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MarketWatch: The Fed-Fueled Fantasy Has Popped

(January, 2023 ) Link: https://bit.ly/3XIk5fK

After the U.S. stock market made all-time highs last year, I spoke with Jeffrey Bierman, a professional stock-trader with more than three decades of experience. Bierman also lectures on TheoTrade.com and TheQuantGuy.com, and is an adjunct professor at Loyola University and DePaul University, both in Chicago. 

At the S&P 500’s high he predicted a drop to 3600 or lower in 2022, and he was right. I recently caught up with Bierman to discuss his latest projections and strategies for U.S. stocks: 

MarketWatch: What strategies do you recommend for investors in this environment? 

Bierman: First, you can’t be 100% in stocks. Second, you have to look for yield. The yield on bonds right now is competitive with stocks. If you can get 4% for a bond with half the risk of the S&P 500, then it pays to buy bonds because the yields are secure and volatility is lower. Move more towards fixed income and move away from high beta stocks with high multiples. Because in bear markets, there is little to no growth. Value dominates in a bear market, and growth dominates in a bull market. 

MarketWatch: How do you know this is still a bear market? 

Bierman: If it looks like a duck, walks like a duck, and quacks like a duck, it’s a duck! Most stocks are far below their 200-day moving averages. Also, even when good news comes out, most stocks can’t get any traction. Finally, during the last few months, money has been flowing out of stocks and into bonds. All of these clues suggest a bear market. 

MarketWatch: If you’re right, when will this bear market end? 

Bierman: When growth stocks start to underperform and value stocks outperform. Then investors throw in the towel on growth stocks. That’s when we know we are close to the end of the bear market. 

MarketWatch: Is it time then to start looking for a new bull market? 

Bierman: Not even close. The final stage of a bear market is capitulation, when investors give up. Retail investors are worried right now but the wealthy are not. If we take out 3600 on the S&P 500, the wealthy will worry. But be careful of a fakeout. The market could drop below 3600 and bounce. That’s when everyone thinks the bear market is over. Instead, you get one final flush.  

MarketWatch: How should traders approach this market? 

Bierman: You must be nimble. Trade in short ranges. This is not a market where you will get “gamma squeezes,” (when a stock soars in a short time period). Traders need to take profits quickly and often, and don’t reach for the big swings or big moves. I call this the “fits and starts” market. 

MarketWatch: How do you personally trade this market? 

Bierman: I trade in large-cap and midcap stocks, and no small-caps. I also trade small size. For example, one of my accounts has $125,000 in it. The largest position I have is $4,000 to $5,000. I trade no more than 1% to 3% of my entire portfolio on one position. You should never trade more than 5% of your portfolio in one position. Trade small.  

‘I call it a slow-motion bear market — think of it as progressive stock bloodletting.’ 

MarketWatch: What’s your prediction for U.S. stocks in the near-term? 

Bierman: I want to be conservative in my projections. Realistically, we tag 3200 to 3300 on the S&P 500. In a worst-case scenario, we could tag 3000 this year. The best-case downside projection is 3500. 

MarketWatch: So even in your best case, stock investors still will feel more pain before the conditions improve.  

Bierman: I’m not Darth Vader but yes, I expect it will get worse, but not extraordinarily worse. We are not in a 2001 or 2008 type of bubbleI call it a slow-motion bear market — think of it as progressive stock bloodletting. It will fool a lot of people. Think about a frog in a warm bath that gets hotter. By the time the water is boiling, the frog is dead. 

MarketWatch: Why are stock investors in such a tight spot now?

Bierman: This market got hooked on the Fed’s easy money. After the 2008 housing crisis, there was a handoff from Bernanke to Yellin to Powell using quantitative easing. Instead of the normal 4% to 5% interest rates, they went to nearly zero. It was like the limbo game — how low can you go? The market got comfortable, then delirious, with that low-interest rate mindset. The Fed had a chance to take away the punch bowl at 3400 [on the S&P 500] but chose not to. Then we overshot by nearly 1400 points. This is the excess that has to be worked off. 

MarketWatch: Aren’t higher stock prices a good thing?

Bierman: It’s detached from reality. It’s like an automatic brainwash where fundamentals and value don’t matter anymore. The only thing that matters is that the Fed is providing easy liquidity and to hell with anything else. That helped create an inflationary bubble and all of a sudden the market’s mindset changed. Last year was a wakeup call. For the first time in 10 years, there was a reality check. That’s when people realized the Fed can’t always stand behind the market and hold interest rates at zero. 

MarketWatch: What will it take this time for investors to get real about market conditions? 

Bierman: People are slowly realizing that something has changed. People had been living in a fantasy world by the three Fed chairs. It damaged the mindset of the average individual. Even many pros drank the Kool-Aid and believed that nothing mattered except the Fed liquidity policy. As you can see now, the market can’t get any traction. The Fed-fueled fantasy bubble has popped. 

Michael Sincere (michaelsincere.com) is the best-selling author of “Understanding Options” and “Understanding Stocks.” His latest book, “How to Profit in the Stock Market” (McGraw Hill, 2022), is aimed at advanced short-term traders and investors. 



 

MarketWatch: Advice From Famed Investor Peter Lynch

Link: http://bit.ly/3JxvcUM

As a freelance writer and author, I’ve been fortunate to have interviewed many stock-market gurus over the years. One of the most memorable was with the legendary Peter Lynch, the former Fidelity Investments mutual fund manager. Years ago for an article, I spoke to him about one of his favorite subjects: Helping young people learn to invest. 

Do your research

Lynch popularized the idea to invest in what you know — meaning to own shares of the companies that you are familiar with. He wrote three bestselling books on his ideas, including actually going in person to observe what people were buying first-hand. 

Lynch was famous for visiting the companies that he wanted to buy stock in. For example, before buying shares in an automobile stock, Lynch would go to the dealer showroom, converse with the salespeople, and check out the inventory. 

His advice, while sounding simplistic, is actually brilliant. After all, most people spend more time and effort researching buying a new refrigerator than a stock. I made that mistake when I first starting investing, sinking $50,000 into shares of a Texas cell phone company that I had never even heard about. Why? Because an acquaintance who knew more than I did about the stock market said I should. “You can double your money,” he promised. Famous last words.  

Instead of doubling my money, I lost half of it within months when the company nearly went bankrupt after some questionable accounting maneuvers. It was also the first and last time I ever bought stocks on margin. 

Using margin, the broker allowed me to use my original $25,000 to buy another $25,000 worth of stock (2-1 margin). When the stock plunged, I not only lost money on my original investment, I also owed the brokerage for the money I borrowed. Mismanaging margin is one of the ways that many investors get into trouble when their stocks go against them. 

Study balance sheets and stock charts 

Had I followed Lynch’s advice and done some basic research, I would have discovered that the so-called cell phone company was a scam. It was being promoted by fake press releases and inflated posts on social media. 

In hindsight, I could have flown to Texas and visited the company. I would have discovered that it had only two employees. It would have been a lot cheaper to fly there than lose $25,000. I also could have studied the company’s balance sheet, looked at a stock chart, and studied its earnings reports. It sounds like common sense, but think of how many people buy stocks every day without doing the most basic research, what is referred to as exercising “due diligence.” Others call it “doing your homework.” 

How Lynch handled bear markets

From my interview with Lynch, I learned that he doesn’t make predictions. “I have no idea what the market will do over the next one or two years,” he told me. “What I do know is that if interest rates go up, inflation will go up and in the near term the stock market will go down. I also know that once every 18 months the market has a decline of 10%. These are called corrections. We could easily have a 10% correction. Perhaps one out of three of these corrections turns into a 20% to 25 % correction. These are called bear markets.”

Lynch took market corrections in stride, including bear markets. Although he disliked bear markets since he was a long-only manager and hated losing money when one occurred, he didn’t panic. “If you understand what companies you own and who their competitors are,” Lynch said, “you’re in good shape. You don’t panic if the market goes down and the stock goes down. If you don’t understand what you own and don’t understand what a company does and it falls by half, what should you do? If you haven’t done your research, you might as well call a psychic hotline for investment advice.” 

I learned from Lynch that although bear markets are inevitable, they cannot be predicted. That is why before one occurs, you must evaluate what stocks or funds you own. If you are confident about your investments, you won’t get shaken out.

For me, it means reducing some of my positions, especially given the U.S. market’s current technical indicators. Although the market has been on a 12-year bull run, it is still vulnerable to a steep correction, or worse, a bear market. That is why it’s more important than ever to do the basic research (i.e. study balance sheets and stock charts). 

Bottom line: If you are a long-term investor, Lynch’s methods and ideas are excellent. If there is a bear-market hiccup, use the opportunity to buy shares of stock or indexes that you have researched. 

MarketWatch: How to Use RSI (Relative Strength Index)

Link: http://bit.ly/3wT5GBY

While there are hundreds of stock market indicators and oscillators, most investors and traders only need a few. One of the most popular oscillators is RSI (Relative Strength Index). Created by a brilliant engineer, Welles Wilder, RSI tells when an index or a stock is overbought or oversold. Like most “bounded” oscillators, it has a reading from 0.0 to 100.0 on the chart.

“Overbought” is when a security makes an extended move to the upside (and is trading higher than its fair value). “Oversold,” conversely, is when a security makes an extended move to the downside (and is trading lower than its fair value). 

Jeff Bierman, chief market technician at Theo Trade and a professor of finance at Loyola University Chicago, confirms: “RSI is a time-tested oscillator that is very accurate at identifying overbought and oversold conditions. It allows you to observe ‘risk management zones.’ Then you can evaluate whether the zone might be broken to the downside or upside.” 

The purpose of RSI is to let you know if a market or stock is overbought or oversold and may reverse. It doesn’t mean that the security will reverse with 100% certainty, but it does indicate it’s in the danger zone. 

How can you identify when a market or stock is overbought? Look at RSI on a weekly (or daily) stock chart. If RSI is 70 or higher, the security is overbought. If RSI falls to 30 or below, it is oversold. It’s really that simple.

RSI is automatically displayed on almost every stock chart. Below is a screen shot of the Standard & Poor’s 500 index RSI on a weekly chart with a three-month time frame and the 14-day default (recommended). 

Here are some additional facts about RSI: 

When RSI rises to 70 and above

  • The RSI weekly chart gives a more reliable and accurate signal. 

  • RSI must be 70 or higher and remain above that level to generate an overbought signal. This is a clue that SPX (or another index or stock) is overbought. Hint: Sometimes indexes or stocks will reverse before reaching 70. 

  • As every technician knows, just because a stock or index is overbought doesn’t mean it will reverse immediately. Securities can remain overbought for long time periods before reversing. 

  • Do not use RSI to time when the market may reverse. Instead, use it as a guide. 

When RSI falls to 30 and below

When RSI on the S&P 500 (or an individual stock) falls to 30 or below, and remains under that threshold, that is an oversold signal. It doesn’t mean that SPX will reverse to the upside immediately, but the possibility increases (much depends on other factors such as market volatility). 

Bierman says that if RSI drops hard and fast (to 40 from 69, for example), even though it may not drop below 30, that hard and fast plunge is a signal that the S&P 500 or other indexes may rally (because the market is oversold). 

While some investment professionals preach that you cannot time the markets, in reality, a hard and fast plunge in RSI is an important tell, one that should not be taken lightly or ignored. Always confirm with other indicators (such as moving averages) before acting.  

Hint: Often, RSI lingers at or near 50, a neutral signal. This is not an actionable trade. However, when RSI makes an extreme move, either above 70 or close to 30 on the weekly chart, it should get your attention.  

Limitations of RSI 

Like any indicator, RSI is not perfect. Sometimes certain stocks will remain overbought (at 80 or 90) not for days or weeks, but for months. The longer the stock remains overbought without reversing, the less effective the oscillator. In addition, like many indicators, RSI is not as successful in a low-volatile market environment. 

Another weakness of RSI (and other indicators) is that it gives false negatives and false positives. Bierman explains what to do when RSI isn’t working properly: “Any indicator has a flaw. The answer is to combine RSI with other indicators. That cuts down your margin of error.”

In other words, don’t make a trade unless you confirm with other indicators (such as moving averages or MACD).  

I know that some of you are distrustful of technical indicators, and wonder if they are even effective. I speak from experience when I say that RSI usually generates reliable signals, especially on the weekly chart. Although not perfect, it is a mistake to ignore or dismiss its message.  

MarketWatch: Start by Practice Trading

Link: http://bit.ly/3YiNDAB

For reasons I don’t understand, most people enter the stock market for the first time without practicing or testing. Perhaps they read articles and books or watch videos about the market. Should anyone get a driver’s license after viewing a “how to drive” video? Of course not. New drivers practice driving in a parking lot or deserted street before getting on the highway. 

Unfortunately, as we’re seeing now with GameStop and AMC Entertainment Holdings, many new traders and investors enter the market without practicing first. It’s not surprising that most rookies lose money — sometimes a lot of money — when starting out. 

By practicing and testing before you trade or invest, two problems are solved. First, you become familiar with brokerage software. Second, the more you practice, the more skills and knowledge you gain. 

Let’s discuss some of the ways to use a simulated or paper money program, and which brokerages allow you to practice before making a real trade. 

Test before you buy

Before making a trade using real money, duplicate the trade in the paper money program. For example, if you wanted to buy 100 shares of Apple, before making that trade, buy 100 shares in the simulated trading program. 

If your timing was wrong, which is a common problem, you will lose money in the paper money program. Maybe your entry was poor. Maybe you bought right before the stock reversed. No matter the reason, the more you test, the more your timing will improve. 

Many people believe that “no one can time the market.” In reality, some traders can time the market. It’s not easy, and it takes a lot of practice, but getting the timing right is an important trading skill. Use the paper money program to develop that skill. 

Fear of missing out (FOMO)

On the other hand, let’s say you bought Apple at the right time, and made money in the paper money program. In this example, you may consider buying in the real trading program. This is a “trend following” strategy. 

If you are the type of trader or investor who hates to miss out on potential gains, then testing before buying might feel like you’re missing out. If you buy a fast-moving stock, you may believe you don’t have time to do a test trade. 

Even with these limitations, if you are a beginner, I urge you to make dozens or more test trades before betting real money. How long do you practice trade? Everyone has a different learning curve. Some may need a few days; others may take months. 

Be sure to paper trade with the same number of shares in the test program as in real life. For example, do not not pretend to buy 10,000 shares of Apple if all you can afford is 50 shares. Test trade with 50 shares. 

For those who want to skip the simulated program and start trading immediately, there is an alternative: Buy between 1 and 10 shares of a stock you believe has potential. By trading small, you learn the brokerage software while also making or losing real money. This is a reasonable alternative for anyone not wanting to test trade first. 

Experienced traders: Test strategies or take a break

Experienced traders often use simulated trading programs to test strategies. Let’s say you were interested in selling stocks short, a strategy not recommended for beginners. Before using real money, practice this risky strategy in the simulated program for as long as needed until you have gained experience and skills. 

If you’re on a losing streak, practice in the simulated program until you get your confidence back. In addition, after practice trading, re-enter the market but with much smaller share size. For example, if you normally buy 1,000 shares and lost money, trade with 100 shares until you figure out what went wrong.  

Listen to tips — but test first 

I used to advise people not to listen to tips, but I’ve changed my mind. Feel free to listen, but test first. For example, if your neighbor or some tout on TV tells you to buy shares of a stock, test it out in a paper money program. 

First, this allows you to evaluate whether the tipster is reliable. Second, you find out if the tip is valid. As long as you aren’t afflicted with FOMO, you can always buy the stock later. 

Where to find simulated or paper money programs 

These brokerage firms offer paper-money trading programs: TD Ameritrade, Interactive Brokers, TradeStation and E*TRADE . I am certain that nearly every brokerage firm will have a simulated trading program in the future. Why? Because customers will demand it. 

In addition to the brokerage firms, MarketWatch has a simulated trading game through its “virtual stock exchange,” with a 15-minute quote delay and $100,000 in play money. Investopedia also allows you to set up a trading game with $1 million in play money and a 15-minute quote delay. 

Currently the best simulated trading program is the paperMoney Virtual Stock Simulator on the thinkorswim platform from TD Ameritrade. You’re given an unlimited amount of paper money to use for 60 days free of charge (even if you don’t have an account with the firm). You can practice trade with this program at platform.thinkorswim.com. 

So the next time you are thinking of buying a stock, test before you buy. Although not everyone is a fan of this method, the benefits far outweigh the negatives. Rushing into a trade without testing is a mistake you don’t have to make.

MarketWatch: Use Puts for Protection or Speculation

Link: https://on.mktw.net/3HqZPbH

There are times when the stock market is in a big, beautiful bubble. During those times, it’s difficult to convince anyone to sell, or bet against it. 

Why sell bitcoin at $10,000, for example, when it might potentially hit $20,000? Why sell the S&P 500 at its all-time high right before Christmas? Are you crazy? 

Often, there is no hard evidence that a market is in a bubble until after it pops. That is why common sense goes out the window during bubble-euphoria as the market reaches levels that seemed impossible only a few weeks before. 

Whether the U.S. stock market is now in a bubble or not will be for the history books. Regardless, one strategy that most traders (and investors) should learn is how to buy and sell options. Those who don’t understand options believe it’s “a sucker’s bet.” It definitely is if you don’t know what you are doing. 

Although you can lose money trading options, many options strategies are designed to reduce risk and protect stock portfolios. 

If you are willing to learn, buying options is an excellent way to participate in the market’s rise or fall, and with limited risk. This does not mean no risk. Although you can lose money trading options, many options strategies are designed to reduce risk and protect stock portfolios.   

There are dozens of fancy-sounding option strategies, but all options are based on buying and selling “calls” and “puts.” If you believe a stock or index will go up in value, you would buy calls on that security. If the market is forming a bubble, typically there is a final melt-up that brings in the last of the nonbelievers. Owning call options during this stage can bring great profits if you’re able to get out before the reversal — easier said than done. 

Now, if you believe a stock or index will go down in value, you would buy puts on that security.

The risks of options trading

Options have a bad reputation because people misuse them. Typically, investors underestimate how quickly option prices fluctuate and how easy it is to lose money. 

Unlike with stocks, when buying calls or puts you have to be right about the direction and the timing of the underlying stock or index price. When you buy calls or puts, the clock is always ticking. If you’re wrong about the direction of the stock or index within a specified time period, you could lose most or all of your initial investment. That is why buying calls and puts are a speculative trading strategy, and not for everyone. 

If you want to reduce risk, there are a variety of options strategies designed to protect stock portfolios. Buying puts is the simplest of those strategies. If you own a portfolio of stocks, you will lose a lot of money when the market plunges. By owning put options, you can offset all or part of that loss. If you own enough puts, you can even earn an overall profit when stocks decline.

Buying put options

If you believe the market or a stock has reached bubble levels, you might want to learn how to buy puts. If the stock or index drops in value within a certain time period, you make a profit. If it doesn’t, you lose money, perhaps the entire cost of buying the puts. You may already know that buying put options has been a losing trade for several years while buying call options has been a winner. 

If you are convinced this market is going to plunge, I do not recommend shorting stocks. Shorting is a difficult skill for most traders to acquire, especially for beginners. Buying puts is less risky than shorting stocks. With shorting, your potential risk is unlimited. With put options, the most you can lose is the money you initially invested. 

When you get a decent profit, sell. When you’re wrong, cut your losses quickly. 

Five basic tips:

If you buy puts or calls, consider these five guidelines: 

1. Start small. The key to buying calls and puts is to use less money to make more money. This is a rule that should be followed when you are starting out. At first, trade with no more than $1,000 or $2,000, that is, buy only one or two option contracts at a time. 

2. Sell quickly. Unlike with stocks, option prices often move fast. You can’t buy a put (or call) and go on vacation, or even take the day off. When speculating with options, you need to concentrate. Options traders do not have the luxury of holding positions for long, so when you get a decent profit, sell. When you’re wrong, cut your losses quickly. 

3. Learn slowly. It might take you at least a year to learn how to trade calls and puts. Consider that initial investment as tuition money as you learn what not to do, and to start developing strategies that work for you. 

4. Focus on one stock or index at a time. At first, become an expert on the personality of only one stock or index. A good place to start is with is the S&P 500 ETF Trust (SPY). You can spend years simply trading this actively traded security. 

5. Make a trading diary. This is extremely important if you want to succeed as a trader. Keep track of your mistakes, the lessons you learned, and the trades you made. Keeping a trading diary is like having your own personal coach.

MarketWatch: 10 Rules for Cryptocurrency (Bitcoin) Traders

Link: http://bit.ly/3JB6jrf

If you’re reading this, I assume you know cryptocurrency basics — for example, that crypto is digital or electronic money not backed by a government or bank. To protect your account, you probably know to store crypto in a digital wallet, preferably offline on a computer, thumb drive, or mobile device. And you should know that crypto currencies are extremely volatile, highly risky and easy to manipulate.

If you still want to trade crypto, let’s discuss security. First, open an account with a trading platform you can trust such as Coinbase or Robinhood. Yes, there are other platforms but you have to start somewhere. These two well-known, reliable providers will do the job until you can separate the good from the bad. 

By the way, absolutely avoid fancy online brokerage firms or crypto exchanges that you’ve never heard about. Many are scam sites designed to exploit your inexperience. Please do basic research and never give your money to unknown companies. Here’s an idea: Call or email the brokerage before transferring your money and determine its level of service. Better yet, see if the company even exists. 

Second, although there are thousands of cryptocurrencies (some real, some fake), stick with the most popular and most liquid crypto in the world: bitcoin. After you gain more experience, feel free to trade other cryptos (after bitcoin, Ethereum is the second-largest). 

Now let’s talk about trading. The first question most beginners want to know is, “Can I make money trading crypto?” The answer is yes, but it takes skill, discipline, and due diligence. Crypto is still in its early stages and it could take decades for it to be accepted and backed by a government or institution (if ever). Until then, buyer beware. 

The worst part is that the crypto universe is populated with dark money, manipulators and pump-and-dump manipulators who give misleading advice on social media, lure you into buying their bogus currencies or try to convince you to join their phony crypto exchanges. Right now, crypto is pure speculation, but as long as you do your research you should be able to avoid scams. 

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Since you’re now aware of some of the risks, here are the top 10 rules that every beginner crypto trader should remember and obey: 

1. Scale into a trade rather than plunking down large sums of money: If you’re new to trading cryptos, it’s a mistake to put large sums of money into bitcoin (or other cryptos) all at once. Because crypto is so volatile, instead of buying $1,000 in bitcoin, for example, start with $200, and if it’s moving in the right direction (up), add another $200. Keep adding until your position size is fully funded. 

2. Buy and sell at extremes: Whenever you trade a volatile financial product such as crypto, you must routinely take profits. If your gains are extreme, sell half or all, but take something off the table. Resist the urge to be greedy when trading crypto (i.e. Fear of Missing Out or “FOMO”) or you risk holding until you lose most or all of your money.

3. Trade small: At first, aim for small gains. Sure, some people have made millions of dollars trading bitcoin, but like lottery winners, there are many more who have lost all or a good portion or all their money. 

4. Never buy on margin: When you go on margin, you borrow money from the brokerage to increase the amount you can buy. This is leverage, and it’s a double-edged sword. If you’re right, you can make substantial profits. If wrong, you may owe more than you invested. Wise traders manage risk, and that means not borrowing money to buy crypto. (You’ll know what I mean after you get your first margin call.) 

5. Keep mental stop-losses: It’s always wise to have stop losses, but because cryptos move so quickly, “hard” stop losses are often ineffective (one reason many platforms won’t let you use hard stops for cryptos). Instead, use “mental” stops and have the discipline to obey them. An alternative method is a “time stop,” i.e. tell yourself you will sell the position by a certain day, Friday, for example. This is an effective way of forcing yourself to lock in winners and cut losers.  

6. Don’t hold losing positions: If a trade is going against you, consider selling all or half — don’t let small losers turn into big ones. It’s true that those who sold bitcoin at $20,000 were shocked when it skyrocketed towards $60,000. Rule No. 7 shows you how to handle that.

7. Have a trading plan: It’s important to have a trading plan, especially for cryptos. Have a plan that helps you decide when to buy or sell. Follow the plan and obey your rules.  

8. Use technical analysis: Technical analysis gives you clues when to enter or exit a position. For beginners, the best two indicators are moving averages and RSI (Relative Strength Indicator). They are easy to grasp and provide good signals.  

As of June 30, 2021, bitcoin was well-below its 20-, 50-, 100-, and 200-day moving averages on the daily chart. (Bitcoin needs to rise to its 200-day MA of $43,794 to climb out of the basement.) On the weekly chart, although consolidating, bitcoin is still slightly above its 50-day moving average. 

RSI is 44.72 for bitcoin on the weekly chart. Although oversold, it’s not at extreme levels yet. At 30 or lower, it’s extremely oversold, but don’t use RSI to time when to enter. 

9. Diversify: Never put everything you own into one financial product. Buy crypto but spread your money across non-crypto investments. If that isn’t possible, make small purchases until you gain more experience and knowledge. 

10. Practice with a simulated account before buying: If it is available, practice in a simulated or paper money account before trading with real money. If you don’t have access to a test account, follow Rule No. 3. 



MarketWatch: 10 Rules for Beginner Day Traders

Link: http://bit.ly/3JzzElS

For those interested in day trading, consider the following: 

1. Start small: The No. 1 rule is to start small. Whether you are day trading stocks, options, or exchange-traded funds, if you are a beginner, start with no more than 100 shares of stock or one or two options contracts. This way you can make every potential mistake using as little money as possible. It can take years to learn how to be a consistent trader. Your tuition is the money you will likely lose as you learn how to manage risk. Remember, most day traders lose money at first, which is why you want to keep losses small.  

2. Trade for real, not practice: I no longer believe in using practice accounts. Practice accounts are not realistic if you want to feel the pain of loss and the thrill of making real profits. By trading small, (say $1,000), you will experience real emotions without severe financial damage when you’re wrong. 

3. Be selective: If you have less than $25,000 in your account, you are limited to making only three day trades during each five business day period in a margin account (contact your brokerage for specific rules). Once you make that fourth round-trip day trade, you will be designated as a “pattern day trader” and must put $25,000 in the account to continue trading. 

This is a good rule. Beginners will learn to make more selective trades, rather than buying and selling dozens of times a day. If you’re that good of a trader, you will eventually be able to build your account past the $25,000 threshold even if you’re starting with $5,000. 

Never trade more than what you can afford to lose.

4. Don’t be overconfident: The biggest danger to most day traders is overconfidence. Often, day traders make 5%, 10%, 20% on their money in one day. So instead of trading small, many traders bet big on the next trade, perhaps using margin (not recommended for most traders) — and instead of making the big score, they blow up their account. Never trade more than what you can afford to lose. Once you cross over from disciplined trading to gambling, you will likely lose money, perhaps all of it. 

5. Be emotionless: The best traders are often the most unemotional. When you think you are a genius (as many long-term investors thought a month ago), you could give back your profits. Here’s a hint: After I make a huge profit, I stop trading for the rest of the day, and perhaps even the next few days. If you feel giddy or too eager to make a trade, that’s a clue to stop trading.  

6. Keep a trading diary: If you want to be an educated trader, keep a trading diary. In this diary you will write all of your mistakes and what you learned. By writing it on paper,  you will eventually find strategies that work for you, indicators that will keep you on the right side of the market, and rules that will help you cut losses when wrong and increase gains when right. 

7. Concentrate: Beginner day traders underestimate the concentration needed when day trading. Although you don’t have to sit in front of the computer and trade all day, when you do have an open position, you must watch it like a hawk or you may lose money. Speaking from experience, in the past I had large open positions, went to lunch, and when I returned I had lost thousands of dollars. If you cannot watch your open positions closely, don’t trade. 

8. Trade only one or two stocks: You do not need to trade or even watch dozens of stocks every day. If you are starting out, focus on trading only one or two stocks or indexes. Popular index-tracking ETFs are good choices, such as SPDR S&P 500 ETF Trust (SPY) Dow Jones Industrial Average ETF Trust, iShares Russell 2000 ETF, or PowerShares QQQ Trust. Or you can choose one or two stocks and learn their trading personalities. The more stocks you trade, the more confusing it gets when the market turns on you. 

Aim for hitting singles, not home runs. 

9. Be content with small profits: Another huge problem for day traders is greed. Instead of being satisfied with a $100 or $200 daily gain, they fret over the money they could have made. At first, your goal is to be a disciplined and consistent trader. Aim for hitting singles, not home runs. Learn to book profits quickly, almost always before the end of the day, if not before noon. 

10. Don’t trade every day: You do not have to trade every day. On the days when intraday volatility is low, day trading strategies may not work. Eventually, after the next correction or bear market is over, volatility will get crushed once again. That’s when you may have to reduce day trading strategies and primarily use buy and hold. Meanwhile, strike while the iron is hot, because day-trading’s day in the sun won’t last forever. 



MarketWatch: 7 Common Day Trading Mistakes

Link: http://bit.ly/3XYbu9b

Stock trading is a high-stakes game, so if you’re playing at least learn how to improve your odds. Here are seven common trading mistakes and how to avoid them:   

1. Big, overconfident bets: Want to lose most or all of your money real fast? Make outsized stock-trading bets, like a roulette player betting it all on red or black. In fact, big trading bets are a form of gambling. 

Steer clear by trading in small amounts — 100 shares or less — and, it goes without saying, don’t bet more than you can afford to lose. 

2. Overtrading: Many day traders buy dozens of stocks that are moving up, hoping for a quick profit. Day trading too often and with too many stocks is a recipe for disaster. 

Trade just one or two stocks a day. Trying to manage anything more is for jugglers, not traders. Although the pattern day trading rule is annoying (you are limited to three trades in a five-day period if you have less than $25,000 in your account), it forces you to trade less but more accurately. 

3. Holding losers too long: Knowing when to sell losers takes experience. If you sell too quickly, you miss out on potential profits if the stock reverses. If you sell too late, you incur bigger losses. Most novice day traders typically hold their losers too long, hoping they will get back to even. 

Remember, you’re trading, not investing. Don’t hold losers, and rarely keep a position overnight. Once it’s clear the loser is not coming back before the market’s close, sell and live to trade another day. 

4. Selling winners too soon or too late: Managing your winning positions is as challenging as managing the losers. Many traders sell winners too early, missing out on bigger profits. Even worse, if they hold some winners too long, a profitable position can plunge to zero. 

The solution: Plan in advance for when to sell and stick to it. If you land a big winner, sell it all. If for some reason you have trouble doing that, then scale out of a winning position by selling half of it now and the rest later. 

5. Too many technical indicators: Many beginners believe the more market indicators they use, the better, as if indicators will lead you to the Holy Grail. Watching too many indicators is confusing and distracting, and prevents you from focusing on the only thing that counts: the market itself.   

The fewer indicators you use, the better. Choose one or two that work best (you have to experiment to find which works for you) and master them. Day traders I know use VWAP (Volume Weighted Average Price), or the NYSE Tick, for example. 

6. Panic buying the hottest stocks:   Momentum trading has been the rage, and many traders did well with hot stocks such as Tesla, Nvidia, Netflix, and Beyond Meat.

The easy days are over for momentum trading, yet many beginners still focus on the stocks that have had the biggest runs. What typically happens to these momentum stocks is that they stall, then fall, taking day traders’ money with them.  

Chasing hot stocks is risky and should be avoided because momentum can quickly turn against you. It’s all right to follow strong stocks whose price is trending higher — just don’t chase them. Day trading is enough of an emotional experience without you buying or selling in a panic. 

7. Not enough practice: Read a book or watch a video about day trading and you might think you’re ready to clean up. You’re not. 

Too much money and too little experience is a bad combination. Before staking a dime on a stock, practice with a simulated trading account to build your trading muscle. When you do venture in, trade with 100 shares or less until you understand how this part of the stock market works. (See tip #1.)  



MarketWatch: Clues that a Bear Market is Near

Link: http://bit.ly/3Y4wniT

Clues that a bear market is near

Although it’s tricky to predict when a bear market is near, there are clues. Here are some of trader Mark Cook's key signals:

1. Watch how the S&P 500 rallies: Cook paid attention when S&P 500 rallies were weak or failed. He said you can tell the strength of the market more by the way it rallies than the way it declines. He called them “one-day wonders,” meaning you may get a 1%or 2% rally in the S&P 500 (or more) that didn’t carry over to the next day. 

Even more alarming, if a strong early rally reverses direction by the end of the day, Cook saw it as an important warning sign. Typically, in a bull market, strong and healthy rallies continue not just for a day but for several consecutive days.

2. The buy-on-the-dip strategy fails: Buying-the-dip works brilliantly in a bull market, but it fails during a bear market. When the buy-the-dip trade is punished, Cook knew it was time to either switch strategies or risk getting mowed down.

3. Prices are always the last indicator to fall: Cook often said that the public watches stock prices for clues of a bear market, but that prices are the last domino to fall. No one knows what causes a crash or bear market. The catalyst usually comes from a source that no one has foreseen, hitting a market that is already weak. Prices plunge and everyone realizes the market is in serious trouble. According to Cook, the clues were obvious weeks or even months earlier. 

Crashes are not welcome

Cook did not like market crashes because they killed volatility. He often said that crashes are not good for anyone, especially traders. Cook thrived on volatility to make money. He preferred an occasional 10% correction to a crash. He told me he made the most money during corrections and bear markets. 

It also bothered Cook that he made money while so many investors suffered. Short-sellers such as Cook are often despised and even blamed for market crashes. Cook had to deal with being called names and not being invited to share his views on typically bullish financial news shows. 

Cook’s to-do list

Here’s a list of some of the ways Cook was able to thrive during crashes and bear markets. Keep in mind that these strategies are primarily for traders: 

  • Sell long positions and move into cash until the storm has passed. 

  • Buy puts on the S&P 500. 

  • Buy inverse ETFs. 

  • Short individual stocks. 

Cook said that the most prudent strategy for many traders is to move into cash or sell stocks to a point where they’re comfortable. Moving to cash is not designed to make a profit but to protect your portfolio and also to be ready to take advantage of future investment opportunities. 

Cook said that you must know how much pain you can accept (i.e., risk tolerance). If you can handle a 30% or 40% downturn, then stay the course. If not, move to the sidelines. 

Another key to surviving bear markets and crashes is diversification. If your portfolio is diversified, there is no reason to panic, which is what many people do when the market loses 20% or more. 

Cook left other valuable nuggets of trading wisdom: “One thing that must be stressed,” he wrote, “is that bear markets are not bad. Think of corrections and bear markets as trading opportunities. There is a pause in buying and then an all-out run for the hills when the grizzly is on their heels. When a bear market arrives, people descend into irrational thinking and actions. It always happens.”

He added: “Take the opportunity to learn about downtrending markets. You should also prepare for the next bull market that will emerge once the bear market ends. That’s when you can really do well. While trading on the short side involves good timing skills and experience, it’s easier to trade in a rising market.”  

MarketWatch: Teach Your Children to Invest, not Spend

Link: https://on.mktw.net/3GZCcac

As a guest speaker at colleges and high schools, I discovered that most teenagers are clueless about investing. They get an “A” for knowing how to spend money, and many work hard for income, but few know how or why they should invest in stocks, mutual funds, or index funds. Typically, most teenagers haven’t thought about building wealth by paying themselves first.

Sometimes the biggest obstacle to making money is our perception. We believe investing is rocket science, or something that only professionals can do. By giving your children the confidence to manage and invest their own money, they can learn to be financially independent with the freedom to do what they want in life. 

Do you want your children to be spenders or investors? In reality, they can be both. Before your children get their first credit card, show them how to make money work for them by investing. 

Here are some actions you can take if you want your children to build wealth:    

1. Open a joint brokerage account: Stick with self-directed brokerage firms such as TD Ameritrade, Fidelity Investments, Charles Schwab, and eTrade Financial  (to name a few). If your children do not know what a brokerage firm is, use this analogy: a brokerage firm is like a shopping mall but instead of spending money on clothing or electronics, you’re buying different investments that can make money. 

2. Open a UGMA (Uniform Gift to Minors Act) account: A UGMA is a custodian account used to hold and protect assets for minors until they reach legal age. The account can be opened at most brokerage firms with no minimum amount. Talk to the representatives for details in opening a UGMA in your state. 

3. Consider potential tax consequences: Talk to a tax professional or the brokerage firm representatives before you open an account. When your child reaches legal age, the custodian (you) must hand over the assets to your child. 

4. Start with an index fund:  The first investment your teenager should make is in a low-cost index fund such as a S&P 500 ETF (exchange-traded fund) that tracks the S&P 500 your brokerage firm will have a list of the most popular). The S&P 500 Index contains a group of 500 large U.S. companies, so when you buy the S&P 500 Index, you are buying a small piece of every company in the index. 

5. Have a routine: The goal in opening the account is to get your child into the routine of investing a certain amount of money into the fund every month (you could also set up an automatic payment plan). If needed, use a portion of his or her allowance to invest in the fund. Here’s a hint: Match by 50% any money your child invests. (If your child invests $100, add an additional $50, etc.). Look for reasons (like a birthday) to add money to the fund. 

6. Think outside the box:  The idea is to get children to think differently about how to manage money. By opening a brokerage account, you can show your children the value of routinely paying themselves the first of each month (in contrast to making a credit card payment). 

7. Dig into the details: Show your child how to read the brokerage statement (either online or by mail), and how to follow the index fund prices (which are posted online at dozens of websites including here). Your children will see how easy it is to make (or lose) money every day without much effort, or having to be involved with the financial industry. 

Here are some other ideas to consider: 

1. Teach patience: Regular, monthly allocations can help your child learn how to be a disciplined and patient investor, attributes they will need as they get older. With the power to manage their own money, they won’t need to depend on others to invest for them. 

2. Teach the difference between investing and speculation: Some teenagers will be so fascinated by the market they may be interested in speculating in individual stocks, or in the latest investment fad. That is fine, but keep the good old reliable index fund separate from any speculative investments.  

3. Teach market realities: As the index fund appreciates, your children may experience the thrill of making money in a bull market, or the agony of losses during a correction or bear market. The odds are good that over their lifetime, the account will grow in value (although there are no guarantees). The secret is to keep adding to the account and letting it grow on its own.  

In addition, help your child become financially literate without overwhelming them with financial terms. They may have questions about how money grows in value (compound interest), why they should put a certain amount in the account every month (dollar-cost averaging), why the index fund goes up or down (profitable companies within the fund go up in price, or vice versa), or if they can invest in something else (diversification). I suggest not teaching these concepts unless they ask. 

After your child has learned how to be an index investor (it can take years), they may want to select various mutual funds, or buy individual stocks. For now, however, teach your children to follow the market rather than trying to pick winning or losing stocks. 

After the investment account gets even larger, it will be hard for most people to resist withdrawing money (unless for a good reason such as college or their first house). But if your children can make investing a lifelong habit, starting as early as possible, they can focus on accumulating wealth rather than only spending. Teaching your children how to invest is one of the most important gifts they will receive, and the time to start is right now. 

MarketWatch: How MACD Can Give Your Trading a Boost

Link: https://on.mktw.net/3D9M7c5

For many stock traders, four letters can spell the difference between a winning and losing position. MACD (moving average convergence divergence) ranks among the key stock market indicators (along with moving averages and RSI) that traders use consistently in their analysis. 

Let’s discuss a number of creative ways to use this powerful and versatile gauge. 

MACD, introduced in the late 1970s, is a trend-following momentum indicator.  It helps to determine when a trend, and its associated momentum (i.e., directional speed and duration) has ended or begun, or might reverse direction. 

Be aware that MACD is a “lagging” or “backward-looking” indicator, which means its signals are delayed, but don’t let that deter you. When MACD yields a signal, it is often significant, especially if used on a weekly chart (versus the daily chart favored by short-term traders). In fact, the longer the MACD time frame, the more valid the results, which is one reason longer-term traders like myself prefer to use a weekly chart. 

When you view MACD on a chart, you see two lines. The black line is referred to as the “MACD line.” The gray (or red) line is referred to as the “signal line.” Remember: the MACD line is the leader line, while the signal line is the laggard line.

In addition, a horizontal line runs across the chart called the “zero line” (0 line).  The main function of the zero line is to alert you to the primary trend of the underlying price action. 

Four Simple Trading Signals

At its most basic level, MACD generates four signals: 

Buy: When the MACD line crosses above the zero line, it’s bullish. 

Buy: When the MACD line crosses above the nine-day signal line, it’s bullish.  

Sell: When the MACD line crosses below the zero line, it’s bearish.  

Sell: When the MACD line crosses below the nine-day signal line, it’s bearish. 

Note: When both the MACD line and nine-day signal line move in the same direction (uptrend or downtrend), that is a stronger, more significant signal. 

Keep in mind that just because MACD generates a buy or sell signal does not mean it is an actionable trade. Like that of any indicator, there are false signals. In addition, it’s essential that you confirm with other indicators before betting real money on a trade. Think of these MACD buy and sell signals as guidelines, not rules. 

Another limitation of MACD is that it does not work as well at stock market tops or when market volatility is low. Therefore, if you use MACD on the Dow Jones Industrial Average or the S&P 500 in this current market, the signal is not as useful. That is why you should use MACD on individual stocks until volatility returns to the major market indexes. 

What MACD says about Tesla

For example, the weekly stock chart of Tesla shows its MACD is above the zero line, and the MACD line is above the signal line. Tesla is also above its moving averages. 

Based on this information, Tesla stock currently is a short-term “strong” buy. If Tesla’s MACD line drops below its signal line while both lines are above the zero line, the shares would be a “moderate” buy.

A few years ago, I spoke with MACD’s creator, Gerald Appel. He told me that he created MACD in the late 1970s by entering numbers into a punch machine and a spreadsheet. After the personal computer was invented, he was able to automate the process. 

Appel expressed surprise that MACD became so popular. “It works because it’s adaptable to any time frame,” he said. “You can get a good reading of the major trend of the market by using MACD patterns that are based on monthly data. You can also use it on a five-minute chart.” 

MACD gives the most precise signals at market bottoms. Said Appel: “It’s more accurate at market low points than high points because of the way the market behaves. Market bottoms tend to be very sharp and pronounced, while tops tend to be broad and slow. It’s also possible for the market averages to keep drifting upwards while more and more stocks are falling.” 

Appel cautioned that you must confirm MACD signals against other indicators. “No indicator is infallible,” he said. “You might get a market rise and MACD turns down. Perhaps you think this is a sell signal. Well, it might not be.” 

Appel added that he likes to work with different MACD time frames simultaneously. For example, if the short-term MACD turns up along with the intermediate MACD, he’s more confident that the signal is valid. 

The MACD-Histogram

One of the most powerful (but often ignored) additions to the MACD is the MACD-Histogram. Developed by Thomas Aspray in 1986, this oscillator is used to gauge momentum. It is a separate program that should be available on your charting package. Traders who use this feature typically view both MACD and the histogram on a stock chart simultaneously. 

The histogram is a series of bar graphs at the bottom of the stock screen. If the bars move above the zero line, it means the underlying stock (or index) is gaining strength, i.e., momentum. If the bars move below the zero line, the stock or index is losing strength.  

Many beginning traders don’t realize that momentum always changes before price does. That is what makes MACD and the MACD-Histogram so valuable. Both indicators detect when momentum is weakening. It could also be a signal to become bullish if the histogram bars move above the zero line. 

Histogram Signals

  • If the MACD-Histogram bar changes to a lighter color, it means that momentum is diminishing. It is not a sell signal; it simply means that enthusiasm for that particular stock is waning. 

  • As mentioned earlier, if the histogram bar rises above the zero line, that is a buy signal. An uptrend may be developing. If the histogram bar drops below the zero line, that is a sell signal. A downtrend may be developing. 

Red Flags

If you see the index prices as well as stock prices move higher, but MACD turns lower, that is a red flag. In addition, if you see the MACD-Histogram changing colors and the bars getting shorter, that confirms momentum is weakening (but confirm this against RSI or stochastics). 

If you have never used MACD or MACD-Histogram, give it a try. Use these measures for any stock that has hit bottom and is on its way higher. They’ll help confirm whether the stock has legs or is a just giving traders a head fake. 

MarketWatch: 10 Rules for Rookie Day Traders

Link: https://on.mktw.net/3Wx2vdl

If you are going to day trade, it’s essential to have a set of rules to manage any possible scenario. Even more important, you must also have the discipline to follow these rules. 

Sometimes, in the heat of battle, traders will throw out their own rules and play it by ear — usually with disastrous results.

Although there are many rules, the following are the 10 most important: 

1. The three E’s: enter, exit, escape

Rule No. 1 is having an enter price, an exit price, and an escape price in case of a worst-case scenario. This is rule number one for a reason. Before you press the “Enter” key, you must know when to get in, when to get out, and what to do if the trade doesn’t work out as expected. 

Escaping a trade, also known as using a stop price, is essential if you want to minimize losses. Knowing when to get in or out will help you to lock in profits, as well as save you from potential disasters.

2. Avoid trading during the first 15 minutes of the market open 

Those first 15 minutes of market action are often panic trades or market orders placed the night before. Novice day traders should avoid this time period while also looking for reversals. If you’re looking to make quick profits, it’s best to wait a while until you’re able to spot rewarding opportunities. Even many pros avoid the market open. 

3. Use limit orders, not market orders

A market order simply tells your broker to buy or sell at the best available price. Unfortunately, best doesn’t necessarily mean profitable. The drawback to market orders was revealed during the May 2010 “flash crash.” When market orders were triggered on that day, many sell orders were filled at 10-, 15-, or 20 points lower than anticipated. A limit order, however, lets you control the maximum price you’ll pay or the minimum price you’ll sell. You set the parameters, which is why limit orders are recommended. 

4. Rookie traders should avoid using margin 

When you use margin, you are borrowing money from your brokerage to finance all or part of a trade. Full-time day traders (i.e. pattern day traders) are usually allowed 4:1 intraday margin. For example, with a $30,000 trading account, you’ll be given enough buying power to purchase $120,000 worth of securities. Overnight, however, the margin requirement is still 2:1. 

When used properly, margin can leverage, or increase, potential returns. The problem is that if a trade goes against you, margin will increase losses. One of the reasons that day trading got a bad name a decade ago was because of margin, when people cashed in their 401k(s) and borrowed bundles of money to finance their trades. When the bull market ended in 2000, so did many traders’ accounts. Bottom line: if you are a novice trader, first learn how to day trade stocks without using margin. 

5. Have a selling plan

Many rookies spend most of their time thinking about stocks they want to buy without considering when to sell. Before you enter the market, you need to know in advance when to exit, hopefully with a profit. “Playing it by ear” is not a selling strategy, nor is hope. As a day trader, you’ll set a price target as well as a time target. 

6. Keep a journal of all your trades

Many pros swear by their journal, where they keep records of all their winning and losing trades. Writing down what you did right, or wrong, will help you improve as a trader, which is your primary goal. Not surprisingly, you’ll probably learn more from your losers than your winners.

7. Practice day trading in a paper-trading account

Although not everyone agrees that practice trading is important, it can be beneficial to some traders. If you do open a practice account, be sure to trade with a realistic amount of money. It’s not helpful to practice trade with a million dollars if the most you have in your account is $30,000. Also, if you do practice trade, think of it as an educational exercise, not a game. 

8. Never act on tips from uninformed sources

Most pros know that buying stocks based on tips from uninformed acquaintances will almost always lead to bad trades. Knowing what stocks to buy is not enough. You also have to know when to sell, and by then the tipster is long gone. Legendary trader Jesse Livermore said it best when he wrote this about tips: “I know from experience that nobody can give me a tip or a series of tips that will make more money for me than my own judgment.”

If you can’t trust your own judgment, you may want to avoid day trading altogether. 

9. Cut your losses

Managing losing trades is the key to surviving as a day trader. Although you also want to let your winners run, you can’t afford to let them run for too long. It’s more art than science to get it right, but learning how to control losses is essential if you are going to day trade. Once again, never forget the three E’s: (enter, exit, and escape). 

10. Be willing to lose before you can win 

Although many traders can handle winners, controlling losing stocks can be difficult. Many rookies panic at the first hint of losses, and end up making a series of impulsive trades that cost them money. If you’re day trading, you must be willing to accept some losses. The key: know in advance what you’ll do if you’re confronted with losses. 

Although anyone can learn to day trade, few have the discipline to make consistent profits. What trips up many people are their emotions, which is why it’s so important to create a set of flexible rules. Your goal: follow the rules to help keep you on the right side of any trade. 

How to Get Started Trading Options

With the stock market becoming more volatile, it will be useful to learn how to use two basic option strategies: buying calls (if you believe the market or a stock is going up), or buying puts (if you believe the market or a stock will go down).

The benefit to buying either calls or puts is that you use as little money as possible to generate large returns. I’m sure you’ve heard the horror stories about speculating with options. Many people are afraid to consider options because they believe they are too risky, too complicated, or that you could lose your entire investment. There is some truth to these opinions if you don’t use options properly or if you don’t follow certain risk-management rules.

If you are willing to take the time to learn just the most basic two strategies (buying calls or puts), and follow the five rules listed below, you can bring in decent profits with less risk than if you had bought stocks. It’s hard for many people to believe that trading options is often less risky than trading stocks, but it’s true. In fact, the best part about buying single options is that your risk is limited while there is tremendous upside reward.  

Another advantage when buying calls or puts is the low cost. For example, instead of paying just over $22,000 for 100 shares of Apple stock (at current prices), you might pay between $500 and $800 for one call or put option (100 shares of stock = one option contract).

If you are right about the direction and timing of Apple, you can make many times your initial investment. If wrong, the most you can lose is all or part of the initial investment. Don’t get me wrong: it takes a lot of practice and studying to learn to get the direction and timing right. Learning how to trade options is like learning a new language. For those willing to take the time to learn, and follow the rules, it can bring in decent profits.

If you’re interested in learning more about options, here are five important risk-management rules to get you started. A failure to follow these rules (and others) can cause you to lose money, so before you make your first trade, read them carefully. I created these rules based on the many mistakes I made when I first started trading.

The following five rules should help you to reduce risk:

Start by learning only three option strategies: Although there are dozens of option strategies, start with only three: First, sell covered calls if you own stock and want to rent shares to option buyers. This strategy works best with low volatile stocks. Next, buy call or put options. Since every option strategy is based on buying calls and puts, it’s essential you master the basic strategies first. Hint: It can take one to two years to fully learn even the basics.

Focus on trading options on only one or two indexes or stocks: If you are new to options, consider trading index options such as SPY or QQQ rather than buying options on individual stocks. The indexes often move more slowly than individual stocks (not always, but often), and they are often less expensive than buying options on stocks. No matter whether you buy options on stocks or indexes, keep your trading universe small.

Use less money: No matter how much is in your trading account, do not trade with more than $2,500. This allows you to buy between 1 and 5 option contracts (equal to buying 100 and 500 shares of stock). The biggest mistake many people make when first starting out is speculating with too much money. Once you start “doubling down” on your option positions, you cross the line from trading to gambling. Limit the amount of money you trade so you aren’t tempted to bet it all on one trade (that’s how traders lose all their money). Consider the $2,500 (or less) as tuition money. You don’t need to trade with a lot of money to make a decent profit with options.

Not everyone should trade options: Keep in mind that “less risk” does not mean no risk. If you get emotional about winning or losing, if you have a gambling personality, or if you don’t have the time to watch your options positions, then you might want to invest in stocks, mutual funds, or index funds and avoid options altogether.

Read and practice: Learn how to trade options by taking introductory online classes or free seminars with the OIC (Options Industry Council) or the OCC (Options Clearing Corporation) at various locations around the United States. If you have questions about options, you can also call the OIC at 1-800-OPTIONS Monday through Friday during market hours. Avoid expensive classes that teach complex speculative strategies. You can also buy books on trading options online or at a local bookstore.

Keep it simple and don’t rush

To review, most beginners only need to learn three option strategies: The two basics — buying calls and buying puts — along with selling covered calls. Start with less than $2,500 (you can open an options account at a brokerage firm for less than $100), focus on a small universe of stocks or indexes, and continue to practice trading with a limited amount of real money.

There is a high likelihood you will lose money when you are first starting out, which is why it’s so important to start small. After a few weeks or months, you will either find that options are not for you, or that they’re a way for you to boost income. Just don’t rush in with too much money and too little knowledge.