In the Article last weekend, I wrote a little about "knowing thyself" in the trading arena. In my estimation, it is critically important to know what you really want and expect from your trading. The answer is much more complex than simply making money. Of course we all want to make money, but at what risk? How much attention can we pay to our trading business? What are the strategies we will employ to achieve our goals? Are we interested more in income or in capital appreciation? What is our money management strategy? What is our level of knowledge? We must address at least each of those factors in formulating our personal plan.

While knowing oneself is an extremely important ingredient in the recipe for ultimate success, it is also critically important to understand completely each strategy we are going to use before we actually use it. To me, that means we need to study it first then pratice it before we ever put money at risk. Every so often I get an email that would curl my hair if I had any. On those occasions, the writer is almost always already in a position and utilizing a strategy with which he is quite unfamiliar. Something unexpected has happened (like the stock price went down instead of up) and the trader has no idea what to do. I then get the "911" email. At that point, I am probably not the guy to write because I am not permitted to and do not give personal investment advice. I can only answer with generalities and often it takes me a little time to respond.

Hopefully the trader has a broker with whom he can communicate and also hopefully the broker is intimately familiar with the strategy. Be aware that many brokers may not be familiar with strategies other than buy and hold. As an aside, I should note that one brokerage firm now advertising on the tube advocates nothing but buy and hold. (I wonder how many of their clients held Enron or WorldCom to the bitter end).

In order to understand a strategy completely, a trader needs to be aware of the risk and how to manage it. Selling stock short has made many rich, but it is a strategy accompanied by very high risk. When we sell a stock short, we make money if the price drops, but we are at theoretically unlimited risk. Suppose, for example, we sell XYZ short at $50; for each dollar the price drops we make a dollar, but at some point we know we are going to have to buy to cover our position. What if the company makes a surprise announcement of a revolutionary new product that has extremely popular appeal and the stock gaps up to $100 a share? What now? If we were unaware of that risk when we entered or if we did not know how to protect against such an eventuality, we could be in an awful fix.

Good trading is a business, not a game. Real money is at risk. Your real money is at risk. I suggest we need to know both ourselves and exactly what we are doing before we ever pull the trigger on any trade. If we don't know how to respond to any given situation BEFORE we enter the trade, we should not enter it, but rather should study and practice the strategy first. In that way, we can reduce the risk of losses that result from our own lack of knowledge.

Good Trading!
Bill Kraft

September 15, 2007

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