When I started out in the markets, I was fortunate to find a mentor. And the number one thing he taught me was the importance of discipline.
Without discipline, you won’t make it as a trader.
You’ll keep making mistakes – like refusing to use to stop losses.
Another mistake is becoming too exposed (overleveraged) to a position, so even a small move in a stock can have a disastrous effect on your account.
For example, if you only have $10,000 in your trading account, and you put $2,000 or more into a single position, you’re likely too overleveraged. It would only take 5 trades going badly to blow up your account.
One of the most common ways this overexposure occurs is by averaging down on a losing trade.
But it’s not just stock traders who need to worry about this error.
Option traders need to be careful to practise strict discipline too…
Don’t Average Down
Averaging down refers to someone who keeps buying stock even as the price tanks…
The aim is to lower their average entry price so that they profit (or at least break even) when the stock eventually bounces.
But as I’ve seen countless times, that bounce may never come… And you can get stuck with way more shares than you ever intended in a stock that’s steadily trending lower.
No prizes for guessing how that double-whammy scenario ends.
But if you’re not careful, you can make a similar mistake with options.
By adding more contracts, you can inadvertently build up a much bigger exposure than you should…
Of course, when you buy options, there’s a clear distinction. You always know what you’re risking with every trade (the price you paid for the option). And since each contract covers 100 shares of stock, you can get a lot of exposure for a pretty reasonable upfront cost – even just a few hundred dollars.
By comparison, for a similar position size in shares, you’d probably have to invest many thousands of dollars.
This huge disparity in risk is why options are a great product for retail investors.
All the same, if we keep adding to positions without the right trade setup, then we’re showing poor discipline and needlessly risking our capital.
That’s why I’m remaining cautious right now with my trades…
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When Markets Don’t Make Sense
This past week, we’ve seen both the S&P 500 and Nasdaq break out to fresh all-time highs. The markets are beyond priced for perfection…
The market is shrugging off any bad news. No one wants to sell – buyers keep voraciously bidding the market higher.
Compare that to a few months ago when stocks couldn’t catch a bid.
This bull market is now well into its third year, and buyers are totally ignoring economic data (both positive and negative). Not to mention, volatility is at extreme lows. That tells me that the market has become way too complacent.
I remain convinced that the market is headed for a fall. Until that happens, though, we’ve got to respect the price action.
So although I could add new positions for just a few hundred dollars, I know that I must remain disciplined.
That means waiting for the market action to start making sense again before adding new option positions.
By doing so, we’re protecting our capital so we’re ready to pounce when that turn comes our way.
Over the many decades I’ve spent in the market, I’ve seen countless traders come and go. And the most common ingredient that brought them undone was their lack of discipline.
But if you keep discipline in front of your mind, you’ll greatly enhance your chance of success.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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