Six Secrets of a Master Trader

Speculating and trading options can be a difficult game – one that many assume, requires throwing caution to the wind. But as Steve Sarnoff explains, there are a few proven ideas that can be very helpful along the way, and perhaps shed that awful stereotype of the ‘reckless speculator’. Read on…

Speculators get a bad rap. The very word conjures up pictures of some carefree playboy throwing money into any crazy investment – not really caring if they win or lose.

It’s not a flattering picture. And that’s why conservative investors shy away from anything “speculative” – lest they be called speculators, too.

Well, I’m here to tell you “speculating” isn’t a dirty word. You can be a conservative investor and still enjoy that chance at phenomenal profits that speculating can bring.

I learned that lesson from my father, Paul Sarnoff. He was one of the first people to offer an options course – introducing novice investors to the concept of Superleverage. But he also had a strong conservative streak. In fact, he was an avid fan of precious metals, advocating that they should be at the core of every solid investment portfolio. He even wrote books on gold and silver investing.

My father proved that even cautious investors can benefit from speculating. But as he always stressed – and as I still stress today – the key to being successful was to have a complete plan of action. You never, ever throw your money around casually…even if it is money you can afford to lose. And you must take steps to make sure you never get in over your head.

Of course, that’s easier said than done. That’s why my father developed six simple strategies for keeping a level head when speculating. They may sound common sense, but I’ve spent enough time in the markets to know that common sense isn’t that common when money is involved.

So, if you’re thinking of dipping your toe into the speculative markets, here are a few proven ideas to keep in mind:

1. Create a sound money-management strategy.

This one flies in the face of the conventional image of a speculator. But believe me, all consistently successful speculators start with a plan. It doesn’t have to be anything too involved – just make sure you’re clear on your objectives, and set some guidelines for yourself. Figure out your entry and exit strategy for each play, starting with how much to invest, how many open positions you plan to have, how you will monitor positions, what kind of stop-losses you will use to preserve capital, etc.

A sound money management strategy is the most important factor in successful speculation and it allows you to stay in the game.

2. Know your broker and monitor your investment

When choosing a broker make sure to ask as many questions as necessary and that you get the appropriate answers before simply giving over your money. If you are a beginner, find out about the broker’s history and references, and speak to them frequently to establish a relationship. Make sure that either your broker or you will be constantly monitoring your investment – today’s markets are very volatile and with options the price can shoot up 30% or more in just a few hours…so it is necessary that your broker is able to see the option is performing and be able to execute an order in a timely manner, to ensure that your capital is protected.

With so many discount Internet brokers out there, it seems like more and more people aren’t doing their homework before opening an account. It’s OK to try and go it alone… unless you don’t know what you’re doing. In that case, it’s well worth the time and money to explore more experienced flesh-and-blood brokers.

3. Stick with your exit strategy if a trade goes against you

With a good money-management plan, there should never be any surprises. No matter what price your trade is at, the action you need to take should be clear.

That doesn’t mean you have to be inflexible, however. Just because an option has met your profit target, you don’t have to automatically sell. But there has to be a compelling reason to stick with the trade – something more than a feeling that the trade will continue climbing above your target price. (After all, you selected that target price for a reason.) And always use a stop-loss or a trailing stop order to make sure you’re ready for any reversal that might pop up.

For a losing trade, however, you need to be a little more harsh. Options are wasting instruments, and their value dies a little each day. Sometimes it’s better to stick to your strategy and settle for a loss than it is to wait it out and hope for a miracle. That’s money you could be plugging into another play.

4. Always, always, always, ask questions

The Internet age is creating a generation of independent investors. But some are still too proud to admit that there are things they don’t know. In the speculation game, what you don’t know can’t hurt you.

If you’ve taken my advice about finding a good broker, you’ve already got a ready source of info to turn to. Dozens of Web sites also offer complete details on options trading. So there’s just no excuse for ignorance any more… and losing money because of ignorance makes even less sense.

5. Learn from your mistakes

Find out what works for you. There will be losers along the way – but just make sure you know what you did wrong in previous trades (e.g. you set a stop loss of 15% and were stopped out too early and the option rebounded to 56% profits). Take every trade as a lesson and use it to improve as you continue trading.

6. Remember that knowledge is power

You can never know too much… strive to learn as much as you can about options and their inner workings, strategies, fundamentals, everything… so that you will be better equipped to profit with options trading.

As I’ve said in the past, options trading is more accessible than ever before. And the profit potential hasn’t diminished a single cent. Going out of your way to learn the myriad of ways they can boost your bottom line is the easiest way to discover what works for you.

Sincerely,

Steve Sarnoff
for The Daily Reckoning
May 10, 2007

Do Shanghai skyscrapers have windows that open? If so, they might want to nail them shut.

The Fed’s rate-rigging group met yesterday. They announced that it was leaving the Fed’s key lending rate where it was (5.25%) but that it still considered inflation its number one worry.

What kind of ‘inflation’ were they referring to? Consumer price inflation? Or asset price inflation? Which one is most likely to do the most damage?

Yesterday, for the first time ever, China’s benchmark index climbed over 4,000. Not only that, but almost $50 billion worth of shares traded hands on China’s two exchanges – one in Shanghai, the other in Shenzhen. That’s more than all the rest of Asia combined, twice the level of Japan, and TEN TIMES trading volume just six months ago.

In China, in the next 24 hours, approximately 300,000 new stock market accounts will be opened. Communists, survivors of the Great Hunger, the Great Leaps, the Cultural Revolution, widows, orphans, mental defectives – everyone wants to get into stocks.

Why? Because they are going up!

“Investors will continue to take money out of low-yielding assets and put it into the stock market, and that will continue to exacerbate a supply and demand imbalance in the market, which leads to inflated prices,” said a source close to the action, quoted in the Financial Times.

Wait a minute. Aren’t these the same people who believed Mao’s silly guff? Aren’t they the same dumbbells who took the Long March…who starved each other…who tried to make steel in their kitchen stoves…who wore ugly gray suits, held up copies of Mao’s pathetic Little Red Book, and put dunce caps on anyone with wit enough to object?

But the Red gods failed. And so they’ve found new ones – stock markets. They’ve been victims of collectivism. Now, they seem to want to be victims of the market system too. And when the end comes – there has never been a bubble without a pop – many of them are going to feel like jumping out of windows.

Meanwhile, in the West…shareholders aren’t so naïve. They weren’t born yesterday, like the Chinese. They were born the day before yesterday.

They’re not stampeding into overpriced investments they don’t really understand. Nope. They’re going into them slowly. Yesterday, for example, the Dow rose again…but only 59 points. Like the Chinese markets, the Dow rises every day, but not as much.

And there’s another big difference. The Chinese are investing real money…money they earn and save…money earned from making things and selling them at a profit. They’re not sophisticated enough to know that you can get rich without really working. They haven’t yet discovered the wonders of the financial industry…or learned how to get rich by doing deals with each other, using borrowed money.

In England, for example, there are now about 200 lawyers who earn more than $2 million per year. Today’s TIMES of London tells us why: because the number of deals done in the City, London’s equivalent of Wall Street, is soaring. “The astonishing rise in profitability mirrors the dramatic rise in the volume and value in UK and international corporate takeover work,” says the paper. The value of those deals has already passed the $2 trillion mark this year.

Someday, of course, all this feverish activity will come to an end. The Chinese bubble will burst. The fad for deals will pass. And then, much of this money – now getting passed around like a groupie in a rock & roll band – will disappear. Or go back to its rightful owners. And then, the expansion phase of the credit cycle will be over.

When will that happen? How it will happen? Join your favorite DR editors this summer at the Agora Financial Investment Symposium for a look at not only global market concerns, but also he best investment bets across the globe. This year’s theme is “Rim of Fire: Crisis and Opportunity in the New Asian Era” and you will not want to miss one of the most important investment events of the year.

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Addison Wiggin, reporting from Los Angeles…

“‘Is anyone who values people over corporations automatically a “nut job”?’ a reader asked after remarks we made about Venezuelan President Hugo Chavez. Instead of responding, we figured sooner or later Chavez would open his mouth again and validate our claim. Well…it was sooner…”

For the rest of this story, check out today’s issue of The 5 Min. Forecast

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And more thoughts…

*** “Living on sponge cake, and Omaha beef steak, watching the shareholders running around,” crooned Buffett at this year’s Woodstock for investors, shareholders and Buffett groupies: the Berkshire Hathaway annual meeting.

No, it wasn’t the Oracle of Omaha himself singing the reworked version of ‘Margaritaville’ (which was aptly named ‘Berkshire Hathaway-a-ville)…it was his distant, and less famous cousin, Jimmy Buffett.

Capital & Crisis’ Chris Mayer milled through the swarms of Buffettheads and sent us back this note:

“More than 27,000 people filled Qwest Center on a cloudy Saturday on the fifth day of May. All of them came to hear two remarkable investors, Warren Buffett and Charlie Munger. The duo sits before the assembled throng and tirelessly answer questions put to them. In two parts, this extended Q&A runs about five hours.

“There are the inevitable grandstanders with their political statements and nutty questions. Then there are the sappy odes of hero-worship. ‘Oh, Mr. Buffett, thank you so much! You are my hero! My wife is pregnant and we are naming our son Warren after you!’ I silently wished the Earth would open and swallow him whole. No such luck.

“On the housing market woes, Buffett noted how Berskshire’s housing-related businesses are getting hit. Unlike many overeager investors today, who feel compelled to run into burning buildings by buying flaming housing-related stocks on the theory that the worst is over, Buffett offered a contrary view: ‘My guess is that it continues for quite a while.’

“No elaboration on how long is ‘quite a while.’ But these guys think in glacial terms. Long-term is a lifetime. Therefore, ‘quite awhile’ could mean at least ‘years.’

“On the private equity bubble – which involves so-called private equity firms raising huge pools of money and then borrowing a lot more to buy whole companies – Buffett noted a great flaw in the scheme. Private equity firms have a ‘great compulsion to invest quickly.’ That way, they can go out and raise another fund and keep the fees coming in. Basically, private equity firms are paid for activity, not results. And the nature of the business means that we won’t know who is successful until many years have passed. Buffett said the ‘score card is lacking.’

“On fears of a crash or meltdown or bad things happening in the market, Buffett offered wise words: ‘Something bad will happen, but you could go back at anytime in the last 100 years and say the same thing…you can freeze yourself out indefinitely.’ Every investor must play the hand he is dealt.”

Chris has been taking Warren Buffett’s investing advice for years now – and it has paid off. He fills his Capital & Crisis portfolio with companies that sweat assets and cash…and are stuffed with hidden wealth. To find out about three new stocks that Chris thinks could soar over 50%.

*** Want a laugh? Take a look at this.

Colleague Merryn Somerset Webb, editor of MoneyWeek, handed us a copy of an article from March 2000.

“The writer clearly wasn’t aware that the dotcom bubble had already begun to deflate.”

The article by Katharine Mieszkowski asked us to pity the poor dotcom CEO, the Internet innovator, the tech mover, and the IP shaker. They were supposed to keep up with all the trends in the fast-moving world of the Internet. But to do so, they had to read a lot of magazines. And the magazines kept getting fatter and fatter.

Remember Red Herring? How about eCompany? Now? Wired? Upside? Industry Standard? Business 2.0? At the peak in dotcom fortunes, these magazines were stuffed with ads. The dotcoms had billions and had to spend them some way. And they had to have articles to read to justify the ads. Remember those articles? We couldn’t make heads or tails out of them.

Red Herring’s March issue grew to 440 pages and weighed in at 1lb. 12.5oz. Business 2.0 had 448 pages and a sumo weight of 2lb,5.3oz. And so on.

If you had to read all the ‘essential’ magazines for the dotcom man-on-the-move, you’d have to get through 2,884 pages – which would be like reading War and Peace twice.

Well, every problem resolves itself somehow. As it turned out, reading all these magazines wasn’t so essential after all. And now, the dotcom execs who survived the industry shake-out have light reading loads. Most of the dotcom magazines went out of business in the tech crash. Those that are left – Wired and Red Herring – have been slimmed down…and refocused.

*** “How is your mother?” we asked a young friend last night. We were sitting at a restaurant, overlooking the Tower Bridge on the south bank of the Thames. That whole area is remarkably lively, with many new buildings, restaurants and shops. Our two companions, one of whom was our own daughter, were both aspiring young actresses – both so stunningly beautiful that a young man, passing by, staring, and not looking where he was going, practically fell into the river.

“Oh…you know, she’s 53 now. And now that I’m leaving home, she’s asking herself a lot of questions. I guess she figures that a whole stage of her life is over. I mean, she spent so much of her time looking after me…and now I don’t really need her anymore. So she doesn’t know what to do with herself.

“She’s been living in Paris for, what, 25 years? But now she’s ready to leave. She says she just lived there because she thought it was the best place for me to grow up. But where will she go? She doesn’t really want to go back to England or America. And what will she do?

“I feel a little sorry for her. It must be hard. She has to invent a new life for herself. I don’t know…maybe she’ll get remarried…but I can’t imagine it. She’s so used to being alone. And I don’t think she can start a career in business or a regular job. It will be too much of a shock for her. She’ll probably drift into teaching somewhere. Maybe teaching English as a second language in the South of France.

“You know, when you’re young…having the freedom to move, and do what you want is such a great thing. I mean, it is such a thrill for me to be here in London. There is so much to do…so many people to meet; it’s all so exciting. And then, I’ve got a job – well, it’s not much of a job, but it’s enough for me to eat – at the Avignon Festival this summer. And after that, I’ll probably travel around with friends; it’s really great.

“But when you’re older, I don’t think this kind of freedom is what you want. I mean, I think about my mother and I don’t think she wants to move around and discover new things. She wants a cozy place to live and cozy people to live with. And that’s what she doesn’t have. I don’t envy her.”