Basic Trading Rules
The Smart Profits Report: Issue #181
Wednesday, February 2, 2005
Basic Trading Rules: The Four Rules of All “Smart Money”
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
As I was escorted to my daughter’s classroom for a fifth-grade “Career Day” presentation, one of my little handlers asked me if I “got nervous” before a speech. I said yes. He asked if it was the same kind of “nervous” as the competitors on the reality show Fear Factor experience. “I don’t watch the show,” I said… adding: “You watch Fear Factor? Aren’t you kind of young for that?”
Within seconds I was standing in front of the class, beginning my presentation, a little more nervous than I otherwise would have been…
So what does all this have to do with options trading, exactly? Nothing. Except for the fact that four of the most important rules about money are so simple, even fifth-graders can understand them.
Yet, they’re so powerful - and so basic to smart investing - that every trader should memorize and follow these four basic trading rules before trading a single option.
Let me explain…
The Four Basic Trading Rules
My goal for the class was to try and teach kids the four rules regarding money that I would encourage anyone to memorize before trading options. Now, I know from experience that even adults have a hard time learning just one thing in 30 minutes. And, when it comes to managing money - it might never make any sense.
I chose four things that I believe are the most important rules of dealing with money… rules that you may want to share with your kids or other loved ones, regardless of their age.
Rule #1) Go with moderation over excess…
I started with moderation versus excess - something a kid can understand and adults often forget.
The first example I gave the kids was the “need” for everyone to buy the biggest car with the worst mileage just to get from point A to point B. To an environmentalist, that’s excessive consumption: End of story.
I don’t go that far, but to a “money person” it’s excessive spending, especially for those who have trouble making car payments. (I also used the Halloween tummy-ache example - go overboard with the candy, and you pay…)
Moderation versus excess affects our future ability to achieve financial independence… To a fifth grader this means being able to buy another video for his Game Boy. To the options trader, it is spending a lot of money chasing hot short-term trades without a system (most of which go bust) instead of focusing on high-probability trades like the LEAPS options.
Rule #2) Stay on the right side of compounding…
Second, I talked about compounding. The example I used here was a kid who got a dollar a day and spent it on candy and the kid who put the money (some of it, at least) in the bank. At the end of the year, I explained that Child A would not only have no money, but also lots of cavities. Child B would have all the money he saved, plus something extra for “lending” the money to the bank. I was quite impressed by how many kids actually knew that banks loaned out people’s savings at higher rates - I know I did not know that at age 10.
Rule #3) Use credit; don’t let it use you…
Third, I talked about credit. I explained good credit (buying a house) and bad credit (spending money at a restaurant and paying for it six months later). I tried to impress upon them that spending more than you can afford would likely result in a sad retirement.
I told them that they would be getting offers for credit cards in the mail once they were in their senior year of high-school. My advice: Tear up the envelope before you open it. I also explained that if they did not know how to manage credit, they could spend 30 years paying for video games that may only be played for a year. The video game themes resonated well with this crowd.
Rule #4) Always own some tangible assets…
Finally, I brought in 450 one-dollar bills and an ounce of gold. I asked the group which they though is worth more. They all pointed to the currency. I tried to explain fiat money and what tangible assets were.
I think I lost them on this one. But, there were a lot of oohs and aahs when they saw the stack of bills. (My favorite response from one girl who picked the gold coin was, “It’s worth more because it is so shiny.” Almost right…)
The day was quite a success and I enjoyed the Q&A. I encourage you to talk to your kids and grandkids often about money and investing. It could be one of the best early childhood lessons that you could impart to them.
And if they want to follow you into the options market someday - and win - they’ll need to know these basics first.
Good trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Ever wonder what a chameleon option is? Click on over to the Smart Profits Glossary, chock full of over 150 option terms!
- If you don’t know how to manage your money, you won’t be in the game long. This is especially true for options trading because of the inherent time limitations. Not only do you have to decide on the strike price, but also on the expiration date. It’s also important to know how much money to put at risk. For more on option trading, check out Smart Profits #286, Understanding Option Trading: Cut Your Losses… And Watch Your Gains Run.
Related Articles:
- Options Market Makers: Two Rules for Beating the Market Makers
- Options Flyer: Three Rules for Profiting from an Options “Flyer”
- Day Trading Stocks: Lessons From An After-The-Market-Closes Plumber
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