Principal Protection

Principal Protection: How to “Defend” Your Principal From a 50% “Bomb”

By Steve McDonald, Contributing Editor
Tuesday, December 20, 2005: Issue #268

Top Gun and other fighter pilot movies have done a great job creating a stereotypical image of an aviator – a daring and adventurous soldier with perfect vision and a propensity for never making a mistake. You’d think they could walk on water… One of the funniest things to watch when I was flying for the Navy was newer guys trying to live up to this Hollywood image of Naval Aviation.

But believe me, it’s not brain surgery. And neither is investing.

Picking stocks and options is a tough job, to be sure, but those of us who do it successfully on a consistent basis don’t walk on water. The truth is, after almost 25 years of stock trading, I have learned, usually the hard way, there are several rules written in blood. And one of them is that you can’t avoid making a mistake somewhere along the line.

But being able to handle those mistakes and protect your principal is a skill you can master. Here’s how…

Three Rules To Protect Your Portfolio

#1: Accept that you will always have losers.

If you are operating under the idea that there is some secret system that you haven’t found yet that will allow you to avoid losers, you’ll have to change your assumptions. Investing is a game of averages. You must plan for losers and have a way to deal with them.

#2: Get out early.

Admit your mistakes early and often. Not only will you limit your losses, you’ll have a happier marriage. If the market says you’re wrong, then you’re wrong. Any effort to change the inevitable will only make you feel more foolish down the road.

#3: Have a system for dealing with your losers.

We call these systems trailing stops, stop losses, stop limits, etc. Know what they are and use them. If you don’t limit your losses, you won’t have any money left when the market goes in your favor.

There is nothing more exciting or satisfying than investing in options. There is also nothing more painful than watching the losers tank.

This is as much a head game as it is a game of numbers. You must be prepared for the downs and be ready to deal with the emotional dips, or they will eat you up. Call it discipline, market savvy or whatever you like. The difference between the big boys and the rookies is how they deal with the losers.

Back To The Drawing Board

Let me give you an example…

Recently, I had a straddle I was following where both the call and the put were down. A straddle is when you buy the puts and the calls on the same underlying issue, at the same strike price and expiration. Then in this case, how could both be down

Well, it’s the market, and with so many variables, anything can happen. Besides, how isn’t the question we should be asking, as it is out of our control. The real question is: What should you do to protect your principal?

In my case, I sold. And I lost about 30% overall. But the point is, two days after I sold it, it was bombed even more, for a 50% loss. I prevented myself from taking a huge bath by having my stops in place… and they worked exactly the way they were supposed to.

Walking away is always tougher, but don’t look back. It’s part of the plan. Learning this simple fact about principal protection is a huge hurdle for most people. Be one of the smart ones.

Great Trading,

Steve