As I have previously stated, I apply separate strategies and approach to my portfolio (investments), and trading account (speculative positions). When it comes to trading, these are some of the trading rules that I follow. All these rules helps me lower risk, reduce mistakes and achieve outstanding long-term return. When I say “long-term”, I vision more than 10 years. I believe that good performance for so long with lower than normal risk and volatility is what really separate the good traders and investors from the mean.
Below I share with you some of my trading rules that I strictly follow. I will regularly update this page with more rules. At the end of the page, I have shown a real trade that I made in 2010, and how I applied these trading rules to the idea.
1. Don’t use leverage more than 1:2 at maximum.
Do I break that rule?
Don’t abuse with credit. Credit can put you at risk. Try producing high returns with less risk (less leverage), instead using high leverage to produce high returns. This is the main thing separating the good investors from mean. I can give you an example with Seth Klarman of Baupost Group. He is an excellent hedge fund manager that not only doesn’t use leverage, but keeps cash at 20-40% of the fund’s assets. Mr. Klarman has produced a net annual return of over 20% between 1983 and 2009. Certain return can be achieved as with high risk, as with low, but the difference is huge. Try to achieve x return with low risk, and let others achieve that same return by risking more.
2. Risk Management.
What is my risk? Risk = (loss * probability of losing)
More about risk management can be found in various books and articles online. I will not disclose much about it at this moment.
3. Timing is truly everything.
Is it the right time to do the investment? Why?
Try to be few moves ahead of the markets, try to anticipate things and prepare before others. Think like contrarian and a chess player.
4. Discipline yourself to wait! Be a jackal, wait much more than initially thought. Cheap things get cheaper, expensive get more expensive.
Have I waited enough? Have I waited longer than I wanted?
Usually, this leads to missing some opportunities, but it also protects your money. And because trading ideas are many, it’s better to miss some instead losing money or keep a losing position. It’s important to be more precise in trading.
5. Be contrarian.
Is what you are doing opposite the general thinking and doing?
General thinking applied to trading and investing, leads to poor returns and bad performance. While individual and contrarian, leads to the opposite. See the example trade below for a reference.
6. Do due diligence. Know more than other’s do.
Do you know something others do not? Do you know more? What are they missing?
You must have an edge. You must be armed with knowledge and courage. Try to deep harder for news and gather more qualitative information than others.
7. The more certain something is the less likely it is to be profitable.
Is your investment certain?
If it’s too certain, for too much people, then it’s probably not worth it. Yes, it might be right for sometime, but will probably lead to poor performance later.
8. Do not think in terms of what you wish.
Do you act upon wishful thinking or there is reason for the expected?
9. Don’t put a specific return to be achieved. Focus on risk p. 2
Why do I trade? What I want to achieve? Risk?
If you target some return to be achieved, it will lead to mistakes and taking higher risk.
10. Buy value, not market trends or the economic outlook.
Do I know the fair value of the asset? Do I buy at price less than fair value?
You must be able to determine what the fair asset value is. If you don’t, you risk buying something expensive or selling something cheap. You need to create or use models to know assets fair value. Don’t buy because of the trend or expected economic outlook. Seek what is cheap, hated and buy it. Sell what is in parabolic up move.
11. Stay away from investments that cost much money to maintain (commodities in contango for example).
Does the position require much capital to keep open, finance or rollover?
If more than 10% annually re-think the idea unless you are good short-term trader. The position rolls depend on the expected return and risk. Using CFDs can reduce significantly your performance.
12. Aggressively monitor your investments.
Do I pay attention to changes?
13. Don’t panic. Do not be fearful or negative too often.
Am I fearful now?
14. Investments are made at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world.
Do I have margin of safety?
The margin of safety will protect my trading account and will limit my downside in case of the scenarios above.
15. Live in longer intervals of time but always be prepared.
How long will I keep my investment if goes up, down or stay calm?
Try to have answer for all possible scenarios.
16. The market looks 6-12 months ahead. Don’t invest on news. Do I invest because some news?
Am I ahead of the news and the market?
An example of a trade – long EURUSD position opened on May 26 2010
What caught my attention:
1. The EUR currency was under severe attack by speculators and public due to the debt crisis that started in 2010.
2. The EUR currency, supposed to be the next world reserve currency, lost 20% of it’s value to the USD. Was the sell of Euros overdone or was it correct.
3. The news was full with predictions. Out of 20 news, 15 were for the EUR collapse and depreciation. Many predicted parity with the USD. The forecasts for EURUSD was lower and lower. Measured by the Daily Sentiment Index in May 2010, EURUSD bulls was 4% and bears was 96%, so basically the retail traders and public were extremely negative about the EUR. The trade was crowded and the general idea was to short the EUR.
What I thought:
1. The markets might be right and the EUR might deserve to be on track with the depreciating USD, but was the Eurozone ready to let Greece restructure or other countries fail? The answer was no. The banks couldn’t write-off the bonds and they needed time to increase capital to absorb the losses. Such big shock was unwelcome and the authorities acted, they needed time because they did not want to risk a banking crisis of high magnitude.
2. Were the USA problems forgotten? For half an year. Was USA in worse shape? Yes. The deficit and accumulative debt was bigger. But Europe is easier to attack due to the structure of the union.
How did I apply my trading rules to the idea about going long EUR against USD.
1. Did I have available capital to invest without breaking Rule 1? Yes.
2. Was the risk/reward ratio good? Yes. I expected the EUR to appreciate at least 10%. What I risked was time, as my analysis did not indicate EURUSD going to parity. Despite the similar profit or loss, the chance of being right was extremely higher than not.
3. Is it the right time? I thought it’s the right time to do the trade, because the Europe needed time to prepare it’s banks and the EUR was extremely oversold by retail traders. The DSI indicated that the public is all-in shorting the EUR.
4. Have I waited enough? It’s hard to determine. I wanted to buy for sometime, but the EUR kept sinking, so I guess it was better time to buy and I have waited sometime. The pessimism in the news really helped me to prove myself that it’s the time.
5. Was I contrarian. Yes. The public was selling EUR, and I was about to buy.
6. Do you know something others do not? Do you know more? What are they missing?
Yes, I did. Eurozone members couldn’t have let Greece fail. Many huge banks weren’t prepared for such losses as their equity would have been wiped out. This is what the public was missing. They missed that something positive will happen that will buy time. Also they thought that ECB’s printing of money and the rescue fund will create inflation and devalue the EUR. In fact, the EZ was about to experience austerity and deflation, while FED and the USA couldn’t do austerity. The inflation was caused by the FED and the rise of commodities. Eurozone was buying time, that was not inflationary, but it was deflationary, as it required Greece to do austerity.
7. Is my investment certain?
No, the public didn’t expect it. I didn’t take it as certain but I was rational behind it. I wasn’t overconfident.
8. Do you act upon wishful thinking or there is reason for the expected?
No. There was nothing about wishes. I had a reason to go long the EUR.
9. If you target some return to be achieved, it will lead to mistakes and taking higher risk.
I didn’t have a target to be achieved. I also didn’t need this trade to be right as It wasn’t about the money I expected to earn. I just wanted to buy what nobody else wanted because I had reasons to believe that the EUR will receive support and the public is wrong.
10. Do I know the fair value of the asset? Do I buy at price less than fair value?
One of the most hardest assets to measure and know fair value of is currency. The most used model to measure fair value for currencies is PPP (Purchasing power parity). According to it, the EURUSD was supposed to be 1.26 in 2010. Due to the potential of the EUR to compete with the USD for a reserve currency status and the fact that diversification can be made only from USD to EUR, I believe that the EUR will most of the time trade at value higher than PPP. The other reason was that Germany, and ECB act more aggressively to fight inflation and to protect the value of the currency, than USA and FED.
11. Does the position require much capital to keep open, finance or rollover? No.
13. Am I fearful now? Absolutely no. I don’t act based on fear, but based on a deep analysis and rationale. The fearful were the sellers of euro, not the alone buyer that I was.
14. Do I have margin of safety?
Margin of safety is mostly used for trading stocks. So it’s hard to say if it can be applied to currency. Point 10 is enough here.
15. How long will I keep my investment if goes up, down or stay calm?
At times of such extreme pessimism and selling of an asset, it’s easy to say that probably the investment won’t stay calm. In this particular case, I didn’t have stop loss or a take profit target.. I was about to wait as long as needed and sell the euros when I wanted.
16. Do I invest because some news? Am I ahead of the news and the market?
I didn’t invest based on news, as the news was “SELL THE EURO”. I thought I’m ahead of the news which will boost the EUR and sink the value of the USD.
Summary: Mostly because of the written above and based on some additional information, I have opened long EURUSD position on May 26 2010 at 1,219. The retail investors were wrong, and in June the EUR hit bottom and started to rally from 1.19 EURUSD to 1.49 EURUSD in 2011. These who were contrarians and bought EURUSD around 1.2 back in 2010, made a killing. I closed the position on October 12 2010 at 1.386 for a 13.7% return. I did timed the trade almost perfectly as the bottom was around 1.19, and I bought at 1.219. My profit could have been better if I had waited more, but I absolutely mark this as a successful trade.