As individuals trading personal accounts, one of the biggest frustrations we encounter can be undercapitalization- not enough money to make that trade, or not enough to be in multiple trades at once. The temptation is to try to rush the process by funding our account with borrowed money. We’d be much better served to take the time to get our personal lives in order first. We’re just so eager to realize that dream of working for ourselves and being wildly successful…
A young man arrived at the gates of a great monastery. One of the elder monks met him at the gate.
“May I help you?” asked the old monk. “Yes,” the young man replied, “I wish to be enlightened, and I will work as hard as it takes to be enlightened as quickly as possible.”
“Very well,” said the old monk, “You will start by sweeping the floors and keeping the grounds clean. You will be allowed one hour in the evening to meditate on a koan.”
The young man asked anxiously, “How long will it take for me to become enlightened?”
The old man thought for a moment, then said “Ten years, perhaps somewhat longer.”
“I don’t have time for that,” said the young man, “What if I work really hard and clean everything quickly, and spend four hours a day meditating. How long then until I am enlightened?”
“In that case, perhaps 15 or 20 years.”
The young man became visibly agitated. “What if I sacrifice everything else and concentrate solely on my enlightenment. How long will it take me then?”
“Then,” said the old monk with a sigh, “you will probably never reach your goal.”
(my apologies to whomever published this… I think I read it in the 1980s and certainly can’t remember where)
What did you use to buy your house? Your car? Many of the gifts you gave last Christmas? Chances are, the answer is credit in one form or other. Credit is just another word for Other People’s Money. Other people, or institutions, risking their money on you for the potential return that you will provide them.
You provide these Other People their return by paying them their money back, plus interest, out of your future earnings. Future earnings which have been devalued by inflation and have often been nearly cut in half by various taxes and expenses. (And if you’re REALLY lucky, that last half is cut in half again by alimony).
The point is: for $1000 of immediate spending power, you must indenture your future self to earn $2000 or more of gross income. Using Other People’s Money is damned expensive! Unfortunately, our society encourages, or rather, coerces us to continue to live further and further beyond our means by making this OPiuM easily and instantly available to us, and all we have to do is secure it with our future earnings… our future labor… our future life.
How does this relate to stock trading? The way we use Other People’s Money is nowhere more important than in our trading. You’ve heard it said a thousand times that you should not risk money you can’t afford to lose. How, then, can you risk money which isn’t even yours?
Risking OPiuM [vs. using it to trade– see below] belies an anxiousness, or even a desperation, in our private lives. That anxiousness is the result of the personal choices we have made for which we’re not yet ready to take responsibility. Those choices more often than not involved our spending money which we haven’t yet earned in order to try to keep up with the Joneses.
I want to add here the point that some of us fool ourselves by trading Other People’s Money that we think is ours. Retirement accounts and education savings, for two. The money in your retirement account belongs to two folks: a chunk of it to Uncle Sam (unless it’s a Roth), and the rest of it belongs- one partial withdrawal at a time- to a senior citizen who doesn’t exist yet. You have contributed to the account for that person, and that Big Balance belongs to them. Doubt it? How much would you end up with if you made a $50,000 withdrawal? What percentage of that balance are you risking? Is that really what you intended to do with money set aside for future security?
The money in the college account- it, plus everything it gains, plus everything else you can come up with will all go to some Institution of Higher Learning at some point. We should not risk our childrens’ education by conning ourselves into believing that we’re “investing” it and will put it all back and then some. If we were that good, we wouldn’t need to borrow it, no?
Now the good news. I’ve been very careful to point out that we should not risk money which isn’t ours. That’s not to say that we shouldn’t trade with money which isn’t ours. Is there a place for OPiuM in our trading? Absolutely!
When we are calculating how much we wish to risk on a trade, we should only consider the balance that’s actually our own money. However, in many cases we must use Other People’s Money in order to risk the correct amount of our money to follow our trading plan. Consider the following example:
Bob has a trading account with a total balance of $40,000. Of that total amount, $10,000 is free-and-clear cash from a savings account, money that would be painful to lose, but which Bob owes to nobody and which would not destroy his way of life if he lost it.
In his trading, Bob is using a common method of placing 1% of his money at risk with each trade. Since his account actually contains $10,000 of his money (vs. money he owes back to a mortgage company or Citibank), his risk on each trade should be 1% of $10,000, or $100.
This morning, Bob’s got a pristine setup on Wal-Mart at $48 a share. WMT had a gap opening, a minor run, and a slight pullback. Then the chart prints a beautiful Dummy Spot where Bob can enter in the direction of the primary trend with an initial risk of only 8 cents per share.
In order to risk $100 with an 8-cent stop, Bob must buy 100/.08 or 1250 shares, which will cost 1250×48, or $60,000.
If Bob only had his “pure” $10,000 in his account, he would not be able to follow his trading plan and would miss a high-probability trade. He might then be tempted to try the trade anyway, using a smaller position or buying calls. Either way he’s not trading his plan, and he’s bound to end up frustrated, or even worse, putting too much money at risk.
That’s right, having too little money in your account can cause you to risk too much!
Now if Bob decides to add some money to his account from a second mortgage or whatever, he must be absolutely sure that he will never go on tilt and risk any of it. He should never fund his account with any OPiuM until he has proven through a significant number of trades (not just after a couple of lucky ones) that he can at least maintain the balance of his own money in the account.
What if Bob has none of his own money in his trading account? What if it’s all from cash advances on the Visa, money he got from secretly pawning his wife’s necklace, and a couple thousand he borrowed from his cousin Bubba, who hit it big at the boats?
My only advice to Bob in that case would be to immediately STOP TRADING, render back to Caesar what is Caesar’s, to Visa what is Visa’s, and to Bubba what is Bubba’s.
Then I would ask Bob to formulate a plan. This plan would focus first on reducing his spending below what he brings home (not what he grosses), and to forget about the freaking Joneses. He would then begin the long, painful process of paying off his credit card debt and accumulating some real, free-and-clear savings. In other words, he would begin to take personal responsibility for his decisions and his future.
This process will likely take three to ten years, and will be as difficult as kicking a heroin addiction. Bob will backslide more than once. He will also find out who his real friends are.
But when he comes out the other end, Bob will be ready to trade. He may have been studying and paper trading along the way, which reduces the number of times he’ll have to “blow up” before he gets some traction. He’ll be able to afford to lose 1% of his money many times in a row, then when the occasional windfall comes along, he makes it all back, plus some. And then he’s on his way…
During his tenure with his nose to the grindstone, Bob would have been learning, even if unknowingly, some very important lessons about what really matters in life. What he needs, what he can do without. What really brings contentment, versus what merely distracts one from one’s worries. Perhaps he’ll learn that he has a stregth of character that he was unaware of before.
And as the old monk in the earlier quote may point out, Bob would have become a screaming success in the way that really matters, and would have learned that much of what he thought was important before would have merely delayed him on his real journey.
