In This Chapter

Your trading business is physically set up like a home-based business, but you can’t stop there. Before you begin full-time active trading, you need a plan for how you will transition from a money-losing startup to a profitable business that will provide the financial support you and/or your family needs. It could happen accidentally, but it will more likely happen intentionally if you plan for it to happen.

Your business is simple compared to most businesses, so your business plan doesn’t need to be 100 pages with charts and supporting documents. It does need to lay out what your goals are, how you plan to reach them, and when you plan for all of this to happen. You may not know precisely how long it will take, but you can make adjustments later. One of the other benefits of having a business plan is that it should describe your time commitment to the business and to yourself and those close to you. How you manage your money and your time are the most important business tasks you face.

It is easy to think that a written business plan is overkill for a one-person business, but that would be a mistake. Once you begin active trading, you may easily get lost in the daily struggle and lose sight of the goals you have set for yourself. A written plan lets you back off periodically to see if your business is still on track toward those goals. If you’re not, what has changed? What do you need to do to get back on track, or do the goals need to be modified in the cold reality of actual trading?

Beginning active traders, especially those doing short-term trading, often overestimate their abilities and underestimate how hard ending the day with a profit is. This wakeup call can be disheartening, but if new traders learn from their mistakes and stick with sound money-management practices (discussed later), they can turn things around.

Your business plan should also include strict rules on money management. These rules will prevent the emotions of greed or fear from taking hold and ruining you financially. These money-management rules will not guarantee you will succeed as an active investor, but if you don’t follow them you can be almost certain to fail.

Your business plan doesn’t need to be an elaborate document, but you should put some time into it well before you begin trading. The primary parts of the plan are goals, deadlines, and strategies. If you want to include information about your physical setup, feel free, but the main focus should be on goals, deadlines, and strategies.

You can approach the business plan several ways—the format is not important as long as it works for you. Here are some questions to help you create a business plan that fits your goals.

What securities are you going to trade: stocks, bonds, futures, options, and so on? We have focused primarily on stocks because that’s where many beginning active traders start out. However, there is no rule that says you must start with stocks.

It’s best to focus on one security type in the beginning and then expand when you become competent with that product. What you decide to trade may influence several other factors in your plan such as when you are going to trade, what strategies you’ll use, and so on.

Do you plan to trade short-term (day trading) or pursue one of the other strategies? Many active traders get into trading for this reason. If this is your plan, it has implications for how much investment capital you’ll need, what type of broker you’ll use, and so on. You don’t have to start this way. Some active traders make a living swing trading a variety of securities. Plan your business on what works for you, not on someone else’s vision of active trading.

Are there areas of your business you need to focus on before beginning trading? The answer should be yes for almost everyone beginning a career in active trading. You’ll need a lot of practice with your trading software, including charting and reading Level II screens. Spend enough time paper trading that when the time comes, you aren’t stumbling over how to enter a stop-loss order or some other basic function.

Most active traders will lose money in the beginning. Don’t set yourself up for failure by planning to be profitable from day one. One way to approach your initial goals is to set a percentage of profitable trades in the beginning and increase the percentage until more trades make money than lose money. It makes sense to space this process out over a six-month period. If you practice good money management, even though you are losing money, you will not lose everything in the process. If you learn from trading mistakes, you may turn the corner sooner than six months.

Depending on how many trades you make and their size, you can work toward a long-term goal of building an income from your business that meets your needs. If you need a huge income from your active trading business, be prepared to make large frequent trades. As you grow your business, it will be tempting to up the size of your average trade—say from 500 shares per trade to 1,500 shares per trade. Obviously, the more you have at risk, the greater your potential reward and loss. It will become clear that your income is a factor of how often you trade and the size of those trades.

It is possible to become just proficient enough to more or less break even in your trading business, but never quite turn a profit. This is a place many active traders find themselves (or worse). Statistics indicate that 80 percent of the people who try active trading don’t succeed. Include in your business plan a reasonable period for you to begin showing success or commit to close shop before you lose too much money. If you have been at active trading for a year and still can’t turn a profitable week, but aren’t suffering big losses either, it’s time to reconsider this as a career. Too many beginners will become desperate and begin making risky trades. In a short period, they will usually go through most of their investment capital. If it’s just not working for you, quit while you still have some of your investment capital left.

If you are not careful, you will find yourself trading around the clock. This is a bad idea for several obvious reasons. Your business plan should set your trading hours, which will be driven in part by the products you trade and when those markets are open. Office hours are a good idea and should be in your business plan. Since you don’t have a boss to ask, schedule vacation when you like, but do schedule vacation—at least two weeks per year. If you have a family, you can schedule it around their schedules. The important thing is to take vacation, no matter what. Close all your positions, leave your laptop at home, and get away from the market. You’ll be a better trader for it. If you are having a run of bad days, take a day off and clear your head.

Your business plan doesn’t need to map out each minute of the day, but it should outline a pre-market opening routine of checking any open positions, doing research, looking for trading opportunities, and so on. Do a general schedule for the rest of the day, including a wrap-up after the market closes (if you are trading on the exchanges). There are two purposes for this. First, it gives structure to your day, especially those times when the market is closed. Second, if you share your residence with someone who may be tempted to pop in the office and ask you to run an errand or want to chat, you can have him or her review your business plan. They’ll see, hopefully, that your day is full and you are not available for errands or chitchat until your work is completed.

An important part of your business plan is the financial section. Here you detail how much money you plan to invest and the expected return on that investment. While you may spend several thousand dollars upgrading your computer equipment, the real investment is in trading capital. If you plan to be a short-term trader, you will probably meet the SEC requirements of a pattern day trader. This means you must maintain $25,000 equity in your account. Some direct access brokers may require more, as short-term traders usually trade on margin.

You will want enough investment capital to keep you trading through your learning period and to maintain the $25,000 minimum in your account. It would be prudent to have $50,000 on hand as your investment in your trading business. Open your trading account with $30,000 or so and add to the account as needed to maintain the minimum equity balance.

You should also have another fund separate from your investment capital of at least three months (six months is better) expenses (mortgage, food, utilities, everything) in cash. This is your escape fund. If you decide active trading isn’t for you and there isn’t much left of your investment capital, this fund will give you a cushion while you plan your next step.

You might balk at this much capital for your trading business, but one of the main reasons new businesses fail is they are undercapitalized. That is true of active trading, also. It would be a shame if, just as you were getting the hang of things, you ran out of money.

It is true that you can start out trading in other securities or markets and avoid the $25,000 minimum equity requirement. For example, the dealers in the forex market tout the fact that you can open an account for $1,000 or so. Using the tremendous leverage available to forex traders, you can build a sizable trading account very quickly. This assumes you are making winning trades of course. If you don’t make the best trades, your $1,000 stake won’t last very long. Other markets don’t require a large minimum investment either.

However, a strategy that attempts to enter active trading on a minimum budget and build up a pool of investment capital through profitable trades is a high-risk, low-probability plan. One of the main reasons 80 percent of the people who attempt active trading fail is they don’t have enough money to get through losing trades. Beginning active traders will lose money, no matter what market or security they choose. Despite what you may hear on infomercials or see on the Internet, there are no easy ways to make money trading securities.

The best source of your investment capital is money you have saved from earnings or some other business activity. Don’t use money from:

It is difficult enough trading and losing your own money, although some people have less regard for borrowed money than they do for their own money. In either case, you should put up equity to fund your business, not borrowed funds.

You need to set profit goals for your trading business even if you have no idea how long it will take you to begin executing more profitable trades than losing trades. If you don’t have a goal with a date to reach the goal, it is harder to measure your progress. Don’t expect too much too soon, but also set goals that are challenging so you push yourself to master the trading strategy. A little pressure is usually not a bad thing.

One way to consider your goals is by percentage of profitable trades. In other words, of all your trades for the day, what percentage was profitable? You can assume that number will be low in the first weeks. You will probably not execute a large number of trades each day the first few weeks. As your skill and confidence grows, the number of total trades will increase and the percentage of profitable ones will climb. It is not possible to say when you should be making more profitable trades than losing trades, since that will depend on each individual’s skill and the active trading strategy they pursue.

It’s common for new active traders to take several months and maybe as many as six months before breaking into profitable trading percentages. Active short-term trading is the most intense and most difficult to learn correctly. Active traders who pursue this strategy may face months of negative returns before finally pushing through to the positive side. Traders who survive this initial trial may go on to very successful careers. However, they won’t survive if they don’t learn and adjust from their mistakes, practice sound time management, and closely protect their money with a management system.

A money management system is a plan for how you will structure your trading business and how much money you will invest in trades. You need to include this system in your business plan and stick with it, especially when times get tough and you are tempted to alter the plan to recoup losses.

A money management plan spells out how much you will place on each trade and answers the “What are you going to trade?” part of your business plan. No matter how difficult the market, you stick to your plan, which may mean, in some markets, you have days when there is nothing to trade. For short-term active traders, the market can present days when there are few opportunities and days when there are too many opportunities. Sticking to your money management plan means you have a fixed trade size no matter the market conditions. The worst mistake is chasing hot tips or what appear to be super trades.

How much of your investment capital are you willing to risk on each trade? This is a question you’ll have to answer personally because everyone has a different threshold. The answer we are trying to get to is how big of a loss on a trade are you willing to suffer before closing your position? There is plenty of mathematical evidence that using a small percentage of your total investment capital as the maximum will keep you from losing all your money in a hurry.

Many active traders use 1 or 2 percent of their investment capital as the maximum they will lose on any single trade. Remember, with stop loss orders, you can keep your losses from getting completely out of control in most markets. If you follow the percentage rule, you will keep your losses to a small amount. Many traders expand on that rule and limit losses in a single day to 5 percent or less. If their losses for the day hit that mark, prudent traders close positions and quit for the day. The natural impulse might be to attempt to catch up by increasing the size and frequency of trades. This just increases your risks because you are forcing more trades to recoup losses.

Traders who use this risk management technique keep their losses under control and preserve investing capital for another day of trading. More experienced traders can use hedging techniques such as opposing trades or options to offset risk, especially on large positions. For beginning traders, sticking to a trading plan is critical. The other critical way short-term active traders control risk is to close all of their positions at or before the end of the trading day. It can be tempting to let a winning trade run or to hold on to a losing trade hoping it will turn around. Both steps more often than not lead to losing situations.

One of the characteristics that distinguishes short-term active trading is the use of margin, or leverage. When the market shifted to the decimal system of pricing stocks, it took much of the profit out of the bid-ask spread. As we have noted in other parts of the book, this has meant short-term traders have much thinner bid-ask spreads to trade. Where a short-term active trader may have been able to make money before decimalization with a 500-share trade, she now has to trade 1,000 or 2,000 shares to make the same profit.

These larger trades usually mean a much greater use of margin. The broker lends a large percentage of the trade amount to the customer so she can buy a larger block of stock just to make the same return under the new rules.

Margin allows traders to buy large blocks of stock, but not all traders are comfortable with using leverage that can work against them if the trade goes bad. There is no rule that says you must use leverage or a large amount of it in your trading business. When you are preparing your business plan, include in the financial part a section on margin and how much you plan to use. Without margin, you may need to seek out trades where you have the potential to earn substantially more than the bid-ask spread. This may mean fewer trades with a slightly elevated risk factor.

After you have some successful experience behind you as an active investor, you may want to rethink your use of margin, but that’s a personal decision.

One of the most important tasks in the daily routine is to review the day’s work and determine if you made a profit or loss for the day. If you are using an advanced trading platform, you should be able to review your account statement and see each transaction along with the associated commissions and interest charges, if you used margin. It will be easy to see a gross profit or loss number using this information. However, you need to get to a net profit or loss, which will include some accounting for your overhead and tax liability. That may be too fine a point on a daily basis, but you should have your accounting software (or a spreadsheet) set up to give you that number on a weekly basis.

You’ll want a report that shows percentage of profitable trades (to relate to your goals), how much was traded, and the return you earned. This information will be invaluable as you move forward. It will tell you whether your trade size is right (does it need to be higher for a higher return?) and it will track the percent of winning trades.

You should also review your trades to see if you can determine why they worked or didn’t work. Sometimes you will clearly see in retrospect what you didn’t see at the time of the trade. Often, only experience will help you “see” the market with greater clarity. You can also note why trades worked and how you might recognize those patterns again. This recap is not a time for beating yourself up over mistakes or for gloating over smart trades, but for expanding your knowledge. The day you think you’re smarter than the market is the beginning of the end of your career as a trader.

Your business plan will help you stay focused on nurturing the two most important resources you have as an active trader: your time and your money. If you waste either, you are asking for trouble and may be looking for something else to do soon. In Chapter 24, we’ll look at some of the emotional and intellectual characteristics necessary to be successful as an active investor. We’ll mention one now because it is so important in making your business and money management plans work.

Discipline is the ability to stay focused on the task at hand and follow a plan when there are many distractions that encourage you to shift your attention elsewhere. For example, if your trading plan calls for short-term trading of large cap stocks, don’t drift over to small cap stocks just because they are hot today. It may seem like the logical thing to do, but the two stocks don’t react the same way in the market, and in the afternoon tech stocks may get hot. The point is without discipline, a trader will be jumping all over the market in search of the “next big deal.”

Here’s an insider’s tip: there’s always another “next big deal.” If you listen to the hucksters, they will make it sound like they have the inside track on the last big deal and, if you don’t get on board now, it will be too late. Discipline is being patient and waiting for your trade. It doesn’t need to be the perfect trade, a good trade will do. If you have discipline, your trade will come and you will make money. Inexperienced traders will trade just to be in the game and that is a mistake. Sit out the whole morning if you must, but wait for a good trade. You’ll make more money than jumping at bad trades and hoping they turn out okay.

If you make a bad trade, let it go and move on to the next one. Don’t let fear restrain you from trading. If you are afraid of losing, your judgment will be clouded.

The Least You Need to Know