Basic rules of trading

Hindi: इस पोस्ट को हिंदी में पढ़ने के लिए यहाँ क्लिक करें।

Contrary to what most people think, trading the markets isn’t easy. The stock market is probably the toughest place in the world to make easy money, especially in the long run. While opening and funding a trading account is perhaps the easiest way to start a “business”, making money trading isn’t.

What is the difference between trading and investing?
I think if you enter a position with a time frame in mind (typically shorter-term) to exit, it is a trade and not an investment. For example, if you buy a house to live in with no intention of selling, it is an investment. If you buy a house just because the price is attractive so that it can be sold when the price rises, it is a trade.

Countless people have been lured to the markets by mis-sold dreams of getting rich quickly and achieving financial freedom. The ease of getting started adds to this allure. Here is the thing though: less than 1% of active traders earn more money than a bank fixed deposit over a 3-year period. While this percentage seems abysmally small, it is, in fact, similar to the success ratio of ordinary businesses; just that the ease of entry entices a large number of people to give it a shot.

I’ve been a trader for nearly 25 years now, most of my adult life. I’ve been immensely lucky to have interacted with thousands of traders in this period, both before and after starting Zerodha. I felt it would be a good idea to share with you the learnings from all these interactions and my own successes and failures as a trader.

Define a hard stop — money & time

Markets can remain irrational longer than you can remain solvent – John Maynard Keynes

The best traders I know are those who stopped trading when they knew that either they are not good at it (they lost money) or they didn’t enjoy it. They didn’t wait for huge losses to force them out of trading. Like how not everyone can play a sport or make music, or run a successful business for a living, not everyone can profit trading the markets. Stock markets are like a black hole where you can potentially lose unlimited amounts of money if you aren’t good at trading. So make sure to define and stick to a sensible stop loss, an amount you can afford to lose, and a time period you will wait to turn profitable, more so, if you are a beginner.

Have a stop loss on every trade as well

Two basic rules when trading: (1) if you don’t bet, you can’t win. (2) if you lose all your chips, you can’t bet – Larry Hite

I had the luck of hosting this podcast with Jack Schwager — author of Market Wizards, a must-read for any aspiring trader. I concur with what he says in this conversation after interviewing some of the best traders in the world — “you should make sure that you don’t lose more than 1% of your trading capital on any trade”. The larger your losses get on a trade, the higher the chances of you acting irrationally during or after the trade, so much that it can potentially ruin your trading career.

And for those who buy call or put options, placing a 1% stop is only possible if your buy option trades are never more than 2% to 3% of your trading capital. Remember, buying naked options is almost like buying a lottery ticket. If you had one lakh rupees, how much of it would you spend on buying lottery tickets?

Stick with the trend

In trading, what is comfortable is rarely profitable. – Robert Arnott

Intuitively, we are tempted to buy stocks whose prices have fallen and sell those which are expensive. While it might be a decent strategy when investing for the long term, it reduces the odds of winning when you trade short term. Stock prices tend to trend, i.e., move up or down in one direction for long periods. Going against the trend — buying a falling stock, or selling one that is going up, is a bad trading strategy.

A common beginner strategy is buying stocks which are at their 52-week low. The thought process being that the prices that have fallen are bound to bounce back up. This is probably one of the worst trading strategies ever. While we are all wired in our heads to buy when something is on sale or has a big discount, the optimal way to trade stocks is buying those that are doing well (going up) and selling when they are not (going down).

Averaging down is a wealth destroyer

Don’t throw good money after bad.

“Averaging down” is when you buy a stock at 100 and buy more as the price falls, say, to 90, some more at 85, and so on; buying more in hopes that a bounce will help recover the losses faster. Unfortunately, hope isn’t really a trading strategy. Stock prices tend to trend (go up or down for long periods), and buying more as it goes down may work out once in a while, but is generally a losing strategy in the long run. Buying more of the falling stock is essentially you trying to fix a trading mistake, which could have been avoided by having a stop loss. What makes it worse is that retail traders typically end up selling stocks which are profitable to average down on ones which are losing (also called the Disposition effect).

At least when you average down on stocks, you can afford to give it time to bounce. But when you buy stock or index options that have a limited time to expire, this strategy of averaging down is a sure-shot recipe for disaster.

To win at trading the markets, the idea is to hold on to winners and cut loose the losers, and not do the opposite. I’d even go on to say that averaging down is the single biggest wealth destroyer for retail traders. Check out this post on lessons from trading Yes Bank illustrating this.

Leverage is a WMD (Weapon of mass destruction)

Money can’t be the goal; it has to be the process.

Leverage (including futures & options) is trading with more money than what you have. It is extremely dangerous in the hands of someone who doesn’t know how to handle it well. While it might lure you into believing that you can make substantial returns quickly when right, the fact is, you can go broke on a single bad trade if you’re over-leveraged. If you speak to any active trader who has stopped, he or she would most likely tell you it was because they traded with too much leverage. If you do decide to use leverage, make sure to use it sparingly and only when you are really confident about the trade. Even then make sure to have that stop loss!

Combining fundamentals with technicals

Buy on rumours, sell on news

Many beginner traders start their journey in the markets by learning fundamental analysis, the most popular strategy being Price to Earnings (PE) ratio. While fundamental analysis is an excellent way to invest for the long term, it isn’t for short term trading. For example, stocks that have a low PE can maintain that low PE and keep going lower for extended periods becoming even more attractive, while the stock price continues to fall. If you did wish to use fundamentals, it is best to mix it with some Technical Analysis (TA).

TA is based on the fact that markets discount everything and is reflected in the price (you don’t wait for the news to buy, you buy when prices go up (rumour) and then sell when it goes down (typically when the news is out)). Most TA strategies don’t let you trade against the trend. So by mixing in TA, if you did decide to buy a low PE stock, you would buy it only if the price of the stock is going up. For example, if the price is above the 50-day moving average (a simple TA strategy) — a trading strategy with much higher odds of winning than buying a stock just because it is low PE.

Just trading the price irrespective of what the stock is, isn’t a good strategy either. Penny stocks (companies with less than Rs 100 crore market cap and mostly with no real business) are wealth destroyers as well. These stocks are generally manipulated and tend to go up fast and then down even faster without even giving you an opportunity to exit. If Fundamental Analysis is part of your trading strategy, you’d end up avoiding such stocks.

Avoid stock tips

Always start at the end before you begin (think of all possible outcomes and be prepared before taking a trade). Professional traders have an exit strategy before every trade. – Robert Kiyosaki

While “advisors” who claim that they can give you stock tips that can generate high returns or make you quick money are a dime a dozen, it hardly ever plays out that way. When trading on a tip, you wouldn’t know the reason to enter, and hence wouldn’t really know when to exit, the most crucial part of the trade. Most of us are terrible at following advice as well, which means if you somehow found an advisor who gives good tips, you might still not follow it properly. Either way, this generally doesn’t work out well. Also trading on tips is almost like being spoon-fed, your learning curve and growth as a trader suddenly plateaus. More importantly, the bulk of the unsolicited stock tips dispensed on social media and as text messages are “pump and dump” scams. These scammers drive the stock price up by generating hype via tips, only to dump large blocks they hold at a profit at the expense of the traders who fall prey to it.

Diversify

Don’t put all your eggs in one basket.

If you are creating an active trading portfolio of stocks, ensure that you don’t have more than 10% of your trading capital in any one stock. Make sure that not more than 25% of the portfolio is exposed to a single sector. While diversification might reduce returns, it also reduces risk. Lowering risk has to be the most important prerogative in the first few years, as a beginner trader. Think of it this way: you have to go through 16 years of education before finding a job. Similarly, you need to give yourself time and chance to learn and grow as a trader. But you can get that time only if you survive trading long enough, and that is possible only if you reduce the risk as much as possible.

Compulsive trading & bet sizing

Many times, no trade is the best trade.

Trading is extremely addictive. Most traders enter trades just because there is nothing else to do that was more interesting or exciting. It is imperative not to become a compulsive trader. Take breaks whenever you feel trading is taking over your life. If you are finding it tough to stop trading altogether, reduce your trading size to 1/10th when you know you are trading just for the heck of it.

By the way, this strategy of changing the size of the trade based on the situation is called “bet sizing”. Essentially, not trading all the time with the same quantity — decreasing bet sizes when you have a drawdown (losing streak) or when you’re not confident, and increasing them when you are on a winning streak and confident about your trades. Having a bet sizing strategy will improve the odds of you being a winner significantly in the long run.

Have alternate income to improve your odds of winning

Confidence is not ‘I will profit from this trade.’ Confidence is ‘I will be fine if I don’t profit from this trade’. – Yvan Byeajee

If trading and making money is tough, making a living off trading is many times tougher. Very few succeed under the added pressure of having to earn from trading to put food on the table. This decision of trading for a living should be taken only when there is large enough trading capital, a source of income to cover your lifestyle, and hard stops in place. Even when all this is in your favour, it isn’t a decision to be taken lightly. The alternate source of income could be from a fixed income instrument, rental income, a salaried job, or anything that reduces pressure on having to earn a profit on every trade. In my experience of meeting countless traders, most of those who were profitable were also those who had another source of income.

And finally, remember that trading isn’t life. Trading is an exciting way to generate income. If you don’t enjoy it or are losing money trading continuously, stop it. Don’t let bad trades or missed trades affect your personal life. As they say, opportunities always look bigger after they have passed. And remember, there is always another trade; if not on the stock markets, something else entirely.

If you are a beginner, make sure to go through Varsity, our education portal on everything you need to know to get started trading and investing. For those trading for a while, make sure to go through this collection of Innerworth newsletters on trading psychology. They are amazing. If you have any follow up questions, you can post them here on TradingQ&A.

Happy trading,