Many of us believe, and rightly so, that trading stocks and trading derivatives are two different ball games altogether. Although the products may differ in return and risk, the underlying principle is the same. Most of the time, the principles you apply to trading stocks can also be applied to trading futures and options. There are 8 such principles that form the cornerstone of trading stocks and derivatives.
Principle 1: Be Realistic in Your Expectations
In any aspect of life, including trading, it's crucial to maintain realistic expectations. While there may be instances where a stock doubles within a short period, these are exceptions rather than the norm. The market demands a high level of skill and discipline to achieve substantial profits. Similarly, don't anticipate overnight millionaire status when purchasing deep out-of-the-money call options. Profits in both equities and derivatives require careful consideration and a strategic approach.
Principle 2: Prioritize Risk Management
Managing risk lies at the heart of successful trading. Whether you're trading equities or derivatives, it is vital to focus on safeguarding your capital and setting appropriate stop losses. For those holding long call or put options, reducing option sunk cost becomes a key concern. Selling options requires a thorough assessment of the risks involved beyond the option premium. By emphasizing risk management, you create a solid foundation for achieving favorable returns.
Principle 3: Maintain Composure and Avoid Panic
Maintaining composure is crucial in both equities and derivatives trading. Your ability to stay calm amidst market volatility determines your success. Avoid panicking during a market decline and instead identify opportunities that arise. Exercise discipline by refraining from engaging in the market during the peak of a bull rally, opting to hold cash instead. Be cautious of falling into herd mentality and maintain an independent line of thinking. Remember, panicking only subsidizes other traders who remain composed.
Principle 4: Consider the Significance of Costs and Taxes
Whether you trade equities or derivatives, adopting a thrifty mindset is essential. Minimize your costs by avoiding excessive trading, which only increases brokerage expenses. Seek the best brokerage rates available to optimize your trading performance. Additionally, stay vigilant about taxes, as every trading action incurs tax implications. Evaluating your trading performance
in post-tax terms provides a more accurate reflection of your achievements as a trader.
Principle 5: Apply the Laws of Motion to Your Trading
The laws of motion can be applied to market momentum. Just as Newton's law states that a body in motion continues until acted upon by an external force, markets exhibit similar behavior. Rather than betting against prevailing market momentum, strive to understand and align with it. Trading on the same side as market momentum often yields more favorable results. Predicting shifts in momentum or changes in trends is best left to the market itself.
Principle 6: Think Like an Analyst, Act Like a Trader
While many novice traders believe in-depth analysis is solely the role of fundamental analysts, it is imperative for traders to comprehend and interpret news and events as well. Adopt the mindset of an analyst, equipping yourself with the ability to understand the broader trading ecosystem. However, thinking like an analyst should be complemented by the actions of a trader. There is no substitute for thorough research, staying informed about news and events, and having a keen ability to interpret data flows.
Principle 7: Focus on Controllable Factors
As a trader, it is crucial to direct your focus toward factors within your control. Speculating on where a stock will trade or the precise outcome of an option price is futile. Instead, concentrate on managing risk through the use of stop losses. While you cannot control the Federal Reserve's interest rate decisions or geopolitical events, you can determine your trading strategy accordingly. Identify sectors and stocks that may be adversely affected by potential trade wars. By focusing on controllable factors, you enhance your decision-making process.
Principle 8: Assume Responsibility for Your Trades
Regardless of whether you trade equities or derivatives, remember that ultimate responsibility lies with you. Blaming external factors such as monetary policies
or budgets for losses is unproductive. Although you cannot control these outcomes, you can influence your trading positions by taking proactive measures. Hedging with put options or closing positions are examples of actions within your control. Instead of justifying losses, focus on extracting valuable lessons from them.
Incorporating these eight essential principles into your equity and derivatives trading endeavors will significantly enhance your prospects of success. By setting realistic expectations, prioritizing risk management, maintaining composure, considering costs and taxes, leveraging market momentum, thinking like an analyst and acting like a trader, focusing on controllable factors, and assuming responsibility for your trades, you are equipped with the tools to thrive in these dynamic financial markets. Embrace these principles, adapt them to your trading style, and watch as your trading prowess flourishes.
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