Why You Should Avoid Speculating in Futures, Options, and Speculative Stocks

It’s happened to me.  It will happen to you.

Your investment program is going along quite nicely.  You’ve made some nice gains on stable blue chip company stocks.  But it has gotten boring and it feels like something is missing.  You hear about people making a killing on speculative stocks.  Maybe even heard it on CNBC or some other “trusted” financial channel how some trader managed to score big on some futures trade.  You don’t want to wait 25 years to get rich.  You want BIG profits now!  So you create room in your portfolio by venturing into the options and futures markets.  You buy gold because, hey why not?  Everyone is doing it and it can only go higher from here! 

In short, you stray from your investment approach, to roll dice. 

Big mistake. 

Making money consistently in the futures and options markets is difficult because you have to be right about the investment and the timing.  Buying stocks is an easier way to make a buck.  As long as you’re right on the stock, your timing need not be perfect.  You can wait until your reasons for buying the stock pan out.  When you buy options and futures contracts, the clock starts ticking immediately.  You can’t afford to be patient, hoping your investment thesis comes to fruition.  With options, you have at most nine months for your idea to develop.  That’s not a long time.  Most options expire worthless.  You shouldn’t think yours will be any different. 

Buying initial public offerings (IPOs) usually is another losing game for individual investors.  The problem with buying IPOs is that the best IPOs are not available to individual investors.  All those Internet IPOs you read about that went from $10 to $60 were never available at the $10 price for individual investors like you and me.  Only the best customers of the of the investment firms taking the company public get a piece of the best IPOs.  Oh sure, you can buy the stock after it goes public and has already jumped 300%.  That’s a bad idea, since many IPOs return to their initial offering price over time.  And if you are ever approached by a broker who wants to sell you shares in the next “hot” IPO, run for the hills.  Any IPO in which that’s offered to you and me is just junk that none of the big guys want.  We consider IPOs to be in the “Speculative Stocks” category since most of them have earnings that are hard, if not impossible, to determine.  

Improving Your Trading and Investing Mechanics

Paper trading (when you place buy, hold or sell orders without the use of real money), note taking, and back-testing are the strategies that I have found to be most helpful to the improvement of trader mechanics.

Novice traders (and at times, we all feel this way, regardless of experience), tend to think of trading merely as the acts of buying and selling.  They don't recognize the considerable role that mechanics play in success.  Reducing trading to buying and selling is like describing NASCAR racing as stopping and going.  Take a look at just a few of the mechanics of trading and the difference they make toward profitability.  Obviously, not all of these apply to all traders as we each have our own niches in the market.

Specific Skills that Comprise Trading Mechanics

• Idea Development:  Translating observations about the market into specific trade ideas on the Macro level.
• Assessment of Market Conditions:  Recognizing the current state of the market's trends.  Whether it is range-bound, volatile, or low volume.
• Order Division:  Scaling into positions to reduce risk exposure and obtain superior average entry prices (Dollar Cost Averaging).  Scaling out of positions to secure profits and possibly benefit from favorable movement.
• Position Sizing:  Risking enough on a trade to make a meaningful contribution to profitability while avoiding risk of ruin under adverse circumstances.  
• Exit Flexibility:  Moving stop-loss points to protect profits while retaining profit potential.

Clearly, trading is not a skill, but rather a complex, coordinated set of skills not unlike athletics or medical practice.  An inexperienced trader will look at a stock chart and say, "I think we're going higher."  He will then buy at the market with his maximum position size and see if the trade works out.  The trades are neither planned nor systematic in their execution.  The performance is not far different from that of a quarterback who calls for a passing play on 4th and 10.

Create Your Trading Plan or Investment Plan and Write it Down in Specific Precise Language Before You Trade

Don't confuse trading rules with a black-box system.  Your trading plan should be a set of Rules, which you follow implicitly time and again.  Sure, you can build in some flexibility, combinations and additions to these Rules, but write them down, understand them and implement them.  Also keep them handy, particularly when you're trading or making a trade decision.

A mind map is the best way to achieving this in a direct and visual way.  A mind map is simply an illustration, like if you imagine a series of branches off a central tree, where you're using different colors and symbols to depict the rules, as opposed to simply writing them down in a list.  Ideally, you should do both.

The Rules need to embrace when to enter, when to exit, when to use a specific options strategy (if options are in the plan) and when to activate your Stop Losses (which often change depending on the strategy you're trading).