Learning how to trade can seem a herculean task primarily because there are so many ways to do it. I know how you feel. Like a thin-lipped, small-mouthed toddler drinking from a freshly tapped fire hydrant. It’s downright overwhelming. And, the irony of it is you may still leave thirsty because the speed and breadth of the deluge are so utterly unmanageable as to make it virtually unsippable.
So what’s to be done?
First, take a deep breath. Humans far less intelligent than you (and, no doubt, far less good looking;) have figured it out.
Second, having context and structure really, really helps. Consider today’s musings my effort to provide some context. In my next message, we’ll tackle structure.
One of my favorite ways to begin a one-on-one mentorship is to introduce the idea that there are three ways to use the financial markets. They vary based on the amount of time and the level of skill required. The first approach demands little, if any, of both. The second requires more, and the third requires most. Let’s take a brief look at each highlighting their respective steps and accompanying pros and cons.
The Passive Accumulator
- Step One: Build a diversified portfolio of stocks, bonds, commodities, real estate, and whatever other asset class you deem worthy. Allocate proper percentages to each bucket to match your risk tolerance and investment objectives. That means don’t place 100% in stocks if you’re not willing to stomach a 30% drop and don’t place 100% in bonds if you’re seeking a 7% annual return.
- Step Two: Invest more money in said portfolio each year to accelerate growth.
- Step Three: Don’t panic and sell everytime a bear market strikes. Be brave, buy more!
Pros: Requires little time and even less skill. Has worked well over time (and by “well” I mean maybe 4% to 10% annual returns depending on asset allocation). Doesn’t require any prognosticating, predicting, or prophesying. No chart reading, market timing, or offerings to the Gods.
Cons: You get whatever Mr. Market is willing to give. Sometimes, like 2013, that’s upwards of 20% to 30% in a year. Other times, like 2008, that’s -30% to -50% in a year. You face all bear markets stark naked. Not to mention volatility will drive you batty on occasion.
The Cash Flow Generator and Volatility Dampener
- Step One: Build a diversified portfolio of stocks or ETFs that have listed options.
- Step Two: Sell covered calls on a monthly basis to reduce basis, increase the probability of profit, enhance returns and dampen volatility.
- Step Three: Buy protective puts to limit risk.
- Step Four: Invest more money in said portfolio each year to accelerate growth. Each time you accumulate another 100 shares, sell one more covered call.
Pros: You have defined risk. Instead of wondering just how bad things will become next time the market slips on a banana peel, you’ll know exactly how much money is at risk. With portfolio protection, you can typically limit your overall exposure to around 12% to 15% even in the most vicious bear market. Covered calls juice your returns in neutral markets. Finally, you experience much less volatility on a day-to-day and week-to-week basis then buy-and-holders.
Cons: You underperform in really bullish markets due to the profit-capping characteristic of covered calls, not to mention the annual insurance costs.
The Performance Juicing, Busy Bee
- Step One: Decide what type of active trading you want to adopt. Is it stock trading, option selling, futures betting, or Forex? Is it day, swing, or position trading? Or is it a combination of all of them?
- Step Two: Build a detailed plan surrounding your strategy complete with position sizing, risk mitigation and profit capturing.
- Step Three: Deploy mercilessly when appropriate and reap the rewards. Rinse and repeat.
Pros: You have the potential for more significant returns and the ability to pivot quickly when market tides turn. Bear markets aren’t as spooky.
Cons: You have the potential for bigger losses due to elevated activity and additional leverage. Success requires the highest degree of skill and more time than virtually every other investing approach.
How much capital you allocate to each of the three approaches depends on, well, you. Those with more experience and confidence are the ones most likely to spend the bulk of their capital in Performance Juicing, Busy Bee things.
It’s worth noting the lion’s share of the investing public pursues The Passive Accumulator because they simply don’t know any better. And, sadly, most even screw this one up by misunderstanding what they own, allocating improperly, or bailing during the depths of a crash.
With a proper understanding of context, we can now talk more about portfolio structure. Join for that tantalizing tale next time.
Financial freedom is a journey
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