This article is mainly directed at individuals who are just beginning the exciting journey of managing their own money and their future. These are specific steps you can take to successful investing. However, I would like to encourage anyone who is considering a new investing system or vehicle to follow these same steps. Regardless of how much experience you may have, and regardless of how much success you have enjoyed in the past, if you are about to invest in a new product (such as moving from stocks into options) or are considering a new method or software, you owe it to yourself to prove its validity before you put real money into it. Don't trust anyone's testimonial or advertisement when your hard-earned money is at stake.
STEP ONE: I believe everyone should start with virtual-trading. This is simulated trading that doesn't involve real money, and it can take a variety of forms. Traditional "paper trading" is one of those forms, but electronic trading through a Virtual Brokerage. Profit Rite’s trading software includes a Virtual Brokerage that allows the trading of both stocks and options with the software – a first in the industry. Whatever method you choose, you should continue to use it until you have achieved sustained success. People constantly ask me how long they should virtual-trade. That is not the right question. The length of time is not important; the benchmark is. A good benchmark would be to practice trade until you are consistently winning 75 to 80 per cent of your trades. Whether that takes two weeks or two years, keep at it until you have confidence in your trading skills and in your trading system.
I also believe everyone should start virtual-trading with stocks, not options. One large seminar company "trained" tens of thousands of Americans to trade options in two-day seminars. Many of those people lost their entire life savings; some had to come out of retirement and re-enter the workplace to make ends meet. Others learned their lesson before they had lost all their money, but it was still an expensive lesson. Here is why I believe it is foolish to start with options.
Options are derivative instruments, as are commodities. The people who have the most success trading oil futures are people who understand that industry, because the value of the oil future is derived from the value of the underlying (in this case, crude oil). Why should we think that stock options are any different? The only value an option has is derived from the price movement of the underlying stock or index. If you don't understand how to successfully trade the underlying instrument, you will not achieve lasting success trading the derivative (the option contract). First learn how stocks trade, and how various events (such as company news and economic announcements) move their prices. Then consider trading options on those stocks.
STEP TWO: Start trading stocks with real money. I strongly recommend that you start with a small amount per trade. Success in virtual-trading does not always translate into success in trading real money. There is a very big emotional difference between trading monopoly money and money that you have sweated to earn! Expect to see your percentage of winners slip somewhat once you begin to experience the stress of trading money. Use a smaller amount than you will use once you are trading "for real." Don't start doing larger trades until you are once again consistently taking profits on 75 to 80 per cent of your trades.
STEP THREE: The more you plant, the more you harvest. You have been doing small trades to minimize your risk. Now that you have proven your system to yourself, you can be more confident in making larger trades, which should bring larger rewards. Here are a few rules of thumb to use in determining how much you should trade.
**Always keep at least half of your account in cash. That way, if disaster strikes, you always have capital with which to start over.
**If your trading account is $10,000 or less, never put more than 20% in any one position. I would actually recommend no more than 10%, but in some cases, depending on the amount you have to trade and the price of the stock, that may not be practical.
**If your trading account is between $10,000 and $100,000, never put more than 10% in any one position.
**If your trading account is over $100,000, never put more than 5% in any one position.
STEP FOUR: Now that you are successfully trading stocks, many would suggest that this would be a good time for those whose goal is to trade options to start doing so. I have a different suggestion for you. Trading options, even simple long calls and long puts, is much more complicated than trading stocks. Some reading this who are experienced options traders are thinking, "What is so complicated about options?" Think back to when you first started in options. With stocks you only had to worry about one variable - the price. With options, you had to learn to consider the price of the underlying stock, as well as deciding between many different expiration dates and a wide range of strike prices. It's rather like changing from a bicycle to an automobile. You have to learn to consider many different things at the same time.
If you were just learning to drive a car today, where would you prefer to learn: on a quiet country road, or in downtown Manhattan? Jumping from trading stocks directly into trading options is like Manhattan - fast-paced and stressful. Options prices move much more quickly than stock prices. Plus options expire, something you don't have to worry about with stocks (unless you own stocks like Worldcom or Enron!). So what is the "country road" way of learning options trading? Try LEAPS.
LEAPS are Long-term Equity AnticiPation Securities - basically, long-term options. They have different strike prices, like traditional options. They expire like traditional options (except that they only expire in January, rather than monthly). The main thing is that they trade like options, only at a much slower pace. Learning options by trading LEAPS allows you the luxury of developing new skills at that slower pace. However, Step Four is not trading LEAPS. Instead, I suggest that you do as we did with stocks. Virtual-trade LEAPS until you are trading them as successfully as you traded stocks.
STEP FIVE: Trade LEAPS with small amounts of real money.
STEP SIX: Trade LEAPS using the money guidelines in Step Three. It doesn't matter what security you are trading (stocks, LEAPS, or options). You should never put more than the recommended amounts in any one position.
STEP SEVEN: Some of you may have decided that LEAPS give you all the leverage you need, or that you don't have the time or the risk tolerance to trade options. However, if you are determined to be an options trader, you have now laid the foundation that should allow you to trade options with more knowledge and less risk. At this point, you should go back to virtual-trading. Sorry; trading LEAPS with money doesn't qualify you to risk money on options.
STEP EIGHT: Now that you are successfully virtual-trading options, dip your toe into the water. Trade small amounts of money (one or two contracts in most cases) until you are winning most of the time.
STEP NINE: Trade options using the money guidelines in Step Three.
STEP TEN: Did you think we were done with Steps? No, Step Ten will be part of your life for as long as you trade. Step Ten is "Go back to virtual-trading." Invoke Step Ten whenever you get a bright idea to trade a new system. Do Step Ten if you buy new investment software. Step Ten kicks in if you decide to trade any security you have never traded before. Most important, do Step Ten if your performance starts to slip.
I keep track of my gas mileage, and take my car in for a tune-up when I see my mileage slipping. In the same way, you should be honest with yourself, and check the percentage of profit or loss in your account every month. You would be amazed at how many people who call themselves investors or traders cannot tell you how they are doing on a monthly basis. "I'm doing pretty well." doesn't cut it. You should know exactly how well or how badly you are doing every month. It's easy to do this if you haven't taken money out or put money in to your trading account in the past month. It's not that much harder to calculate of you have. In any case, every month you should compare the value of your trading account to the value of the previous month to determine your percentage of profit or loss. This is the only way to know how you are doing. If you see that your are making less than you have been, or that you are losing money, consider going back to practice trading while you fine-tune your technique.
Finally, most successful investors continue to simu-trade even while they are trading with cash. One reason for doing this might be that you have all your available money committed, and you see a good trade. Simu-trading it can be a good learning experience. Also, you may see or hear about a different way of trading that you haven't tried before. Try it with play money before you risk your hard cash.
Does all this sound time consuming? Might it be boring to simu-trade when you could be experiencing the excitement of real trading? Yes and yes. But if you want to be a responsible, successful trader or investor, you will take the time to follow the advice in this article, and lay a strong foundation for real wealth-building.
Dr. Tom Barrett is a pastor, teacher, author, conference keynote speaker, professor, certified executive coach, and marketplace minister. His teaching and coaching have blessed both church and business leaders. He has been ordained for over 40 years, and has pastored in seven churches over that time. Today he “pastors pastors” as he oversees ordained and licensed ministers in Florida for his ministerial fellowship.