Five simple rules for new traders
The COVID-19 pandemic has shuttered most workplaces. Many people are now working from home, or not working at all. Large-scale social activities, including sporting events, concerts, bars, restaurants and casinos were closed to slow the spread of the coronavirus. Although restaurants are starting to re-open (as of June, 2020), most major sources of entertainment are still shut down.What are people doing for entertainment instead?
According to a popular media narrative, millions of “bored young people” have started day-trading stocks and options. In April, the no-fee trading platform Robinhood announced that they added three million funded accounts in the first three months of the year.
If you are one of these new traders, then as an old(er), not-bored, experienced and successful options trader, I would like to offer up five simple rules to help you be successful with your newfound hobby (or career, as the case may be).
1. Don’t risk more than you can afford to lose.
This simple rule is about as basic as as a rule can get but it is also 100% the most important. Look at your personal finances, set aside enough funds for three to six months of living expenses and only then deposit any excess into your Robinhood or other brokerage account. Only add more cash when you have more disposable income to work with. If you need the money for rent, groceries or baby food, don’t put it in your Robinhood account.
To ensure that you do not lose more than you can afford to lose, adhere to these corollaries:
- Do not take out a margin loan. Sure you can make bigger trades by using Robinhood’s money, but you have to pay all of the loan back, at 5% interest¹, even if your trade is a total loss. At the end of 2019, Robinhood had loaned out $656 million² to their trading customers. Hopefully these borrowers understand the risks involved.
- Do not open unlimited-risk trades. These include shorting stocks or indexes and selling naked calls. Robinhood does not allow unlimited-risk positions, but most other brokers do allow them in a margin account.
- Likewise, be wary of defined, but large-risk options positions such as selling naked puts. Sold puts are technically a defined risk since the underlying equity cannot go to a negative value so the amount you can lose is fixed. However, if you do not have the cash in your account to cover assignment of an in-the-money sold put option then you can end up with a potentially large margin loan or even a margin call in which you have to immediately add more money to your account or have your other positions liquidated to protect the brokerage.
2. Study how options work (at least the basics).
There is a vast amount of options trading educational resources available on the Internet for free. Every broker, including Robinhood, has tutorials and documentation about trading. Invest the time to learn. At a bare minimum, you should know:
- The difference between puts and calls.
- The difference between selling an option and buying an option.
- What happens when an option is in- or out-of-the-money at expiration.
- How options are priced.
- The mathematical aspects of options premiums, including “the Greeks” and implied volatility (IV).
- What time value and intrinsic value are.
- How volatility affects an option’s price movement.
- How to manage the options strategies you use.
Does this mean that you have to be an expert or a mathematician to trade options? Absolutely not. But the more educated you are, the more successful you will be.
3. Understand emotion and its effect on decision-making.
When a trade goes against you, it’s natural to feel disappointment, fear or anxiety. Likewise, a position that is mooning can cause irrational exuberance that feeds into a desire to make even more. In both cases, your emotions can hamper sound decision-making although they tend to be more intense when you are dealing with losing positions.
This is one of the toughest rules to implement because we’re only human and emotions play a role in every decision we make. To combat the negative effects of emotions on your decision-making, develop a trading plan, write it down, and stick to it. Implement your plan unemotionally (or as close to it as you can get). Losses are going to happen, because they happen to everyone. Your goal as a trader is to have more profit than loss, not to salvage every losing trade and turn it into a win.
Keep a trade journal and document every trade and the decisions you make as you manage each trade. Your trading plan should evolve and change as you gain experience and learn from both winning and losing trades.
Related Article: Five Traits of Successful Traders
4. Understand your brokerage account statement.
There are a lot of numbers on your account page. Make sure you know what those numbers mean in terms of your financial health as well as your obligations. There might be line items such as:
- Buying power
- Margin requirement
- Withdrawable cash
- Cash available to day trade
- Gold used (Robinhood-specific)
And so on. Read your broker’s documentation and thoroughly know the meaning of each of the numbers they show you. If you are unsure, get help. You can contact the broker, post on reddit or other forums, or ask an experienced friend or relative. Make sure you know what they mean since sometimes the numbers can be scary.
Recently, a young Robinhood trader took his own life because his account page showed a negative $730,000 cash balance. According to a relative, the twenty year old man appeared to misunderstand his account position, saying, “He thought he was exposed, he thought that ending his life would protect his family from the exposure.”³ It is unclear from news reports what actually happened, but it’s likely that the negative balance was transitory while the collateral side of a trade was pending. To their credit, Robinhood does not allow the riskiest types of options trades, but most other brokers do.
5. Don’t YOLO (too much).
There are a number of web site forums, Discord servers, Reddit subs and so on where people talk about their trades. It is very easy to get caught up in other people’s (supposed) success. Remember, the people you see on the screen are all just some random guy on the Internet. They could very well be lying about their trades or showing screenshots from paper-trading accounts where you can put on much riskier trades since there is no money involved.
There is a trading-related sub-reddit called r/wallstreetbets where the traders throw around terms like YOLO, or “you only live once.” It can be fun to join the sub and follow along. You might even be tempted to partake yourself. I won’t be the old guy that calls you foolish and tells you not to trade like that. If you are young, with few responsibilities (like children to feed), then it can be fun to put on some exciting trades like they do that have a huge, but low-probability profit potential.
If you choose to YOLO, follow these guidelines:
- Adhere to Rules 1–4 above, first, before you start speculating.
- Acknowledge that YOLO-type trades are more like gambling than trading, and treat the funds and the activity as such.
- Limit your speculative exposure to a fixed percentage of your overall portfolio. For example, if you have a $10,000 account, choose some amount that you are comfortable losing entirely ($1000? Half? All of it?) for these activities, and then don’t kick yourself when you lose it.
- Acknowledge that you will almost certainly lose all of your speculative money. There are many stories on r/wallstreetbets of people with accouns that went from $10k to $100k to $3k. If you cannot be at peace with yourself after that happens, then don’t YOLO.
Remember, it is easy to make money in a bull market, but not so easy when the inevitable black swan or bear market or recession hits.
When you are young, you think the market only goes up because that is mostly all you have ever seen. You can absolutely make money trading and if you learn from the mistakes you make along the way, you can make even more money in the future as you gain experience and expertise.
Enjoy and entertain yourself. Learn and then learn more. Perhaps you can even make a career as a retail trader.
Want to Learn More About Options?
Tim Garlick has been investing and trading stocks and options for over 25 years. Visit Tim’s site at The Options Hive, where you’ll find free education, tools and resources to learn more about stock options trading.
¹ Robinhood Gold margin rates per Paying for Robinhood Gold (robinhood.com)
² Robinhood X-17A-5 Part III filing (robinhood.com)