All long-lasting edifices are built on a sure foundation, one designed to stand the test of time and Mother Nature’s wrath. Structural engineers have this truth etched deep in their bones and it’s one they abide by each and every time they begin a new project. Before getting bogged down in the details of the building, they focus first on establishing a solid base. Otherwise, their structure is destined to be unstable and dangerous.
Even singing superstars like Meghan Trainor know it’s all about that base.
In a similar vein, traders need a well-fortified base to build their trading empire on. If you’re interested in longevity, if you want to be investing until your inevitable trek to the Pearly Gates above, then focus first on your foundation. It’s easy to get caught up in the glitz and glamor of attention-grabbing trades like the Iron Condor or the Naked Strangle. But before you go chasing after these sexy-sounding strategies, you need first to build your base. To aid you in your quest, allow us to introduce you to the four core trading principles that comprise a successful trading approach. Consider these the unbreakable pillars that will ensure your trading can survive anything the chaotic markets can throw at it.
And because you’re undoubtedly a cool cat (else why would you be reading this?) we’ll be referring to these as “The Core 4” from here on out. All important concepts deserve a neat name to make them more memorable.
The Core 4 are as follows: Fundamental Analysis, Technical Analysis, Cash Flow, and Risk Management. Successful investors of all stripes understand not just the definition of each, but how to properly implement them. Each deserves its own well-thought-out and masterfully presented introduction, so let’s hop to it.
Putting the FUN in Fundamentals
With a name that begins with F-U-N, how can we not start with fundamental analysis? While you may not find this particular pillar wildly entertaining, it will at least be enlightening. And it’s actually a topic you already understand as a consumer. Any time you buy something you are making a conscious decision as to how much it is worth, its value in other words.
Let’s use a recent purchase of mine for example. I bought a book on Amazon.com for $20. Do you know why I was willing to pay $20? Because the information contained in the book, not to mention the joy received as I read it, was worth at least $20 to me. In this particular instance, I would have paid upwards of $30 or $40 for the book. But don’t think I’m telling the seller that. 😊 So my willingness to pay $20 says something about how much I think the book is worth.
Fundamental analysis is all about value. Except on Wall Street we use the term “valuation.”
Let’s suppose you are a real estate investor focusing primarily on flipping houses. How would you describe your job? Wouldn’t it be that you’re trying to spot a bargain? You know, an undervalued house, one you could buy on the cheap with the intent of selling it later at a higher price. You certainly wouldn’t want to buy an expensive property trading higher than its fair value.
Really, this is what value investors buying any type of asset do. They seek out things that are trading relatively cheap and scoop them up. Then they wait. And hopefully, prices return to some fair value or, better yet, they overshoot and become really expensive allowing these investors to now sell their asset for a pretty penny. This is the age-old game of buy low and sell high viewed from a value (or valuation) perspective.
Got it?
Fundamental analysis is all about studying the value of a company. This in turn tells us if the price we’re paying for that company right now is good or bad. And in this case, cheap equals good and expensive equals bad.
Let’s get Technical, Technical
Buy the best asset, but at the wrong time and you’ll lose mountains of money. Buy the worst asset, but at the right time and you’ll win boatloads. The trick, then, is in the timing. And that’s what technical analysis is all about. Whereas fundamental analysis focuses on identifying what to buy, technical analysis focuses on when.
When used in tandem the pair packs a mean punch.
In short, technical analysis is the study of price action. Any tool that focuses on analyzing the behavior of markets falls under its banner. Picture technical analysis as a super-sized umbrella with countless indicators and measurements falling beneath it.
While the usefulness of each tool varies, the indisputable champion of them all is the price chart. This is where all the action is displayed, where the twists and turns of each trading session can be viewed in high definition. It chronicles the evolution of an asset’s price over time and allows for all sorts of customization so you can tinker, test, and analyze to your heart’s content.
The price chart – a technician’s best friend
Like a radio, the stock market broadcasts a message each and every day. But only those schooled in price analysis can understand its meaning. To everyone else, the broadcast is garbled and meaningless. Fortunately, there isn’t any barrier to entry for those interested in learning how to understand these daily broadcasts. It begins with an investigation of what makes technical analysis tick.
As one of the Core 4, technical analysis is a pillar used to build a sure foundation for investing. But if you look closer, you’ll see it’s a pillar of pillars. It’s like a dream within a dream à la the movie Inception. But since we lack the wizardry of Christopher Nolan we’ll keep things on the simple side today. The three pillars of technical analysis are:
- Price Discounts Everything
- Price Trends
- History Repeats Itself
Let’s delve into each for greater detail.
Price Discounts Everything
Spectators complaining about the complexities of the financial markets will find a friend in the price chart. It’s a one-stop shop for comprehensive analysis. That’s because the price of a stock reflects all knowable factors – everything about the economy, the political environment, the management of the company and its fundamentals, and market sentiment. The price of a stock immediately reflects such variables.
It’s certainly a comforting principle, not to mention a massive time saver as once embraced it means you don’t have to sift through balance sheets or economic reports, or suffer through the daily barrage of news flow. True technician’s care little for such activities. Like Patrick Henry of old, their battle cry is, “give me price charts or give me death!”
The recognition that price is the only variable that makes or loses you money helps underscore its importance. Think about it this way. You could predict everything Apple Inc. does as a company over the next year perfectly – its earnings, new product offerings, increase in market share, and so forth. But get your forecast on its stock price wrong and you still lose. Alternatively, you could fail miserably in predicting everything about the company’s fundamentals over the next year. But if you get your forecast on its stock price right, well, you still win.
Price Trends
Some academics profess stocks follow a random walk. Predicting the market’s next move, they say, is as foolish as forecasting the next step of a drunk stumbling down the alley. Technical analysis lovers disagree, professing that prices aren’t completely random. And that is primarily because of the principle that prices trend. Indeed, much of the work in price analysis is determining the current trend of prices.
You see, a trend in motion stays in motion. The idea is to spot trends early, climb aboard, and ride them. Trading in the direction of the primary trend stacks the odds in your favor. The reality of trends is blatantly obvious when you look at a long-term chart of the stock market.
Trends with Benefits
History Repeats Itself
To introduce this particular pillar we turn to a famous trader of an earlier era, Jesse Livermore.
There is nothing new on Wall Street. What has happened in the past will happen again and again and again. This is because human nature does not change, and it is human emotion that always gets in the way of human intelligence. Of this I am sure.
The one unchanging element to the financial markets is humans. And though today’s landscape is vastly different than that of earlier centuries, you and I aren’t all that different than our predecessors. Fear and greed drive our decision-making just like it drove theirs.
And if you think about it, the collective decisions of investors is what creates chart patterns. This is why adherents to technical analysis spend so much time pouring over the past. Hidden within its closets are clues for forecasting the future. If you want to understand better how stocks bottom at the end of a downtrend, then study bottoming patterns of the past. If you want to understand better how stocks top at the end of an uptrend, then study stops of the past.
In summary, making money in the markets is all about timing and technical analysis provides the best timing tools on the planet.
Cash Flow
The ultimate goal for most individuals seeking to exit the rat race is to create enough passive income to pay their bills. If you have $5,000 in monthly expenses, then your goal is to build enough cash flow from your businesses, real estate, or financial investments to score $5,000 a month. Accumulating assets isn’t as important, then, as being able to generate cash flow off of those assets. Business owners create cash flow from tapping into the profits generated by their company each month. Real estate owners generate passive income through rental income. Most people were probably aware of both tactics. But few realize you can also generate cash flow using the financial markets.
That’s right, friends. It’s possible to create monthly cash flow in stocks and even commodities like gold and silver by using options strategies like covered calls and naked puts.
Here’s how we like to think about it: Investors holding stocks and commodities who fail to sell covered calls are like real estate investors who own property but fail to rent them out. They’re missing on a potentially life-altering avenue for cash flow! Buying an investment property today with the sole purpose of sitting on it for five years in hopes that you can later sell it at a higher price is fine and dandy, but the truth is you’d be much better off by throwing renters in there and at least collecting rent along the way.
Stock investors that are willing to learn about how to sell options discover it’s possible to get paid for their willingness to both buy a stock they didn’t previously own and to sell a stock that they currently hold. Month to month it is possible to get paid for your willingness to part with the financial assets in your portfolio.
And that’s just step one.
Once you learn how to generate this monthly cash flow, you then have the ability to use it to compound your gains. Now when you hear the word “compounding” just think of it as acceleration – it allows you to speed up the rate at which you make money.
Essentially we can use the cash flow generated from our rental income (aka the covered call) to buy more shares of stock. And with more shares of stock we can sell even more covered calls. And more covered call selling brings in even more monthly cash flow which can be used to buy even more shares of stock.
It’s a virtuous cycle.
Smart investors learn not just how to accumulate assets, but how to effectively generate cash flow on those assets. And the key that unlocks this ability for investors in the financial markets is options.
Risk Management
The allure of financial gain is what drives people to Wall Street. And understandably so. If you want to retire or grow your wealth you must, of necessity, invest. But darn it if the exercise didn’t involve risk! Now, risk is a multi-headed hydra with various threats to be concerned with. But undoubtedly the biggest is principal risk. That is, the risk of losing your precious capital. The venerable Warren Buffett, known to many as the world’s greatest stock investor, had this to say about risk:
Rule N° 1: Never Lose Money. Rule N° 2: Never Forget Rule N° 1
Your capital is your castle, one deserved of protection. You’ve worked hard for your money in the hopes that one day your hard work, your scrimping and saving, would bear fruit. It’s important therefore not to be frivolous or cavalier about the way in which you invest. Think of risk management as the act of building a moat around your money. The best traders adopt sound risk protocols that make it impossible to lose a significant portion of what they’ve fought so hard to accumulate.
Boxing brute Mike Tyson said,
Everyone has a plan ‘till they get punched in the mouth.
Well, if you want to be a successful trader you better have a plan for the exact moment you get punched because it will happen again and again. And in case you weren’t aware, Mr. Market boasts biceps the size of Popeye and knows how to swing.
For most investors, the days of black eyes and bloody lips arrive in the form of bear markets where stock prices tumble 20%, 30%, 40%, or worse. There are few things that test your mettle as much as an episode where your beloved portfolio, one which you’ve built for years and even decades, experiences a harrowing haircut. Historically, these bear markets strike roughly once every four to five years. Once or twice a decade, essentially. For context, check out the following graphic which chronicles the duration and magnitude of every bear market in the Dow Jones Industrial Average since 1929.
The worst two on record was the 1929 crash which saw stocks crater some 90% and kicked off the Great Depression and the 2008 crisis which delivered a 55% decline and ushered in what has been called the Great Recession.
While both were certainly outliers, we can’t rule out the possibility of the stock market getting halved at some point in the future. To prepare for the next downturn you must have risk protocols in place. Sitting on your hands as your investment portfolio goes up in flames isn’t just a heart-wrenching, dream dashing exercise, it’s entirely unnecessary. If you’re willing to but educate yourself, you can learn how to protect your entire nest egg. Building a moat around your castle is a cinch with the right tools.
Just as you purchase insurance on your home to protect yourself in the event of a natural disaster, you can buy insurance for your portfolio using options contracts. This is something professionals and informed individuals do in the marketplace right now.
The contract that is most analogous to an insurance policy is known as a put option or put for short. Puts give you the right to sell an asset at a set price and it rises in value as that asset falls. It is possible to buy puts on the S&P 500 or any other popular stock index to protect against a large loss in your portfolio. Instead of suffering a 30% or 50% drop during the next crisis. You can minimize your loss to something like 10% to 15% even if the stock market another crash like 1929 or 2008.
In summary, we will suffer numerous bear markets over our lifetimes. But you don’t have to suffer through these episodes unprotected. Learn how to use portfolio protection and you won’t find these catastrophes near as bothersome.
Upon learning and properly incorporating the Core 4 pillars you will be well on your way to building a profitable and long-lasting approaching to investing for the rest of your life.