplines is then at its most difficult.
This chapter has two objectives. The first is to help you organize your thought processes in a way that will better equip you to do battle with the markets (and therefore yourself). The second is to emphasize the necessity of constantly reminding yourself to follow up and review your activities. In this respect, it is vital to remember that it is the function of the market to search out and exploit your every weakness. To overcome this challenge, you have to be constantly on guard to limit those opportunities as much as possible. Only with constant surveillance and continuous review can you accomplish this task successfully. Eventually, such perseverance will be rewarded with a change of habit and thinking, but this will take several years to accomplish.
The remainder of this chapter is organized under the following headings, which we will consider in turn: "Setting Up Your Personal Investment Objectives," "Adopting an Investment or Trading Philosophy," "Establishing a Plan to Maximize Objectivity and Minimize Emotion," and "Establishing a Review Process."
This overall, four-point plan is relevant to both traders and long-term investors. The principal difference will be the amount of time between progress reviews. Obviously an active trader, in the market on a daily or even intraday basis will need to review his progress on a much more frequent basis than someone who makes transactions as infrequently as three or four times a year. Even on the latter schedule, it is important not only to review the progress you have made but also to monitor any major economic, financial, or technical changes that may have occurred. It is easy to slip into complacency by getting into the habit of closing your mind to what goes on in the markets.
Setting Up Your Personal Investment Objectives
When we are uncertain about our goals, our minds become a battlefield of conflicting desires. In this mental environment, the result will be total paralysis that will make it impossible to achieve investment success. Therefore, it is necessary to develop specific objectives for our trading and investment activities. If correctly done, setting up investment objectives helps to transfer our energies from the external forces where we often allocate blame to the real source of our problems, namely ourselves. For ex
ample, if an individual has a large position in the stock market and some random event such as the 1991 summer coup in the Soviet Union comes along to push prices down significantly, it is natural to blame "the market." In such circumstances, we can rationalize the situation because we have no apparent control over it. The real issue, though, is ourselves, and until we can learn to come to grips with that problem, it will keep resurfacing.
Arnold Toynbee, the great British historian, recognized that fact in his principle of challenge and response. He spent a great deal of time studying the characteristics of rising and falling civilizations. He noted that all civilizations faced challenges from time to time. The difference between a civilization that was on the rise and one that was in decline was that the rising civilization was able to meet challenges successfully and move on. The declining civilization, on the other hand, either failed outright or inadequately met the challenge, which then would continually resurface and become a even greater burden.
An example of a classic challenge occurred in the fifteenth century. The Western world faced the dilemma of how to trade with the Orient when the land routes were barred by the Islamic Ottoman Empire. The challenge was met by Columbus. Although he failed to find the elusive route, he instead discovered a new continent, thus paving the way for others to develop it later. When it comes to meeting challenges, the position of an investor or trader is no different. If you continually make the same mistakes and do not learn (i.e., fail to overcome the challenges put forward by the markets), you are doomed to fail. Setting some realistic objectives can help to put some of these problems in perspective and lay the groundwork for success.
Investors
The starting point of any plan is to establish a set of objectives. After all, if you do not know where you are going and how long it is likely to take, how can you possibly make the correct investment decisions? These objectives should be established, keeping in mind your status in life, financial situation, and ability to tolerate risk.
The three principal investment objectives that almost everyone has are liquidity, income, and growth. The term "liquidity" refers to that portion of the portfolio that can easily be turned into cash to meet an unexpected expense. Both equities and bonds are liquid in the sense that they can be easily turned into cash. However, it is not always convenient to sell them. Perhaps there is a taxable gain that you do not wish to realize at present. Alternatively, the market may be down, and you do not want to take a loss because you feel that prices will soon recover. Liquidity, therefore, has a broader meaning than just realizing a sale to make a payment. It implies that the principal amount will not materially change. In short, it can be counted on. Hence, you need to balance your portfolio to provide sufficient funds to meet such obligations without jeopardizing the overall investment plan.
Occasionally, you will need funds, for example, two or three years down the road, to pay college fees. In this sense, a liquid investment would be one that matures at a much later date. In this way, it would still provide the ability to make a payment, but the principal value could also be counted on, thereby meeting the dual test for a liquid asset.
The second investment objective, income, will depend a great deal on your own financial requirements. For example, if you are retired and are relying solely on social security payments, your income requirement will be a great deal higher than if you have your whole career ahead of you. You may also be quite young and in the process of taking a higher degree. With no other income source, the need for earnings from your portfolio will be of paramount importance. Once you have earned the degree and have a good income stream, you would then be wise to change your investment objective toward one of growth. A heavy income requirement is not therefore confined to widows and orphans.
The final objective is growth. Here we are faced with a trade-off. As a rule of thumb, the greater the potential reward, the more substantial the risk and the uncertainty. If you are young and earning a good living, you are clearly in a better position to assume more risk than someone who is retired. The young person not only has more time to recoup a lost investment but will also be blessed with a potential cash flow that can make up for past mistakes. The retired person does not have that luxury.
For most people, the objective of liquidity will be relatively unimportant, so the decision will rest on an appropriate balance between bonds and stocks. It is important to assess your particular stage in life and your financial requirements in setting goals. Equally as significant is the need to make sure that your goals are not only realistic but also consistent with your temperament.
For example, if the stock market has appreciated by 15% in the past five years, you may decide that you want your portfolio to grow at a more conservative rate of 12%. This may appear to be realistic on paper, but the problem is that the market has experienced a compounded annual growth rate closer to 9% historically. Since the return over the past few years has been way above normal, it is likely that the next few years will see average or, more likely, below average growth. Over time, market performance has a habit of regressing or returning to the mean, so after a few good years, it is reasonable to anticipate a couple of poor ones. Unrealistic expectations therefore can lead to disappointment when they are not met.
Temperament is another factor that should be considered when establishing investment objectives. For example, we know that the average return on equities historically has been about 9%. However, we also know that this increase did not take a straight line and that the rate of return was not consistent; there were peaks and valleys along the way. In some years, the gain can be as high as 25%, and in others, there can be an equal amount on the loss side. If you are unable to live with the loss years and find the stress too great, you will not be able to stay the course and so you will not achieve even a modest investment objective. This is why you must recognize your own ability for risk tolerance and build it into the plan at the outset. It may be unrealistic to expect an unduly high rate of return, but it is even more unrealistic to expect such a performance if you cannot live with the pressures and swings in the market.
The degree of risk that can undertaken comfortably will depend on your own character. It is a personal decision, for you are the only person who knows when worries about investments cause a knot in your stomach or result in sleepless nights and so forth. If anything, you should lean on the side of caution, because the loss of principal due to an overly aggressive stance will be far more painful than the fear of losing out. Losing out on a major rally does not take anything away from you, whereas losses in the market do.
Traders
Since positions held by traders are of much shorter time horizon than those of investors, their objectives will also differ. Liquidity and income are not important; the prospect of growth is the uppermost objective in the minds of traders. In this respect, the danger of unrealistic expectations and the concept of risk tolerance should be of primary importance. For instance, you could rationalize that because of the leverage potential for futures trading, the expected return should be equally as great and the results ought to be that much better. If the S&P Index gains an average of 9% per year, it should be possible working on 10% margin to average 90% (i.e., 10 times as much). In reality, it doesn't work that way because to earn the 9% return, it is necessary to sit through some pretty big bear markets that would more than wipe out the equity in the account. The smallest gyrations in markets can have a tremendous effect on the equity in leveraged accounts, so the ability of the trader to know his limits of risk tolerance is that much more crucial.
Since traders are in and out of the markets every day, often on an intraday basis, their need to establish a campaign plan is even greater than someone who has a longer time frame because such a highly volatile environment has little margin for error.
Adopting an Investment or Trading Philosophy
Establishing investment objectives helps to tell you where you want to go and how long it will take you to get there. Adopt
ing a philosophy or approach to trading or investing is the vehicle that will enable you to reach that destination.
As I have said, there are many religions in the world, each taking a different path in search of the truth. In the financial markets, there are also many different investment and trading approaches, each seeking the realization of profits. Your job is not to find the best, because they all have weaknesses. Instead, you need to choose an approach with which you are comfortable, provided, of course, that it works. Because of the leverage involved and the life-saving requirement of not permitting losses to continue, traders usually favor using technical analysis; this enables them to set objective "stop-loss" points. A long-term investor, on the other hand, can afford the luxury of buying a stock with a low price-earnings multiple and patiently waiting for the price to increase. Others prefer to buy companies with high growth rates and high price-earnings ratios, believing that the fast growth of the company will result in higher stock prices. Still another might involve the adoption of the Theory of Contrary Opinion, discussed in Chapters 7 and 8.
Your chances of success will be higher if you combine some concepts of contrary-opinion principles with your chosen approach. For example, if in using technical analysis, you use oversold conditions as a basis for making purchasing decisions, contrary analysis will represent a useful confirmation. If your indicators are pointing out that the market is oversold, but you cannot find much in the way of bearish sentiment, the chances of a meaningful bottom will be much less than if a negative or pessimistic story was splashed on the cover of a major magazine.
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