5 Profitable Trading Rules

Thursday, July 26, 2007 | Chris Rowe

Rule One: Never Trade Just to Trade.

Having an itchy trigger finger can turn a trader into his own worst enemy. This is a classic mistake. We’ve all made it. I may even go so far as to say that this is what I see as the most common mistake among professionals AND non-pros.

When I'm at bat, I like to wait until I get a pitch that is directly over the plate. The good news is that the pitch can be anywhere (over the plate, low and outside), but I will never have a strike called on me for not swinging. But we must also assume that I only get one chance to swing. It’s either an out or a hit, so I’d better make it count.

Savvy traders know that there are times when the best action is to take no action. I never wake up one day and say, “Okay, I need to find a good play. I’m going to pore over a list of good stocks and pick my favorite one. I know that it is best to first get a good feel for exactly the way the stock trades before considering it as a profit opportunity.

We don’t think that a trader who does such a thing can have a good enough feel for the stock’s price action, or for the other major players who are controlling the stock’s price movement. The savviest players on Wall Street know several great companies for months or years before buying the stock.

Rule Two: Only Buy When Both the Fundamentals and the Technicals Tell You to Buy.

There are two stars that must be aligned: Technical and fundamental. If I purchase a stock, it is because the situation is such that a smart technical analyst and a smart fundamental analyst would both agree that the time to buy is NOW.

Generally, once I know that the company is well positioned from a financial standpoint, I then make sure that I have a good understanding of what the charts are telling us. Then I get more detailed by checking who the major buyers, sellers and current shareholders are, evaluating their reputation and whether new major shareholders are entering the picture.

Rule Three: Never be greedy; small profits never hurt anybody.

As long as I am profitable, I am happy. Remember, I only swing at the pitches that I love. I only stick with a position because I think it has strong potential. I never stick with a trade because I have not yet achieved the profit that I want.

The market doesn’t owe us anything! If anything, Mr. Market owes me a couple of losses. I never look a gift horse in the mouth. Waiting for the profit that you feel is owed to you is another classic emotional mistake and an emotion that makes a trader his/her own worst enemy.

It’s just like holding a stock because you are down 5%, and you only want to sell at a profit or at break even. Mr. Market doesn’t know you and doesn’t care what you paid for the stock.

I make moves strictly based on what the indicators are telling me. NEVER based on the price of the stock.

If I moved based on stock price alone, I would never hold a stock for a 500% increase.

Rule Four: Welcome unsuccessful trades.

What the heck is this guy talking about? Don’t worry, this is not the “go down with the ship” philosophy.

My rules are simple. They are what has built fortune after fortune for myself and my clients, so listen to me here: I might limit my downside to 7% or I might cut my losses at 20%. Very often, I hedge my stock positions with stock option contracts that limit my downside to a few percentage points.

My stock screening system usually keeps me from buying stocks that get crushed. Okay, I know that you can’t guarantee that a stock won’t take a beating here and there. And when I'm trading options, we take an occasional beating. But if I'm right more than I'm wrong, and I make a lot more than I lose, then I've achieved my goal.

Some of the biggest winners that I have had - ones that have traded thousands of percentage points higher - have traded lower first. If I hadn’t run them through my stock screening system, I would have limited my losses to 7% and, therefore, missed those winners that mean the world to your overall portfolio.

Rule Five: Whenever possible, utilize options as a way to generate income in a flat market.

You can take in additional income every month by selling covered calls.

Every month there are ways to have from 1.5% - 7% of the value of your stock positions either deposited into your account, or sent to your home in the form of a check.

Every single month, so many investors leave an absurd amount of money on the table. The worst part about it is that the only reason they don’t pick the found money up off of the ground, is that they don’t have eyes that have the ability to see it. My heart goes out to those people who don’t understand this simple strategy, just as it does to people who literally have vision problems. It's simple, really, and all that you have to do is take a few hours to understand it. IT'S WORTH IT!

Some markets are better than others to implement this strategy. As a matter of fact, today’s market is nervous and the VIX has been climbing, which reflects expensive options on the S&P500. This usually indicates that a large portion of optionable stocks are attractive covered call candidates. If you are familiar with these strategies, you can make over 15%- 20% in a market that trades flat for 12 months.

Related Articles: "Become the Casino" with this Simple Options Strategy, How to Be Wrong and Still Make Money, What to Do When You're Bullish/ Neutral, What Sports Can Teach Us About Investing

“Profit from the Trend”

Chris Rowe
Chief Investment Officer
The Trend Rider

13 Comments

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Matt (1 year ago) Is this Spam?

Chris,

I'm intrigued about the VIX. But when you mentioned that it settles in cash, a couple of questions came to mind.

(1) Will the VRO always equal or be near the VIX as of closing on the last trading day before options expiration? (2) When the VIX options settlement formula refers to options price, does this mean the premium? And if it does, as of when?

If I'm not mistaken, the VIX options settlement formula equals: VRO minus options price multiplied by $100, isn't it?

Anyway, thanks for your insights.

Cheers.

Ken L (1 year ago) Is this Spam?

WOW,

I just linked here from yesterdays column, to check your comments on VIX options. You should really repost those comments to Julia somewhere so we dont lose them, they were excellent.

The original article was excelent as well, and deserves to be reread multiple times. I still have problems initiating trades when things arent perfect.

One more thing, other than the VIX, which I sort of knew was European style, but always seem to forget is tradable, what other options trade Euopean style.

Ken Long

Wei (1 year ago) Is this Spam?

Hi Chris

Your lengthy reply to Julia's post totally blow me away! I read about your writing on VIX in 7 for 7 report too and now I feel that I really get the whole picture. All Tycoon Report readers should read your last post! I can't begin to tell you the sense of joy I get every time I read and learn new things from you, from thousands of miles away. You're not only the subject matter expert but a wonderful teacher! If I pick up a textbook and read about all the stuff you've been teaching I'd probably fall asleep. Enough to say you've made my learning easier and with much more fun too!

With great thanks

Yang

Chris R (1 year ago) Is this Spam?

Hi Julia,

I really hope that you check this site again for the answer as it's important right now with the VIX over 24. Even if VIX pulls back (which is likely,) I would still hedge it the way I'll explain in a second. In fact, I should put a quick note in a Tycoon report on Monday about this.

First of all, let me say that I'm glad you got a hold of that report. I'm also glad that you are looking at the VIX calls as "Insurance" and not as something we're trying to profit on. It's a hedge. I talk about the VIX frequently, and I know that many different people have hedged bets with different VIX options with different months and expirations.

At the end of last year, when we released the special report, we specifically talked about the scenario that happens to be unfolding RIGHT NOW with sub-prime lending, and ARM loans. And here we are. And watch, the noise will probably die down and heat up again a few more times before it goes away. When the noise dies down, don't forget that it is still in existence. These things don't go away fast.

First of all, I can't give personalized advice, but I can give a general answer here which hopefully will help anyone who owns any VIX calls.

What I do when I own (I'm long) VIX calls and VIX moves higher is I sell short-term calls (to open) as a "Calendar Spread".

The goal is to collect the premium by selling short-term calls. (Since I own, or am long a call with a lower strike price, I'm "covered.") If you sold short-term calls to open WITHOUT also having a long position in VIX calls with lower strike price, then I would essentially be selling NAKED calls, which is EXTREMELY dangerous.

But here, since I'm ALREADY LONG VIX calls, it is safe to hedge the position by selling OTHER VIX calls to open.

Given what has happened with the VIX lately (approaching 25 on Friday's close)the call options are pricey.)

In most cases, I say it's best to sell the short term calls that are the "at the money" and the closest to the strike price. But the VIX options are "European style." For one thing, even if the VIX were a tradable security, you STILL wouldn't be able to use the calls to convert into the security until expiration because they are European style.

VIX is an index. It settles in cash. (All of this is in the report you are referring to by the way, in more detail. I HIGHLY recommend that you re-read it.)

Long story short, I would sell the calls that are in the money, but the ones that have a strike price which is higher than the calls that I am long.

VERY IMPORTANT: I would (short) sell short-term calls that expire in the same month as the calls that I am long. If I was long the August VIX calls, I would sell short higher strike price AUGUST VIX calls. If I owned September VIX calls, I would sell short (sell to open) September VIX calls with a higher strike price.

Again, I go into serious detail in the report that you should read (since hard earned money is at stake), but the reason for selling calls to open (to create the calendar spread with VIX options) has to do with them being European style options. Option prices won't act the same as stock options or options that are "American style."

Here's an example:

If I owned the September 10 VIX calls (which have shot up to about $9.50,) I might sell (to open) the VIX September 16 calls (which are at $4.00.)

What happens is I receive $400.00 for each option that I sell. (I DON'T SELL A LARGER NUMBER OF CONTRACTS THAN THE NUMBER OF CONTRACTS THAT I AM LONG.)

Based on Friday's close, my account would look like this:

1 Sep. 10 call $950.00

- 1 Sep. 16 call -$450.00

What I have done here is I have taken $450.00 off of the table. If I originally paid $4.00 )$400.00) for a long September 10 call, then I have guaranteed myself a 50 cent ($50.00 profit) even if the VIX goes to zero. This is because I have collected $450.00 and I originally spent $400.00. If VIX went to zero (which it won't) then BOTH options (long and short) would go to zero. But I collected that $450.00.

(I hate to sound repetitive, but sometimes it's necessary.)

Now if VIX is at 50 on settlement day (which I highly doubt, but let's just say,) then what do you think will happen? Really think about it first, then continue.)

Well since VIX is an index, it settles in cash. In other words, if my VIX options settle "in-the-money" then I would have cash allocated to my account.

Here's the easy way to look at it... Because I sold short the September 16 call option, and I'm long the Sep 10 call option, I will end up with a 6 point net on that. I also collected $4.50 so the total net sale would be 10.50 ($4.50 + $6.00.)

This would be the same scenario if VIX settlement value were anywhere over 16, or whatever the strike price is of the option that the trader sold short.

Here's another, little bit more complicated way to understand it... If VIX settlement value was $17.00 after September expiration day, then I would essentially have a debit of $100.00 (because I'm short the 16 call,) and I would also have a credit of $700.00 because I'm long the Sep 10 call. NET = $600.00 credit. And I collected the $450.00 along the way so I net the same $10.50.)

Now what if VIX settled at something in between the 2 strike prices of 10 and 16? What if VIX settled at $14.00?

Well then I would have a $400.00 credit due to the long Sep 10 call that I'm long, and the Sep 16 call that I'm short wouldn't matter because it would be worthless. So essentially my Sep 10 call is in the money by 4 points, but instead of only netting 4 points at expiration, I ALSO have that extra $450 that I've collected.

NOW - What if, after initiating this position, the VIX drops much lower causing the Sept 16 call to drop from $4.50 to $1.90? Well now I have a choice of either keeping things the way that they are until expiration and settlement day, OR I can BUY BACK the Short Sept 16 call at $1.90 and stay long the Sept 10 call.

This way I collected how much on the Sept 16 short call? Think about it first.....

I've sold it for $4.50 and bought it back for $1.90 so I collected an extra $2.60 ($4.50 - $1.90 = $2.60.)

THIS WAY, if the VIX pops again, and all VIX calls move up again, I can repeat the process.

So basically, I'm holding my long call, and I'm trying to short the HIGHER STRIKE PRICE CALL when it's high, and buy it back when it's low - over and over and over again, until expiration day.

I hope that this helps. Please do yourself a favor and re-read this, and the report you spoke of. It's worth it, unless you plan on getting out of the market for good today.

C

Rodger P (1 year ago) Is this Spam?

The advice is sound and practical, also easy to access and understand. Thanks

nl7rmg (1 year ago) Is this Spam?

Very good article on "options". I don't really know a lot about options but your article provided me with a little clearer picture on the various ways you can make money and protect yourself when the market goes against you. Thanks--Norm

Julia (1 year ago) Is this Spam?

Chris, you've given very good overall advice. But, I was wondering if you could write an article specifically about the "VIX". I purchased a report that The Tycoon advertised last December (that was the best $100 I've ever spent), and that report advised on purchasing VIX options as "insurance" against a bear market. Well, I took that advice and I'm up 59%! Thank you very much. But, I don't know when to get out - how long should I hold the option? I have 4 months before my option expires (Nov 2007). The "GREED mechanism" is telling me to get as much profit as possible, to hold the option til the very last minute. But, then I thought, what happens if the option price goes down dramatically and I have to sell for less than my now 59% profit?! Being that the VIX option is not exercisable like a regular stock option (I can't exercise my right to buy the stock - as the VIX is not a stock); so, what would happen if I held the option till it expired? Not that I would do that, but I'm just wondering. I know I should do my "due diligence" and research the VIX, but I was hoping that you would provide a good strategy for buying/selling VIX options. Any advice you give will be much appreciated.

Daryl N (1 year ago) Is this Spam?

I printed out "5 Profitable Trading Rules", framed it, and hung on the wall in front of my desk where I can read it every day!

johannes (1 year ago) Is this Spam?

Hi Chris,

Maybe a good artikel but for me an little above my had. I am in stocks for two (2) years with U$ 5000.00 I am with the fallen Angel stock service, so unable to build a diverse portfolio. So with my bonus report ---Profit From Azia 2007--- I put my U$ 5000.00 in EWS as was recommended. I expect with the rate it is growing 40% this year.

I love the artikels from al of you, but with a small portfolio like mine, I don't know if this is the right service for me. I mean 40% is great but no diversification, so verry tricky.

Greatings, John Bleeker Vanderhoof Canada

Dylan (1 year ago) Is this Spam?

Great article Chris. Very informative stuff. No joke, I hope folks read this as many times as it takes to sink in because it's so important!

--DYLAN