This week we are going to begin to separate the rookie trader from the professional trader!  I know this is supposed to be a rookie blog, or a blog for those who haven’t quite reached that pinnacle of trading but I have come to the realization that if we drop a concept in the mind of a rookie trader that at some point they will have an awaking when they are truly ready and this knowledge will be front and center and perhaps it will get the newer traders to view the world of trading through a different lens or perspective.

So here it goes…do you want to know what separates the professional from the newbie?  If I took a poll of the things that separate the pro from the rookie I would bet that I would get a vast multitude of answers but that a few common ones would percolate to the top of the list.  In no particular order I think the answers might go a little like this.

1. The pros have better strategies than the rookies.
2. The pros have better ability to adapt than the rookies.
3. The pros have a better ability to adjust to different market conditions.

These are the top three things that I believe would come from the above mentioned poll of traders.  Do these sound familiar? Would these be the ones you would have picked? These are all definitely advantages that pros have over newer traders but I don’t think these encompass the most important thing that a pro does versus a rookie.  We talk a lot about mindset at Tackle Trading. We talk about having the proper mindset to be a successful trader.

This mindset is really what sets the pros apart.

If you look at all the successful people in the world, chances are they have a different thought process or mentality then the average joe.  In trading this is even more on display. There is a specific mental process that the pros possess that makes them pros. This mental process is called aversion to risk.

The pros spend an inordinate amount of time thinking about the risk of every trade and how they can use their skills and knowledge to reduce that risk.  This is secret sauce of trading!! The lower the risk and the greater reward one has in conjunction to that risk the better chance one has of being successful on any individual trade and over the long haul as well.

I will demonstrate below a scenario in which this aversion to risk is brought front and center by the choosing of the specific type of trade.

Here’s the picture…lets say that company XYZ has been in the news lately and has had some unfortunate events affect their bottom line.  This has affected the company so much that they are rumored to be on the brink of bankruptcy. A common practice when this type of scenario comes along is to short the stock of this company and profit if the fall continues.  Seems pretty simple, right?

Well, let’s say XYZ company is trading at $25 per share and we think we can short the shares all the way to zero.  For this scenario, we are going to propose that we are shorting 100 shares of XYZ stock. What then is our risk in this trade?  If you answered: “I don’t know” then you would be somewhat correct. See if we short the shares we don’t know how much risk there is because the stock could turn higher and then it really is unlimited risk at that point.   

We know that there is a better way to trade this scenario because we have an understanding of options, right?!  In this case, instead of having unlimited risk could we not just buy a put and cap our risk at the cost of the put option.  This is smarter thinking because it gives us virtually the same potential reward with a, now, limited risk. See this is the kind of mentality that a pro has on every trade,  how can I get the most reward for the least risk? As for this XYZ trade, have we gone far enough? Is there another way that we can put the trade on that gives us the same or almost the same reward for the less risk?  This is the question that every pro trader asks about every trade and sometimes they ask it even after the trade has begun. For example, now that the trade has begun is there a way I can take further risk off the table.  I say there is yet another way to reduce our risk in this trade.

Let’s say that the put option in the above example costs us $3 to buy.  Then our risk is $300 total and our reward is the stock going to zero. So if we recap, the shorting of the stock gives us unlimited risk and the reward of the stock going to zero.  

So I would say the put option is decidedly better than the shorting of stock, on that I’m sure we can all agree? Remember, the pro trader always asks, can I do better? Well, the answer is most likely yes.  What if we were to fashion a trade where we sell something first to collect some income and then buy something in return that would give us a similar return as the other two trades? That sounds good, doesn’t it?  Well, that is absolutely possible, in fact, with the XYZ stock we could sell the $25 put for say $2.50 and we could buy the $24 put for $1.75 and have a credit of $0.75. However, would this give us a similar reward like that of the other two trades?  No, it wouldn’t but it could if we tweaked it slightly and bought a second $24 put. This would mean that we have to pay a debit of a $1 but this would give us the reward from $24 all the way to zero, very similar to the other trades only the difference is our max risk would be $1 per share or $100 total.  Sound good?

This is how the pros approach trading, they look for the best setup possible and they get the risk as low as possible whilst still being able to make the max gain!  That my friends is trading!!!

So, if you want to move from the rookie space to the professional arena, start asking yourself this one Important question: how can I reduce the risk?

This week we went over the risk aversion scenario, next week we will look at it in pictures to get a real clear understanding of how this concept truly works!  Until next time, trade well!!