Should You Trade For A Living?

At some point, most of us wonder if it’s possible to quit our day job and become a full-time stock investor or trader. That moment comes usually after a big win or, more often, a string of big wins. The first time my annual investing income exceeded my business income, I thought about re-orienting my life to focus on managing my money.

Recently, a reader named Michael wrote to both Dave Van Knapp and me asking our advice on whether he should make the plunge to full-time management of his money. Both Dave and I replied to him separately, Dave in more detail than I. Below are all three notes plus a follow-up from me.

Michael wrote:

During the dot-com crash, I lost 100% value in most of my investments, and I forgot the stock market completely for many years.

For some reason this past February something sparked in me (maybe turning 50 did it), and I dove back in head first. I started a learning frenzy — buying books, reading articles and such, watching CNBC, Bloomberg, etc. Wow, what a hodgepodge of information! There is a lot of conflicting information and nonsense, but also some really good stuff.

I opened two brokerage accounts and started investing again. Unfortunately, prior to some of my investment decisions, I was not aware of my now two favorite sources for investment information (Jason Kelly and Dave Van Knapp). I made some really bad decisions and some good ones along the way. In each portfolio I have some stocks that are up a bunch and some that are down a bunch.

I have just completed reading one of your books, and I am reading a second on dividend investing. I really enjoy this stuff, and if I could would be a full time trader (do you think that it is possible to do stock investing/trading as a full time career?).

My biggest concern now is a way of backing out of some of my bad decisions and not losing my shirt. I am using margin heavily and wish to eliminate this and to start using sensible techniques to manage my portfolios. Any thoughts would be appreciated and I look forward to many years of profitable investing.

Dave replied:

Hi Michael,

Thanks for writing.

There is a lot in your letter, and it leaves me with the impression that you are caught in a variety of modes of investing, particularly as to how much risk you take on and how you manage that risk. I was struck by the fact that you expressed interest in both dividend stocks and living the life of a trader. Those two modes of investing are very different in terms of their goals, time horizons, amount of activity, and the like. I am glad that you find Jason’s and my books and newsletters helpful, because while our tactics differ, we both advocate a sensible, realistic, risk-aware, and methodical approach to stock investing.

This will sound like a pain, but I suggest you take a step back and think about, and then write out, your investment goals, both long range and short range. Once you have your goals firmly in mind, write out the strategies you think would help achieve them. I consider this exercise a foundational step for any sensible stock investing, and I refer to the documents as “constitutional documents.” Just as with our nation’s constitution, yours can be amended from time to time. The exercise need not be long — I bet you can boil it down to a page. Review it often (to remind yourself of your investment policies), but keep changes down to about once a year.

The point is, I do not want to see you go off in 50 investing directions at once. That’s not to say that someone might not trade “risky” stocks with part of one’s money and invest another part in “safe” dividend stocks. But you should do so with your eyes open as to the benefits and risks of each approach, what percentage of your “stock money” you want to devote to each, how much time you have to spend, and so on. Any investments you make along the spectrum of high-risk to high-safety stocks should strive to reach your investment goals. Only you can articulate your goals.

In general, the shorter your average holding period, the closer you are to being a “trader,” and the longer your average holding period, the less you are a trader. In my higher-risk investments, I use sell stops to protect myself on the downside. My holding time for a stock may be anywhere from a few days (for a mistaken pick) to many years. My approach focuses on Buffett’s Rule #1, not losing.

In my dividend-stock investing, on the other hand, I do not use sell stops, relying instead on a semi-annual review of my portfolio for suitability and the continued dividend-paying ability of the stocks. In “pure” dividend investing, one is far less concerned with what the portfolio is worth at any given time than with the reliability of receiving continually increasing dividends. The dividends can be reinvested or used as current income.

I applaud and encourage you to continue to move away from using margin, especially since you have suffered deep losses in the past. Margin simply amplifies everything, the bad as well as the good. In all of the hedge fund “blow-ups” that I have ever read about, and in things like the recent collapse of Bear Stearns, excessive use of margin has always been involved. I have never used margin. That said, many successful investors do. I know that Jason is a proponent of leverage. He buys funds that are themselves leveraged rather than using margin (borrowing directly from a broker to fund investments).

As to backing out of your bad decisions (by which I think you mean mistaken investments), I have two suggestions: First, conduct a portfolio review. Examine each stock and decide whether it advances your investment goals or not. That will be relatively easy after you have written out your goals. You will probably conclude that some stocks were mistakes and should be sold. Second, you must sell them. You may find it psychologically difficult to sell stocks at a loss. Many people do. Selling at a loss is a well-known but self-defeating hang-up for many investors. But you must sell the stocks that do not fit your investment strategy.

As a technique, you might consider setting a very tight sell-stop, like 2%, under each stock you intend to sell. That way, if they catch a temporary updraft, you can squeeze every last nickel out of each one. Keep re-setting the sell-stops just under the stock’s price. Before long, they will hit their stops and sell. Many investors find that psychologically easier, because it takes some emotion out of the transaction. The sale takes place “automatically” according to the rules you set up when you are emotionally detached.

Again, thanks for writing, and best of luck in your investments!

I replied:

Hi Michael,

I think it is exceedingly hard, but possible, to make a living as a trader. I also think it’s not a very fulfilling life, but some people swear by it. My friend succeeded at it financially but returned to work because he felt so isolated in front of his computer all day, nobody to talk with, and without anything in common with people anymore.

As for margin debt, I would eliminate it and never use it again. Warren Buffett said that if you’re smart you don’t need it and if you’re dumb it’ll kill you. I don’t know what your positions are, but I would think carefully about what you can do to get rid of that debt for good. Maybe selling the losing positions makes sense because then you can get a tax write-off even as you use the cash to pay down the debt. Every little bit helps.

Even though Dave offered clarification between margin debt and leveraged products, I want to expand that a bit here. You won’t amass margin debt using leveraged funds or ETFs like the ones offered by ProFunds and ProShares. You won’t have to pay interest on borrowed money with leveraged
products because all of the leverage happens within the funds and ETFs. You hold them the way you hold any other investment bought with cash, and there’s never a margin call.

That being understood, the dangers of leverage still apply because the investments themselves change price with greater force (usually 200%) than their underlying target index. If that index gains 10%, the 200% leveraged fund or ETF will gain 20%. If that index loses 10%, the 200% leveraged fund or ETF will lose 20%. The tracking won’t be that precise in practice, but that’s the idea.

Leverage is risky. Those using it believe that the risk is more than counterbalanced by the potential for a higher return. For instance, if a sector or the broad market has sold off hard and an investor has enough time to wait, buying a leveraged long fund or ETF at cheaper levels can be a great way to ride a recovery to stellar performance. For the chance at that, some investors like me are willing to expose themselves to the downside risk of leverage.

One way that leveraged funds and ETFs are better than margin for using leverage is that you can’t lose more than 100% of your investment in the funds and ETFs. You can lose only what you put in. With borrowed margin money, it’s possible to lose everything you invested, plus what you borrowed, and still need to pay interest on what you borrowed. That situation can be a life wrecker.

Hats off to Dave for a nice technique to back out of losing positions. I like the 2% stop-loss ratcheted up daily to squeeze as much money as possible out before selling. Longtime readers know that I’m a big fan of limit orders precisely because they take a lot of the emotion out of this emotional business.

Before making trading your career, be sure to read some books on the subject such as Alexander Elder’s classics Trading for a Living and Come Into My Trading Room and his newest, Entries & Exits.

Finally, understand that trading is extremely hard. Even well-known pros get it wrong from time to time, as this recent gaffe by Jim Cramer illustrates:

[youtube=http://www.youtube.com/watch?v=_nkZ3eHeXlc]

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