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Four Questions to Ask Yourself Before Making a Trade


Here's a brief checklist that will help you avoid trading blunders.

To say I had a lousy 2012 would be putting it mildly. The S&P 500 (INDEXSP:.INX) was up about 16% for the year, while my trading account finished down.

So what happened?

Did I have a run of bad luck with a bunch of bad

Nope! Due to big fat bets on Apple (NASDAQ:AAPL), Qualcomm (NASDAQ:QCOM), and Lions Gate (NYSE:LGF), I was up over 30% by March, despite being over 50% in cash.

Unfortunately, I then ingested a lethal hubris cocktail and started dabbling in all sorts of nefarious activities, including (but most definitely not limited to):

Messing around with natural gas options.

2. Being "smart" by making everything complicated.

3. Ignoring my bread and butter (betting on consumer trends) in the name of becoming yet another wannabe global macro trader.

My only consolation is that my idiotic moves were done behind my kimono, not appearing here on or on the Buzz & Banter.

To keep myself from making another mess, I've constructed a checklist of questions I ask myself before making a trade to ensure that I never repeat last year's extreme bout of self-sabotage. In the interests of entertainment and education, I've decided to post it here for you.

So let's start with the most basic of questions you should ask yourself before making a trade:

1. Do I Have Any Idea What I'm Dealing With Here?

The commodification of trading through cheap commissions and the ETF-ication of everything on planet Earth means it's easy to speculate on whatever comes to mind.

However, just because you can trade something that you don't understand doesn't mean you should.

Want to bet on Greek stocks? Then maybe you should know whether the EU is about to vote on an aid package.

How about corn prices? You should probably have some idea of what corn demand looks like right now, and what happens when futures contracts roll over.

Or maybe you're looking at a bank stock like JPMorgan (NYSE:JPM). Wouldn't it make sense to know how the shape of the yield curve affects bank earnings? Or whether some Senate subcommittee is about to launch a drone attack on the financial services industry?

At the very least, before placing a trade, you should have an idea of what makes that particular stock or bond or ETF or whatever go up and down.

That's just the tip of the iceberg -- so if you can't figure that out, it's time to head back to the drawing board.

That brings us to...

2. Why Am I Doing This?

It's important to ask yourself why you're considering a particular trade.

It's reasonable to make a trade because you expect some fundamental catalyst, are eyeballing an attractive technical setup, or are hedging some other holding.

However, if you're hitting the buy button out of boredom on a slow day or because of an unconfirmed rumor that's floating around on Twitter, then it's time to check yourself.

If you can't answer "Why Am I Doing This?" with something at least halfway sensible, slow down and reevaluate your thought process.

Now, if you know what you're dealing with and have a good reason for making a trade, it's time to think about timing.

So ask yourself:

3. Have I Checked the Calendar?

Successful trading and investing is all about timing. (
See also: Four Real-World Investing Rules That Should Be Taught in Schools.)

You can have a perfect grasp of a company's fundamentals and perfectly forecast earnings, but still lose money if you buy or sell at the wrong time.

A stock can go down on good news just as easily as it can go up on bad news; making money in the market is all about determining what's priced in and what isn't at a given point, which is a dark art, not a hard science.

However, one way to help improve your timing is to be aware of what's on the calendar.

For example, if you're thinking about buying Cirrus Logic (NASDAQ:CRUS), whose main customer is Apple, you should know when Apple and other suppliers report earnings.

Additionally, if you're eyeing cyclical sensitive sectors like housing and industrials, you should know when the big economic data points like the jobs numbers and GDP come out.

So if you're ready to go long or short on something, it's time to think about an actual battle plan, the most important component of which is:

4. What Is My Exit Strategy?

Aside from trades that have defined risk-reward characteristics -- I'm thinking options strategies like calendar spreads -- figuring out your actual risk-reward for a particular trade is incredibly difficult.

Therefore, it makes sense to hone in one thing: What are you going to do when things go wrong?

The good news is that there are a bunch of ways to skin this cat.

The bad news is that none of them are perfect.

For example, you can have a hard stop loss, but that won't help you if a stock gaps against you in the wrong direction.

You can also hedge stock positions with options, but that will cost you through either the payment of options premiums or through a reduction in upside potential.

This doesn't mean that either of these methods are bad. Just understand the pros and cons of whatever risk management strategies you are considering.

It's also helpful to look back into your own trading history to see where you've incurred big losses.

We all have our own tendencies and behave in certain patterns, so go through your account statements and figure out where you've consistently gone wrong in the past.

Through examining my own history, I've found that the number one thing I could have done to improve my returns would be to have cut losses sooner. I tend to have a few monster gains each year, but far too often, they've been offset by losses that ran too big.

So for me, if a stock position goes down by 10%, it gets tossed in the trash (now if only I'd done this with my Apple position ahead of the company's Sammy Hagar era). For an options position, if I lose 25%, I'm out. There's not much science to what I'm doing here; these just seem to be the points where I start to feel like an idiot.

But it's funny -- I feel like my newfound willingness to surrender and pull out the white flag is leading me to victory.

P.S. If you're seeking more information on this topic, Todd Harrison's classic article The Ten Trading Commandments is a must-read.

Twitter: @MichaelComeau

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