The Single Most Important Rule of Trading

by Nicholas Vardy
Wallet_In_Street

"So what do you think the single most important rule of trading is, Nick?" a friend asked me as we had drinks at the Connaught Hotel in London's tony Mayfair district.

As a portfolio manager at one of the U.K.'s top hedge funds, he's a big deal in the finance world.

But that evening, my friend was looking worse for wear after a very tough 18 months.

He had been unwilling to cut his fund's losses on bearish bets that went against him.

The answer I gave him was deceptively simple...

"Don't lose any money."

Of course, traders hear this so often...

It goes in one ear and out the other.

But the truth is most of them ignore this rule.

They may claim they follow it... but they don't.

Instead, most focus on generating the best trading ideas. And that's where they run into trouble.

Having put so much work into generating an idea, they become reluctant to sell, even if the trade goes against them.

Psychologists call this reluctance the "endowment effect" - the tendency to overvalue anything (including stocks) that you already own.

The One Rule All Top Traders Have in Common

Ask a group of 20 world-class traders how they make money... and expect to hear 20 different answers.

But whether they are fundamental investors, technical traders or commodity speculators, "Don't lose money" is the one rule they will all have in common.

Take the example of value investor Warren Buffett. He said, "Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1."

With his focus on global stock markets, currencies and commodities, George Soros' investment style is vastly different from Buffett's.

Yet Soros may be even more obsessive than Buffett when it comes to not losing money.

As former Soros Fund Management CIO James Marquez explained...

Soros would be the first one to tell you that sometimes his actions... look like the most rookie, odd-lot, wrong-way kind of thing, selling at the lows, and buying at the highs. But it's much easier to understand in light of his avowed mission: to be able to come and fight another day. He says: "I don't want to wake up broke."

Victor Sperandeo, perhaps better known as "Trader Vic," best explained the psychological challenges of implementing this rule...

The single most important reason people lose money in the financial markets is that they don't cut their losses short. It is a curiosity of human nature that no matter how many books talk about this rule, and no matter how many experts offer this advice, people still keep making the same mistake.

The lesson?

No matter how bulletproof your idea seems on day one, a trade can always turn against you for unexpected reasons...

Even if your original analysis was spot on.

So instead of fantasizing about how a trade will work out in your favor, focus on defining your worst-case scenario.

And if you are right, the upside will take care of itself.

Your mission should be, as Soros says, "to be able to come and fight another day."

I know my investment performance dramatically improved after I adopted this rule many years ago.

I urge you to adopt it as well.

Good investing,

Nicholas

Thoughts on this article? Leave a comment below.

Follow This Fracker

We here at The Oxford Club are all about helping Members make money - not lose it! That's why no recommendation we make is ever going to be one that we've "dug our heels into" - and why we always recommend (unless noted otherwise) placing a 25% trailing stop on any of your positions.

Because he carefully evaluates the fundamentals underneath wild market swings, Macro Strategist Eric Fry recently suspended the stop loss on U.S. Silica Holdings (NYSE: SLCA) in Fry's Pinnacle Portfolio. Despite some recent downward pressure, see why he expects strong results from this company over the next several months...

U.S. Silica Holdings (NYSE: SLCA) is a leading producer of sand proppants, which is the kind of sand oil companies use to "frack" their oil and gas wells. This 100-year-old company also produces an array of industrial minerals that serve a diverse mix of end markets like glass for smartphones/tablets, building products, foundry, filtration, chemicals, fillers and extensions.

The company derives about two-thirds of its revenues from the oil and gas sector. And it is this sector that is key to the turnaround that is underway at the company.

Unfortunately, almost as soon as I recommended buying U.S. Silica in December, the stock stepped on a land mine and blew off about 10% of its market value.

Nevertheless, I continue to believe that U.S. Silica is offering an excellent investment opportunity.

U.S. Silica has stated repeatedly that it anticipates large capacity increases in the frack sand market this year. Specifically, the company has been predicting increases of about 25 million tons to 30 million tons of new capacity.

Demand for frack sand is very strong right now, especially in the Permian Basin. This is an industry that needs additional supplies just to maintain the status quo.

U.S. Silica has nailed down a large chunk of its business under long-term contracts. About 70% of the company's sand sales are under contracts ranging from one to four years. And many of these contracts require customers to pay a large portion of the bill upfront.

In February, U.S. Silica's fourth quarter earnings results featured record-setting sales volumes of fracking sand, and overall revenue was up more than 98% year over year. And contribution margin and EBITDA saw significant triple-digit growth.

But as solid as these results were, Wall Street analysts had expected more. So that meant U.S. Silica committed the cardinal sin of "missing estimates." The punishment was swift and severe.

While it is ALWAYS important to respect the stock market's "opinion" about a stock, it is also important to try to differentiate between a transitory selling panic and an underlying fundamental weakness.

Based on the company's latest disclosures, it remains fundamentally strong and the rationale for investing in the stock remains intact.

Bottom line: I believe there's been an excessive knee-jerk reaction to the threat of rising sand supplies, and I remain enthusiastic about U.S. Silica's growth prospects and earnings potential.

- Donna DiVenuto-Ball with Eric Fry

Live Twitter Feed