Commandment No. 1: Keep It a Trade
Never turn a trade into an investment.
That's the number-one commandment of trading, and yet, no matter how many times I say it, no matter how many times I scream it, people just don't listen. When I came up with the Ten Commandments of Trading, which I detail in Jim Cramer's Real Money, I did so after analyzing literally billions of dollars in losing trades.
Remember, I am a lab -- no, I am the lab, because of the millions of trades I have made in the last 25 years and my insanely rigorous method of analyzing any bad trade north of $5,000. The sheer magnitude of the sample alone made it worth my while.
My tremendous masochistic streak made it doubly worth my while. I would analyze positive trades only when they generated $20,000 in profit, but anything that generated more than $5,000 in losses got the microscope, big time. The commonality of many of those losses? They started out as trades, a stock bought for a specific event, a specific catalyst, and I turned them into investments, because I failed to wipe the trade off the books the moment it got busted.
The bigger the loss, the more I rationalized. I would buy the equivalent of a Research In Motion for the era in advance of the quarter. The results would come out, and I would say, "You know, I am really in it not for the results but for the new Blackberry iteration, so let's buy more." I would dig in my heels. I was more likely digging my grave. Or, I might say, "This time Alcoa's got to get it right. I would put some on."
Then the quarter would come out and it would be a stinker, but on the conference call management would say how things were looking up in aerospace. Suddenly, it would be an aerospace play! Buy more! How do you decide not to go down this path? By declaring right up front that the position is a trade and noting exactly why you are buying the stock and when the catalyst is going to occur. The stock comes off no matter what after that catalyst.
This is a brutal rule. It is so easily disobeyed that we seem to do so instinctively. But if you are like me and you sit there and are obsessed with the losses, you just don't have time to keep disobeying this rule.
It's just too darned damaging to your psyche in the long-term. Start the process today. You buying the Yahoo! (YHOO:Nasdaq) for the quarter? After that quarter is reported, you skedaddle, no matter what. Promise?
Commandment No. 2: First Loss Is Best
Good trading, no matter what it's based on, technicals, fundamentals, the stars, the news, requires a level of discipline that goes against human nature. We are taught in life to be patient, to let things work out, not to be hasty, yet none of that works when it comes to trading. You have to be willing to cut and run, to use that "flight," not fight, instinct that we supposedly are born with but suppress wholeheartedly when we are grown up.
That's what the second commandment of trading is about, and that's why it is the second commandment of trading: Your first loss is your best loss.
I genuinely believe that most trades need to work almost immediately for them to be right. I am willing to put a trade on and take it off immediately even if it doesn't feel right. There's a simple reason why that is so. When I trade, I try to trade for points, or for at least a point. Less than that is too hard. But if I am willing to have a trade go more than a half of a point against me, then it will be almost monumental to get back to even. So I like to stop myself out quickly. (Notice how different this all is from investing, where I expect the stock to go "against" me and welcome it so I can improve my basis.) So, let's say that I bought Starbucks
(SBUX:Nasdaq)
Wednesday because I figured the comp numbers would have improved. You have to believe that wherever that stock trades after that number comes out and you have digested it, you are at risk to having a very big loss. So, you take that first loss. And you move on. Rather than fight it. That's how you have to think, every day, about every trade.
Commandment No. 3: Take Your Losses
It's OK to take a loss when you already have one.
So many investors who call me on my radio or television shows have big losses on stocks. They stay in, though, because they genuinely believe that they don't have a loss until they take it. That, of course, is ridiculous. It's another flaw of human nature, another flaw that hurts long-term performance.
If we played with unlimited capital, it wouldn't matter that we're hanging on to Applied Materials (AMAT:Nasdaq) because it once traded at $30. We could keep our positions in Nortel (NT:NYSE) and JDS Uniphase (JDSU:Nasdaq) because, what the heck, they aren't that much capital.
But the investing process takes time, inclination and capital that most people don't have. You can't find the next Sears Holdings (SHLD:Nasdaq) if you are stuck in EMC (EMC:NYSE) waiting for it to come back. You can't do the homework needed to learn Ultra Petroleum (UPL:Amex) if you are keeping up with the Verizon (VZ:NYSE) and BellSouth (BLS:NYSE) spending plans that could revitalize or trash JDS Uniphase.
That's why I always tell people that it's OK to take the loss, especially if you already have it. The opportunity cost of staying with losers is always either misunderstood or chronically underestimated by investors. Go through your portfolio. Kick out that AMR (AMR:NYSE) that's been hanging there all these years because you bought it much higher.
Sell the Delta (DAL:NYSE) you picked up at $11 because you thought the asset too valuable to sell. And start learning new stories. That's the way to make bigger money than you are now.
Commandment No. 4: Trading Gains, Not Investment Losses
When you mark something as a trade, you should not expect to make as much money on it as you would as an investment. A trade, like buying something into a quarter, is not about trying to make money over a long period of time.
Let's take Apple Computer (AAPL:Nasdaq) . I think that Apple's a good trade into the quarter on Wednesday. I genuinely believe there is enough good news there that this $42 stock can ramp to $45. But if there isn't? I would be gone either way.
I am not going to buy the stock for the quarter and then, if it doesn't work out, switch it into the investment file because I like the Tiger operating system's prospects for next quarter, or because the iPod Shuffle's a really cool gizmo.
And, most important, if it works and the stock goes up the next day, I am not going to say "You know what, this Apple's one good long-term story. I am going to stick it out." I can't do that, because I had earmarked Apple for a trade before I started it.
I can't tell you how many times I have bought something for a trade, had it go up and then held on to it only to lose the trading gain and come up with an investment loss. Hence my commandment:
Never turn a trading gain into an investment loss.
This year, in particular, I am talking to a lot of people who bought stocks for a trade and then ended up carrying them as a loss into the investment column. I recently spoke to one investor who had bought Valero (VLO:NYSE) for a trade on gasoline prices, quickly picked up 7 points, and then rode it all the way back to where he bought it because he decided he "liked" Valero.
What does that mean? You don't like Valero; you like the profit Valero generated. Never confuse the two. Or you most certainly will give back the profit.
