Evolve as a Trader or Polish Up Your Resume

Six years ago to this very day I walked away from corporate America to trade full time.  As each anniversary day comes, I can’t help thinking back on March 31, 2006.  Well over a year of preparation, planning and deep reflection went into that moment.  After all, I was walking away from a great 6 figure job with significant responsibility and latitude.  It wasn’t like I was leaving a dead end job that I hated.

We have all seen the statistics that claim that 90% of traders fail. Although I have never seen any data behind the claim – it is easy to accept as true.  We all know many people who have been wiped out in the market, but very few who have been trading full-time for 5 years or more.  That being said, I would still love to see the data.  Who are these people?  Did they work on Wall Street before venturing on their own?   Were they capitalized sufficiently?  How is success or failure being measured?   A few weeks ago I received an email from a writer that was  working on a story on people who lost their jobs or took a buyout and turned to trading instead of pursuing another job.  I think my response may have surprised the writer.

I can’t recall anyone who has attempted to trade after losing their job in the last few years. As you know that was quite common in the late 90s. After the internet bubble many decided that their time would be better spent looking for a job.  2008 reinforced it for those that had forgotten.  IMO, entering trading reactively (like after job loss) is asking for trouble.  Trading full-time is very difficult. It requires a well thought out proactive plan for any hopes of success.  Even with a plan it is still a difficult endeavor…

With all of my preparation and planning – it nearly all went out the window in the recession/depression of 2008.  Like Mike Tyson says “everyone has a plan til they get punched in the mouth.”

 

Up until 2008, I was primarily as position trader / investor.  I preferred thinking in terms of months instead of days or weeks.  Some of my best trades have been 18 months or longer.  To capture longer term moves you will have to suffer through some significant pull-backs.  This works well when there is a guaranteed paycheck coming in, but sans paycheck it is a whole different ball game.  I had thought through this scenario before resigning, but 2008 was 10X worst than any situation I had imagined.  Fortunately I was well enough capitalized to survive, but emotionally I was a wreck.  It was clear that changes were REQUIRED.

One way to control draw-downs is to reduce your time frame.  A good swing trader can stay near their highs by thinking in terms singles or doubles instead of home runs and by only trading when the market is in a confirmed up trend.  I have spoken about Mark Minervini’s seminar that I have taken to help with this style (here and here).

After I had taken the Minervini seminar in October 2010, the market made a nice move higher.  It was easier to stick to my old strategies than to adopt the new ones I had learned. However, when the market turned back down in March – my old ways failed me once again.  I had just lived through this in 2008. Clearly, it was time to either evolve as a trader or polish up my resume.

BTW, My resume still has dust on it.

How Much Money Do You Need to Start Trading Full-Time

A Twitter follower just asked me how much dough did I have when I started trading full-time.  Instead of a quick response that will soon be lost in the Twitterverse, I decided to share a document that I wrote 5-6 years ago addressing this very question.  To be honest I haven’t reviewed it since, but it made sense at the time.

 

Capital Needed to Walk

 

It’s a consensus agreement among entrepreneurs that a business plan is essential for anyone starting a business.  How can you reach your destination – if you don’t know where you are going?  Most don’t question this wisdom, especially if start-up funding is sought.  It’s quite simple – whenever I am approached about investing in a business, I ask two deal-breaking questions:  How and when am I going to get my money back?  Those questions are impossible to answer satisfactorily without a plan.

I remember writing my first business plan and discovering the power of Microsoft Excel.  My business could be moderately or extremely successful by simply changing a couple variables in my revenue projections.  It was quite interesting how I always managed to make money no matter how much I tweaked the numbers.  Mystically, the sales always materialized.

One of the many lessons I learned during my first full-time entrepreneurial venture was that you can never have enough start-up capital.  I was so convinced that my day job was limiting my opportunities that I quit before securing the big contract.  All of my revenue projections included this contract as the baseline, without it – being moderately successful was a pipe dream.

In addition to not closing the large contract, collections were a challenge. As I waited for payments, the operation had to continue – payroll had to be met, supplies had to be purchased and don’t forget the rent man.  It is crucial to have enough cash on hand to manage through these types of circumstances. You can probably guess how this story ends.  Nine months later I was back punching the clock.  It didn’t have to end this way or at least not as quickly.

This story is quite common.  Ask ten entrepreneurs and most will have experienced similar scenarios.  I am willing to bet that even Bill Gates has a comparable story or two.  It is very rare that an entrepreneur doesn’t have cash flow problems at some point. My latest venture is much different.  I didn’t walk away from my J.O.B. until I had 4.5 times my annual expenses in the bank. Why four and a half times? Why not three or five?  Let’s take a look at how I derived the number.

First, I divided my capital into three buckets – day to day cash, intermediate cash and long term cash.  The day to day bucket is to address everyday living and business expenses.  The intermediate is to address unforeseen matters 1 to 5 years out.  Long term is for issues at least 5 years in future.

Next, I determined the return on investment (ROI) my business would generate.  This is quite subjective.  Really the only true measure is if it is based on history.  Thus, I highly recommend working the business part-time before venturing out.  The steady paycheck takes a tremendous amount of pressure off and allows time to determine whether the business is feasible.  The ROI is simply your profits divided by your investment.  So, if you invest $300,000 and return $100,000 – your ROI is 33%.  If your ROI is less than 20% – it may be wise to figure out what’s necessary to make your business more profitable before venturing out.

Once you are satisfied with your ROI, your Capital Needed to Walk (CNTW) is simple to calculate. The basic formula is the inverse of your ROI plus one and a half times your expenses.

CNTW (20% ROI) = 1/.2 + 1.5= 6.5 * Expenses

CNTW (25% ROI) = 1/.25 +1.5 = 5.5 * Expenses

CNTW (33% ROI) = 1/.33 + 1.5= 4.5 * Expenses

In my case, based on history, I believe that I can generate a 33% return on my investment each year.  So, before quitting my 9 to 5 – I accumulated 4.5 times my annual expenses.  The logic is that if one has 3 times their annual expenses invested in the business and can generate a return of 33% it will result in enough money to cover the next year’s expenses.  If this can be continued in perpetuity there will always be enough money to keep the doors open.  Obviously, some years will be better than others.  So, in the good years the additional money is moved into the intermediate bucket.  This serves as reserves that can be drawn upon in the in bad years.

Here are some CNTW break downs:

33% ROI:

  1. 1 Year Expenses Up Front
  2. 3 Years of Expenses Invested
  3. 0.5 Years Expenses in Intermediate to address shortfalls

25% ROI:

  1. 1 Year Expenses Up Front
  2. 4 Years of Expenses Invested
  3. 0.5 Years Expenses in Intermediate to address shortfalls

20% ROI:

  1. 1 Year Expenses Up Front
  2. 5 Years of Expenses Invested
  3. 0.5 Years Expenses in Intermediate to address shortfalls

 

Let’s take a look at a couple examples.

Annual Expenses – $100,000

ROI – 33%

Capital Needed to Walk = 1/.33 + 1.5 * ($100,000) = $450,000

 

Annual Expenses – $100,000

ROI – 25%

Capital Needed to Walk = (1/.33 + 1.5) * ($100,000) = $550,000

 

Annual Expenses – $100,000

ROI – 20%

Capital Needed to Walk = (1/.2 + 1.5) * ($100,000) = $650,000

 

Obviously there are many variations on this thesis.  Maybe one would be more comfortable with more reserves.  For instance, 2 years of expenses up front and 1 year for intermediate needs.

Annual Expenses – $100,000

ROI – 33%

Capital Needed to Walk = (1/.33 + 3) * ($100,000) = $600,000

 

Or maybe expenses can be reduced from $100,000 to $80,000.

 

Annual Expenses – $80,000

ROI – 33%

Capital Needed to Walk = 1/.33 + 1.5 * ($80,000) = $360,000

Cash is king and this rings especially true for businesses.  I have applied this approach to my stock trading business, but I believe that is applicable to any type of business.  The bottom-line is under capitalization is the demise of many businesses.

For the inquiring minds:

How did I accumulate my CNTW?

I did it the old fashion way – I earned it.  Whenever I received a bonus or a pay increase from my J.O.B. it went into the bank. It seemed kind of boring when my friends were buying all kinds of neat toys, but not so much now when they are stuck in traffic driving to work.  Also, I learned to use the bank of Wall Street.  Simply depositing money into the local bank is not good enough.

There is a Bubble in People Calling Bubbles

If you have read my blog or my tweets on Twitter – you know that most of my stock trades are in commodities including precious metals, emerging markets or technology preferably related to the mobile internet.  I have found that I can attain a slight edge by focusing on certain themes or trends.  If Freeport McMoran (FCX) and BHP Billiton are both signalling a buy, from past experience I know that FCX has a little more giddy up. So, I would buy FCX.  Without the sector specific knowledge, I would have to flip a coin if I couldn’t buy both.

The sector specific knowledge also empowers me to raise the BS flag when I here it.   I’m willing to bet that the word “bubble” is espoused more than any other word on the various financial media outlets.  The experts say Gold, Silver, Copper, Oil, Emerging Markets – all are in bubbles.  Listening to them, one would think that almost anything that goes up is in a bubble.  Interestingly, very few of the people calling for bubbles identified the two largest bubbles over th past 10 years – the internet and housing.

After awhile, you start tuning these people out and forming your own opinions.  The following chart from US Global Investors tells me all I need to know about bubbles in Commodities and Emerging Markets.

You can see that the emerging world currently holds roughly half of the world’s population but less than one-fifth of its economic clout. Already we are seeing a tremendous transformation of the emerging world….

Most significant has been the doubling of the world’s population since 1970, with 40 percent of the world’s population being in China and India….

With this population surge and integration into the global economy comes a need for new and improved infrastructure. Did you know that when the U.S. built its Interstate Highway System in the 1950s it consumed roughly half of the world’s available commodities?

People in the Emerging Markets are no different than people in the developed ones.  They want housing with running water and appliances.  They want cars.  They want their children to have a better opportunity than they had.  The demand for copper is not going to subside just because some expert on TeeVee says prices have risen too fast.  Unlike the internet or housing bubble – in commodities supply is not keeping up with demand.  Most importantly, the supply of copper or oil or iron ore or “fill in the blank” can not be turned on overnight.  It is getting harder and harder to extract these resources.

That being said, prices can’t just grow to the sky.  There is a natural ebb and flow to prices.  Once again, Frank Holmes nails it in his US Global Investors piece.

This table shows the monthly volatility based on 10 years of data for a number of different investments. You can easily see each asset class has its own unique DNA of volatility.

For gold stocks, it’s a normal event to see a positive or negative move of 11 percent over just one month’s time. For emerging markets, it’s just over 7 percent. Understanding this volatility is essential to removing emotional reactions and making the best investment decisions.

Recently, I’ve noticed many new faces on business television commenting about a bubble forming in commodities due to the Federal Reserve’s Quantitative Easing (QE2) policy and resulting weakness in the U.S. dollar. Both of these are a part of the commodity equation but focusing on them omits several long-term factors driving commodities.

Frank goes on to say,

I do not see a bubble at this time but our quant models are showing we are due for a short-term correction. Investors need to anticipate this correction and not lose sight of the long-term trend.

I don’t have any quant models, but my eyes are in agreement with Frank.

Notice the nice orderly increase in Silver prices since August.  Now look at the volatility over the past week.  It is simply one of those times for a pause to refresh.  It has nothing to do with bubbles.

Why I Dropped $4K to Attend Mark Minervini’s Trading Seminar

So, let me start out by saying that $4,000 for a seminar is a lot of money to me.   Trading is a business and I plan for a certain level of expenses each year, but $4000 for seminars wasn’t in this year’s budget.  That’s twice as much as I have ever spent on a seminar and I don’t attend $2K seminars that often either.   Needless to say, when Mark Minervini announced his seminar I wasn’t the first one to sign up.

Mark is featured in Jack Schwager’s, Stock Market Wizards, the third book in his series.  The book originally published in 2001 featured 13 of America’s top stock traders.  At the time of publishing, Mark had compounded 220% return over 5 1/2 years.  This included his 155% first place finish in the 1997 U.S. Investing Championship.  In other words, the man knows how to print coin.  This past year Mark has been blogging and tweeting.  My ears perk up whenever he sends out a tweet.  Mark’s pedigree was definitely an attraction, but 4000 bucks.  However, as I reflected back on my journey to this point in time – there was no way I could pass up on this opportunity.

I opened my trading account in October of 1995 with $3000.  I was an engineer by training and the stock market was something I dabbled in during lunch breaks.  Over time I added more money to the account and worked my magic.  By the time the market peaked in March 2000, I was sitting on 7000 shares of CMGI at $145 per share.  That was my largest position, but I had other significant holdings as well.

That being said, you have to understand that I was completely self-taught.  Everything I knew about the stock market I had learned from books.  Unfortunately, I hadn’t discovered the books that discussed when to sell.  By the end of 2000, those same freaking shares of CMGI were only worth $5.60 per share.  I sold a few shares on the way down, but for all practical purposes I was wiped out.  Fortunately, my engineering job paid the bills so life continued as though those 5 years never happened.   In 2002, I got serious about the market again.  By 2005, I had grown my account large enough that I could walk away from my full-time gig in March of 2006.

When I began trading full-time, it became apparent that my trading style had to change.  The crash of 2008 really drove this point home.  Although, on two separate occasions I had proven to myself that I could grow small sums of money into much larger sums.  I had accomplished my success while holding through significant draw downs.  This was possible since my real job was paying the bills.

From Schwager’s book:

Most traders and money managers would be delighted to have Minervini’s worst year during this span – a 128 percent gain – as their best year.  But return is only half the story.  Amazingly, Minervini achieved his lofty gains while keeping his risk very low.  He had only one down quarter – barely – a loss of a fraction of 1 percent.

Unless I had experienced everything that I have over the past 15 years that statement would simply be words on a page.  However, those words spoke volumes.  The concepts of high return with low risk may be in another undiscovered book, but I can’t afford to blow up again before  reading it.   Time was of the essence, so I forked over the dough.

I signed an Non-Disclosure,  so I can’t share specifics of the seminar.  I couldn’t do it justice anyway.  However, I want to share some of the general insights learned.  Hopefully, it will help someone.

1) High risk and high reward are not one in the same.  Mark stated on several times during the seminar that he is the most risk adverse person in the room.  He consistently produces triple digit returns and has very few +100% winners in his portfolio.  He uses the power of compounding to his advantage.  It is much easier to find 20% winners than 100% winners.  So, he compounds as many 20% winners in a year as possible. The other side of that is cutting his losers quickly.  His absolute “Uncle Point” is a 10% loss.  However, his average loss is much smaller than that.

2) Mark combines technicals and fundamentals.  Both have to line up.  The fundamentals provide the story, but the technicals provide the entry point.  His goal is to buy stocks right as it starts its move.  His best winners are winners immediately.

3) Focus on one strategy and learn as much as possible about that strategy.   He pointed out that Warren Buffett and Bill Gates are best friends.  However, over their entire friendship Buffett has never owned a share of Microsoft’s stock.  Buffett sticks to what he knows.  I often find myself drifting from swing trading to position trading to options.  Mark’s advice is to narrow your focus and know it well.

4) The most important lesson that I learned was that making money in the market should be easy.  If it is not either one of two things can be wrong.  Either your selection criteria is flawed or the market is flawed. I have proven to myself that I can pick winners.  So, when I am struggling getting stopped out constantly – the market must be “flawed.”  In other words, it is not the appropriate time for my strategy.  When the market is “flawed” it is time to step aside.  Being constantly invested in the market is not smart.  Leave that to the people on TV.

Finally, a side benefit of a seminar in such an intimate setting is that the people in attendance are serious people.  They are there to learn, but interestingly you can learn from each other.  Obviously the questions asked add insight to your understanding, but the talks during breaks are as valuable.

I have known Joe Fahmy through StockTwits and his show “The Next Big Move.”  It was a pleasure to meet him in person.  The beauty of Twitter is that it is the real you.  If you have generated over 1000 tweets – your real personality will reveal itself.  Joe was exactly as I expected – a really sharp down to earth guy.  I also met Pradeep Bonde.  He runs an investing site called StockBee.  I hadn’t heard of the site before the seminar, but it boast over 1100 members.  If your site has 1100 paying members you must be doing something right.

I also met a trader that had been trading with Mark for eight years.  He wasn’t generating triple digit returns, but he was attaining significant returns and was running a large sum of money.  That was really the proof in the pudding.  It is great that Mark is a superstar trader, but if he is not helping others become better – what’s the point?