Well, I promised I’d get back with you on the basics of a fundamental investing plan - and by that, I DON’T mean I’ll be answering questions like “what should I buy?”, “when should I buy it?”, or “when should I sell it?”. I assure you, there is no shortage of advice available on those questions - you can hardly swing a dead cat around the room without hitting a dozen or so people eager to provide the answers - especially when there’s a commission involved.

No, when I say “investing plan” or “trading plan” (with the latter becoming a more logical approach every week), I’m referring to something that, if written down (which it must be) and followed with an ironclad discipline (another must), will allow you to approach the market of your choice with a set of rules that, properly chosen and adhered to, come very close to answering those more specific requests for guidance all by themselves.

Let’s also take a moment to reiterate that investing and trading is no longer optional (please refer to Part 1 of this article, printed last month in this journal, if you need a refresher) - the plain fact is, you won’t make it without it. There is no way in today’s financial climate to achieve any semblance of security otherwise - or as USA Today put it so chillingly in a week-long series on retirement a few year’s back, “for an increasing number of Americans, retirement consists of a trailer park and a satellite dish” - not exactly a match for the silver-haired couple you see on TV today, smiling at each other as they stand near the rail of a cruise ship that is plying the Alaskan waters. Do those couples exist? Sure they do - just not in the numbers one would hope or anticipate. For many others the stark reality is much more likely to resemble USA Today’s description than the image of the cruising, carefree couple.

If you prefer not to be among those in the trailer park, then squeezing something extra out of every dollar that passes through your hands is mandatory - not a task that you plan to do “if you have the time”. You will make the time, or, financially speaking, you will perish.

OK, let’s dispense with the obvious first - you must never invest (or trade with) the rent or mortgage money, the grocery money, or any other funds that, as they say, “you can’t afford to lose”- because, when you really can’t afford to lose something, along will come one of those “law of the universe” things again, and lose it you will. And of course a good investment for a 20-year old who has 40 years or more to either realize a gain or to recover from the experience of a loss, may be quite different than what may be considered appropriate for a 60-year old who intends to retire within the next few years. We could continue in this same vein, but you get the point - any good plan will have allowances for both present circumstances and future goals. For both emotional and demographic reasons, “risk tolerance” must be assessed with a clear eye. Lastly, if you are capable both fiscally and temperamentally to trade as a genuine “speculator”, then you don’t need this article anyway and you can just go watch “The Bulls and The Bears” right now.

With that having been said, there are nonetheless some universal principles which apply to the rest of us, across the board - they just need to be tweaked or adjusted in such a way that they apply specifically to you. And neither am I referring to the “financial plan” such as is provided by a fee-based CFP from American Express or some similar firm. I’m talking about the plan you need if you are self-directed, either will or already do use an online Broker, and possess the requisite self-control to do what you’ve set out to do, no matter what - not to mention saving that $1000 or so for trading, rather than giving it to someone who is more concerned about their own retirement than yours. In any case, a plan emerging from that kind of consultation (not necessarily from American Express, but from a “financial planner” of any stripe) will also most likely ignore the fact that “buy and hold”, while it did have and still has, in some circumstances, its place - just doesn’t cut it as a strategy for creating financial independence for anyone closing in on that time of life when one has the realization that financial matters are not proceeding as once had been hoped. The plan referred to here is that which applies to those who want to actively make money in the market - whether as a day trader, swing trader, or whatever - but whose investment timeline is measured in months, weeks or less - and who will then be trading again.

As was mentioned previously, Elliot Wave International editor Jeffrey Kennedy states in his “Five Fatal Flaws of Trading” piece that if your plan cannot “fit on the back of a business card”, it’s probably too complicated. In that spirit, let’s review the elements of a sample trading plan.

Let’s first demonstrate how few (in this case four) “rules to live by” a good trading plan must contain.

With the foregoing having been duly considered, you should first take stock of the sum of all funds available for trading purposes - your total account balance - and resolve that at any one time, there is some percentage of that total beyond which you will not commit to be at risk at any one time. Most traders I talk to suggest a number around 2% of your account value. This means that if you have $100,000 to trade with, you will never place at risk more than $2000. I don’t mean in any single trade (unless you only take one position at a time) but rather that if you were to aggregate all of your open positions, and calculate your total exposure, it would not exceed $2000. If this seems excessively conservative, the purpose of this rule is to ensure that you will live to trade another day. Expose yourself to a risk of 25%, and just four losing trades will clean you out - you’re done, finished, over.

This first rule implies that to experience some gains in a relatively short period, you will need to trade in some kind of derivative - like options - as opposed to buying equity positions outright. The benefit here is twofold - you gain the advantage of leverage, by controlling positions for a fraction of what they would cost otherwise, and secondly your total exposure to risk is clearly identified - you can lose no more than you have invested (either through cash or margin) and the gain or loss will be realized within a short, predictable time frame. Options expire (most often worthless - which can be either good or bad depending on which side of the trade you were on) on a specific date; you take stock of gains or losses at that time, and make plans to re-enter the market. If you adhered to your 2% rule, in the worst of scenarios you would still have $98,000 with which to continue.

For rule number two, resolve to place limit orders only. Why anyone would expose themselves to the possibility of a trade being executed at a number other than that which they had intended (unless it is more favorable one), via a market order, defies comprehension - but investors do it by the thousands every day. In many cases, investors and traders become emotionally attached to a particular security, and are simply not happy unless they can own or control it - whatever the cost - because it is the darling of the market at that moment. Never lose sight of the fact that you are trading to make money, plain and simple. What do you care if that money is made from Acme Widgets or Allied Doodads? Let your friends at the office get lathered up over Apple or Google - unless they fit into your trading strategy, the cache of ownership will never outweigh the pain of losing money because you were seduced by a cool company with a sexy new product. If it doesn’t fit with your plan, don’t buy stock or options on Apple - go pick up an i-Phone instead, if your self-image demands that you be associated with the latest and greatest in the eyes of your friends.

Your third and fourth rules are simply the target you place for profit, where once achieved you have resolved in advance to take your money off the table - say 20%. That’s a tidy little sum, especially if achieved in a few months time. On the other side of the ledger, you resolve that you will allow no loss in excess of 7% - this is in a given position, which must still conform to your overall account limitation in rule number one - so again, the money comes off the table once that 7% trigger is reached.

OK - four simple rules. You are safely on the “back of a business card” - and how have you done?

Remembering that these rules are IMAGINARY (disclaimer) and will vary from person to person, in addition to requiring adjustment based on results - let’s see how your trades turn out, using as examples equally imaginary positions. In no way does their imaginary status detract from their validity - they are imaginary solely to allow round numbers to be used for purposes of simplicity and clarity - and in the real-world markets, simplicity and round numbers are not to be expected, and we will further assume they take into account items like commissions, etc.

After having removed all thoughts of lawsuits from your mind, either against this writer or this publication, IMAGINE that you were dividing a $10,000 account balance among 10 positions, each position requiring $1000 to open (you would not do this if it violated your 2% rule, of course). Let us further imagine that you had done rather a poor job of selecting positions, in terms of the percentage of those that went well and those that did not. In fact, let’s say fully 60% of your trades are closed out because the 7% loss mark has been hit. If out of ten positions, 60% had been closed, per your instructions, at a loss (even though they MIGHT have returned to the positive), then 6 trades would each lose 7%. At an opening value of $1000, the loss per trade would be $70 - or $420 for the group of 6. (For those who are actually following along, you will note that this loss exceeds our rule number one risk limit of 2%, or in this example only a total risk of $200 would have been permitted. The way you would accomplish this, had you actually been placing these trades, would be to have limited your exposure at the appropriate level by hedging the position - in other words, opening a position (or positions) with risk “a” would require a hedge in another position that had risk “b”, appropriately limiting your net risk to the 2% self-imposed rule. If one position goes against you, a second has been so positioned to make up for the potential loss incurred by the first).

As the poor trader you are, you managed in this example to pick only 4 winning positions, each closed at your instruction at a 20% gain (even though they MIGHT have gone higher) - your money is taken off the table, and you content yourself with the 20% gain you set out for. Although these represent only 40% of your original 10 trades, they each have a 20% profit - $200 per position, or $800 total gain.

Well, an $800 gain less a $420 loss nets $380 into your account balance - a 3.8% return on the $10,000 invested. Your account balance is now $10,380. It may not sound like much, accustomed as we are to seeking the “big score” - but what if you could repeat this process every three months? That would be 3.8% times four - or 15.2% annual return with no compounding. Do it every two months and its a 22.8% annual return.

It’s starting to sound better, isn’t it? According to the Rule of 72, your account value would nearly double every three years (38 months) at that rate.

Starting with $10,000, that would be $20,000 in three years, $40,000 in six years, $80,000 in nine years, and $160,000 in twelve (again, no compounding).

Start with $100,000 and the twelve year account balance has become about $1.6 million. That’s encouraging if you’re closer to retirement than you are to high school.

If all this is imaginary - what is the purpose?

The purpose is this:

• The imaginary aspect was just to illustrate a point
• Although we don’t live in a round number investment world, similar results are achievable
• You can lose more often than you win, and still come out ahead - focus on your account balance, not the individual trades
• Having and sticking to a plan removes the emotions that cripple and kill traders - fear and greed - if things still look good, re-open the position
• It is the existence of this plan, and the adherence to a sytem, that separates the 10% who make money trading from the 90% who do not

A few more items worth mentioning:

• This same system works for short term plays on equities
• You can do all this in the options market with simple puts and calls - there’s nothing wrong with spreads, strangles, or Fibonacci numbers - but you don’t need them either
• Get an education before you start - find people, publications, and trading environments you trust
• Don’t pay $50,000 in valuable trading dollars for software or other tools - many that are just as good are available free from brokers or other trading sites on the web - and definitely for a lot less
• These rules may or may not be good rules for you and your situation - identify your goals clearly, get some education from a trustworthy source, and then stick with your plan - remember, no matter how much you start with, if you never risk more than 2%, you’ll never go broke

Lastly, the real value here is to have a system that can work whether the market goes up, down or sideways - and recently, we’ve seen it all.

Get rid of the emotion - don’t let fear and greed, sweaty palms and a sinking feeling in the pit of your stomach prevent you from doing what you HAVE to do - if you’re feeling those things, you’re doing something wrong.

Once accomplished - in other words, if you have a plan, and you’re sticking with it - you are on your way - and you will be able to create an income -independently, requiring jobs or favors from no one - for the rest of your life.

Continue reading journals like this one - expanding your knowledge base and exposing yourself to opportunity - and things will only get better.

Your friend in self-reliance,

George