Trading Lessons You Will Not Find in Books

I have read around six books and countless articles on trading. I have been trading equities for about a year and a half now and options for about four months. There is one thing I realize now: there is no better teacher than experience. Even after reading all that literature, I make mistakes that are stupid and easily avoidable.

In this article, I will list as many of those mistakes as I can remember and what consequences I faced (or someone else faced) by making those mistakes.

1. Diversify
   I cannot stress the importance of this lesson. The main point is if you do not diversify, eventually you will make a bad call and get wiped out. Such a disaster can essentially end your trading endeavors.
   One of my friends made this mistake and brought his trading career to a halt. Close to a year ago when Wachovia hit $10/share, his analysis and thought process said that Wachovia would not fall much further. He proceeded to invest close to 80% of his money in Wachovia. Next day, Wachovia crashed to mere pennies, pretty much wiping my friend out (Although thanks to Wells, it came back close to $7. I personally bought at around 53 cents and sold at around $6 - best trade of my life :)).
   Even if your analysis is perfect, there is always a chance that you could be wrong. Individual traders especially have very limited information and thus can very rarely assume that they are 100% correct. Because of this reason, always know what your max loss on any one trade will be in the worst case scenario and make sure that such a loss will not completely wipe you out.
   


2. Watch the commission rates
   This applies close to home for me because I have very limited capital and any commission I pay significantly cuts into my profits. Things get especially worse when I have adjust and readjust my trades to show profit. There have been many times where although I am showing a 10%-15% profit, really I am breaking even because of all the commission.
   Even now, more than 5% of my account has gone to commissions and in fact at this moment, my commission fees outweigh my profits!
   However, I have truly cut down on my commission fees by making better decisions and cutting down on the number of trades. I think in the past two months I might have spent only 20% of my total commissions and I have been trading options for only 4 months.
   If you use TOS software, make sure you turn on "INCLUDE COMMISSIONS" on the analyze tab as this will really help make better decisions. If you do not use TOS, try to take advantage of any discounts/perks your broker might offer. Keep in mind that some brokers will make special deals with you if trade more than a certain number of trades/month. Apart from that, I have no real way of avoiding commission fees.


3. Have an action plan before you enter the trade
   A lot of the equity/futures trading books emphasize this point quite a bit. However the option educational material seems wanting in this area. Ironically, this probably applies a lot more to the options market than to any other market.
   I think the problem is that there are infinite possibilities of how to handle an options trade. You can simply exit the position, you can switch your position for another one, you can change strategies, you can make a horizontal shift, and you can pretty much do anything you want if you are creative.
   If you do not have an action plan, however, you will simply end up spending a bunch on money on commissions while you keep readjusting your trade and at the end still make a loss.
   I suffered greatly from this when last month I traded a bunch of calendars expecting the stock to remain in the calendar's trading range. However, I was hit with unexplained volatility which took me for some of my largest losses yet. Because I did not have a plan, I chose to simply exit the positions, sealing in those losses. Looking back, there are a variety of things I could have done to avoid those losses and even turn some of those trades into profits.
   I strongly urge you to analyze all the possible scenarios and have plans for each of them: what will you do if the underlying goes up/down 0%, 2%, 5%, 10%, 15%; What will you do if the implied volatility falls/rises 5%, 10%, 20%. If you have these bases covered, most of the times you should be in good shape.


4. Keep a close eye on Bid/Ask before trading
   This, again, holds especially true for options. Let me illustrate with the following example:
   
   Today, PRU is trading at 49.12. I am looking at the option chain and see that the "Mark" (or the quoted price) for Jan 2010 49 Call Option is 3.30. But the Bid/Ask tells a different story.
   Bid Price: 3.20; Ask Price: 3.40.
   So I say, "OK, let me buy a call option". I spend $340 and buy one contract. Five minutes later I realize that I need the cash for a margin call and am forced to liquidate the position (Of course you would never get into this situation if you follow advice # 3).
   I turn around and sell the option while the Mark is still 3.30. No big deal, right? No profit/loss, right? Wrong!
   When I sell, I must sell at the bid price, which is 3.20. So I get $320 back, taking me for a $20 loss. In five minutes I lost almost 6% of my capital even though the option price has not changed!
   I have made this mistake many times because I look at my positions and they show a profit of $XYZ so I get rid of them. But because of the Bid/Ask spread, many times I have quickly turned healthy profits into heavy losses.
   My advice is to use the Bid/Ask prices in your analysis rather than the quoted "Mark" price as most options software will use. If you use TOS, the analyze tab does an excellent job of graphing your profits/losses based on the bid/ask prices.


5. Beware the ITM short options
   When you are short an option and it goes ITM, I become very wary and try to get rid of the ITM options as soon as I can. The reason is that if you get assigned those options, your position changes drastically and unpredictably. Below is an example.
   I had traded a HPQ calendar and the trade, one day before expiration showed a nice profit of approx 20%. On the expiration date, the short options went ITM and at the end of the day I was assigned those shares. Next thing I know, I am short 500 shares of HPQ and the stock jumped around 5% the next day, wiping out all my profits.
   My advice is to buy back ITM and close to ITM options as expiration approaches. You might give up some time value but are protected against drastic market changes that could take you for a much larger loss.

I hope the lengthy advice can help you in your trading career and you can learn from my mistakes. I am also certain I will make many more mistakes and I will try to update this list as I make those mistakes. I only hope that overtime my right decisions outweigh my wrong ones.

-Wown
StockJockz.blogspot.com