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Reducing Risk and Keeping Your Financial House In Order

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  • Reducing Risk and Keeping Your Financial House In Order

    Reducing risk to your money and protecting your trading capital must come before making money in the stock market; it must always be put first in your mind when trading. You must learn and become comfortable with this being your first priority when trading. I know that sounds a little strange, but it's 100% true and a very important mindset to get into. After all, you can't play the game if you don't have the dollars. You should always be willing to give up a trade in order to reduce risk and save capital.

    You absolutely must seek to reduce risk and protect yourself at every turn in the stock market, even before making a profit. Don't get me wrong; you are here to make a profit, but never at the expense of taking silly risks.

    Always consider the risk to reward ratio of any trade you plan to take up. What is the risk? What is the reward? Keep that ratio in your favor and you'll be well on your way to making a good start in the trade and protecting your trading capital. I would rather miss 10 trades, than make 10 bad ones. Any trader would. Bad trades, mistakes, and large risks are like leaks in a dam. Forget about everything until you correct the leaks, and then worry about increasing the water level.

    Trading and speculation in stocks (more commonly called 'Daytrading') has been around as long as the stock market has been in existence. Whether it's the days of the Buttonwood tree on Wall Street, or the Bucket Shops of the 1920's, or the electronic trading that takes place every day across the Internet, there are and there always will be "traders".

    It's certainly not difficult to imagine that the first time a person bought a stock and saw it go up, they had the urge to sell and take a quick profit. Daytrading is nothing new - it's simply human nature to want to take a quick profit and then repeat the process.

    Some people would like you to believe daytrading is something new, and that, therefore, it must somehow be "bad". However, when you really stop and think about it, daytrading is really no more risky than any type of investing or financial speculation. Any investment or trade can go bad, just like any trade or investment can go well. Just talk to anyone that has owned large amounts of real estate for any extended period of time. There have been times in the economy when interest rates sky rocketed and suddenly exposure to a large mortgage has been quite risky. No matter what the situation, speculation with any financial instrument brings some amount of risk, especially if done incorrectly or unwisely. Daytrading is no different.

    Certainly, daytrading, like anything else, can be risky if you don't know what you are doing. I've known of people making one silly mistake and getting wiped out over night. Since daytrading does come with a certain amount of risks, it's only wise to get your financial "house" in order before you begin. As such, a few basic guidelines are in order.

    To begin, we should understand that there are two basic categories of people that tend to seek out daytrading, and that these two categories are drastically different in their approaches to the markets.

    The first (and more historically typical) category is made up of people who are basically pretty financially well off. These include individuals who have solid financial worth from other means. They also tend to have homes, which are paid for (or largely paid for) as well as being relatively high net worth individuals, particularly in the liquid assets category. For individuals in this category, daytrading most likely is only a small part of an overall (and diversified) investment strategies or portfolio, and typically it's only used to further an already solid net worth without exposing a high percentage of the individuals assets to undo risks. Basically, these are individuals that can "afford" to do a little day trading and typically don't go over board in "only" stock speculation.

    The second (and not only more recent, but more dangerous) category tends to be people who are attempting to build their net worth strictly from daytrading. These are individuals who view daytrading not so much as simply one small aspect of an overall financial investment landscape, but more as the major way to generate and build their entire financial worth. This tends to also be the category of people who take larger risks and sometimes generate a bit of negative press regarding daytrading. This negative press would be along the lines of people that daytrade using funds from a credit card and/or home equity mortgage of some form or another. When things don't go well in the markets, typically the losses tend to have a more dramatic impact on the individual's net worth and life style.

    It's pretty clear that these are two radically different approaches to daytrading. If you are in the first category, then as long as you do not expose more than around 10% to 20% of your overall liquid net worth to stock speculation, you probably won't get into too much trouble. However, if you fall into the second category - where you are trying to create wealth through daytrading and/or you are using daytrading as your only means of addressing stocks - then some guidelines are in order. Of course, at the end of the day, no one can force you to follow these guidelines. However, if nothing else, you should strongly consider the following information as it relates to your individual case.

    First and foremost, you should never trade using money you cannot honestly afford to lose should some catastrophic event wipe you out in the markets. These funds should be largely similar to funds you would ear mark for Vegas or other forms of higher risk speculation. In the event you lost these funds in total, they should not have any dramatic impact on your life whatsoever. Generally speaking, these funds should represent no more than 10% to 20% of your overall liquid net worth. Beyond this, you should strongly take into account areas of your financial picture such as home ownership, outstanding short and long term debts, as well as future responsibilities such as college for your kids, etc. You should also take into consideration your age as it relates to your future retirement. Daytrading at age 20 or 30 is one thing; daytrading your retirement funds at age 65 or 70 is a whole different situation and very unwise unless you limit the amount of funds at risk.

    Again, before you undertake anything but causal daytrading, you should seriously consider such things as paying down all of your short term debt. This would include paying off all credit card balances and any loans that may be near maturity. You should also consider allocating funds for and/or paying off longer term debts such as car notes and/or home mortgages. Additionally, if you have a family to provide for, you should not only consult with your wife, husband, etc. before attempting any sort of daytrading, but you should take into account what impact large and unexpected losses could have on your current as well as future living situation.

    Generally speaking, unless you have tremendous earning power, you should have very little debt and a stable housing situation before using much capital in the markets for day trading.

    Good luck in the markets!

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    "Step into the arena and hold on to your hat. Don't get discouraged if you don't make 8 trillion dollars in your first month. Trading is not a get rich quick scheme. Realize that trading is a skill and just like any other skill it takes time to learn. Have convictions in your decisions in life and trading. Ignore the comments and "advice" of those that have never traded a day in their life."

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    Good KARMA and positive energy abound.

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