Get Rich or Die Trading: 10 Rules to Live By in the Stock Market
Part 1:
Plan your investment and invest in your plan
There’s no worse feeling than being turned into an accidental investor on a short-term trade. One of the most common mistakes that stock traders make is failing to plan and therefore turning a speculative trade into becoming an involuntary shareholder once the trade goes against you, after you become too afraid to take a loss and accept defeat. The most common rookie mistake is to throw a few thousand dollars at an opportunity and then to hold the course even thought it doesn’t go up as you anticipated. This is the easiest way to blow up your trading account.
Later I’ll break down the importance of stop losses, but for now it’s important that you understand the monumental difference between investing and speculating.
Investing vs. Speculating
When someone invests in a stock, their outlook should be upwards of 5 or more years with few exceptions. When you’re trading, your outlook can be as little as 5 minutes. The key difference between the two is that when someone is ‘investing’ they shouldn’t care what the price does short-term once they own their position.
Think of it as the difference between renting shares in a business vs. owning a small piece of a company.
If you invested in a stock at $10 per share and the next month it falls to $5, you should be pleased at this opportunity because now you’re buying more of a company that you like, at 50% off. It’s on sale and you can buy 2 for 1 vs. your cost per share last month. It’s a gift if you’re a long-term investor of the business. BTFD, as it were.
Alternatively, If you were making a trade and you bought a stock at $10 per share and it falls to $5 the following month, then you have lost half of your position when you could have implemented a stop loss of maybe 10% and protected your downside, losing only a $1 per share on the trade. You gave up 50% of the position due to not having a plan in place – and may never see it back if the return to $10 takes longer than you can wait, if it happens at all. Once you’re cut in half, you need to make 100% to get back to even. It sounds obvious, but if it was, traders wouldn’t let their stock holdings fall by 50%. With a plan it’s impossible.
One of the most critical tools of the trade is your trading journal
When you use a journal and physically write down your plan prior to making any moves, it allows you to stick to a pre-defined plan, refer to it when needed, and to not allow your emotions to get in the way when things inevitably go unexpected. More often than not, even on a good trade, a trader will chop the trade early because greed and or fear kicks in and he sells to realize or “lock in” the gain. We’ve all done it, and it can be damn hard to sit on your hands on a winning position. But that’s exactly what the disciplined traders do; chop their losers quickly and let their winners run.
Conversely, if the trade goes against you and you failed to create a solid plan around a stop loss, you will turn into an inadvertent investor and you will watch that position fall day after day, greatly affecting your mental state and thus future trade decisions. Failure to plan is certain death.
Averaging down
Averaging down is a controversial subject, mostly because it is often the right thing to do, and other times it is the kiss of death.
For example, if you are investing for the long-term on an ETF with a basket of various stocks and you are buying and adding more to that position every month, then you are properly averaging down and it’s referred to as dollar-cost-averaging – which is a very good practice to do over the long term to take advantage of pricing dips.
For a trader that speculates on a gold position using call options; if the position goes south on him when he is trying to play to the upside and he starts to average down on his call options, he is literally “throwing good money after bad”. He is doubling down on a trade which he should have been stopped-out of immediately. This is an incredibly common practice and probably the easiest way to reduce the value of your portfolio. It’s the number one mistake I see with new and seasoned traders alike.
There are many strong opinions about averaging down, many of which fail to make the massive distinction between long-term investing in short-term speculation. In short, averaging down, or dollar cost averaging on positions which you aim to keep for a long time is generally a sound practice. Whereas adding more money to a position that has gone against you to try and lower your cost basis only to “get back to even sooner”, is a common, amateur mistake. The author is speaking from experience.
Paper-trade first
Before a trader ever submits a fill order to go long or short any sort of position he should spend a considerable amount of time paper trading. It’s free and it’s the most effective way for you to plan out your investment or trade. Failing to plan means you are planning to fail.
Paper-trading is just like it sounds, it’s the practice of making the trade, but only on paper as a free way to test the waters and to see how you would have done had you traded with real capital. There are also many online brokers that now allow free practice-trading accounts and there is also plenty of software programs out there that now allow you to do simulated trading for free. Although doing it with pen and paper is just as effective and in some cases great practice for future journaling once it’s real capital.
The best traders out there still paper-trade as well as back-test on paper to find out how they would have done in a simulated environment before they put capital to work. It’s easy to be impatient and ready to step into the game immediately, but like any skill it requires significant practice and repetition behind the scenes before you are ready to show up and perform at a pro level.
Example
In early 2009 I read a compelling article about the incoming need for cost-effective solar energy solutions. I was of the same opinion so I started researching various solar stocks in which I could speculate on in the near-term – something like a 2-3 month swing trade to take advantage of the coming popularity in solar. I settled on the cheapest priced one I could find which was my first critical error. Oftentimes the lowest price-per-share of your options is the most attractive because you can buy the most shares, when in fact you are statistically far better off to pick the first or second largest in the respective arena you are looking at – both in terms of protecting your downside as well as statistical performance probability to the upside.
The company I chose had a price per share of about $0.80 so I bought my first 250,000 shares hoping for a swing to the dollar range for a nice 20% gain in a few months.
The first mistake I made was picking a very illiquid stock which is something I will discuss in detail at a later date.
As many penny stocks do, as soon as I started to bulldoze into the market and buy shares off of the offer, the sellers hiding behind the curtain came out of the woodwork and started to sell into the bid thinking this could serve as a liquidity event for them (very common). As such, the stock subsequently was down in the $0.70 range in a period of about 5 days. I didn’t think too much of it so I continued to buy another hundred thousand shares all the way down to about $0.68. I didn’t panic, I simply let greed run rampant as I now “controlled over 350k shares of this promising new solar venture” ….what a degenerate, gambling and blind-greed mindset it was in hindsight.
I didn’t start to worry until about a month later when the stock was now hovering around the $0.45 mark, so I decided to double-down, lower my cost per share yet again, and at this point I had well over a half-million shares so I started to reach out to the company to see if I could get some reassurance from management that I wasn’t making a stupid decision. Now of course when I got the CEO on the phone he said everything I wanted to hear, validated my fear and even triggered my greed even more which caused me to buy more shares. In hindsight, that was the most damaging part during this. Now my ego wanted to be able to say “I owned a million shares”, and to feel like I was “a part of” something, since my trade had gone so bad and now I was an investor in this promising young startup – an involuntary investor mind you.
I kicked the plan and was now running on pure fear & greed FOMO – emotional decisions never work out.
Now keep in mind, at this point I have not only deployed much of my liquid capital, but I was also showing a significant loss with a cost basis somewhere in the $0.75 range on my 1 million shares trading at about $0.40. What happened, which so often happens with penny stocks is that the treasury ran dry and the company had to go to a market offering called a ‘private placement’ which is the sale of new shares to accredited investors at a set price, in this case it was $0.45 which had a negative impact on the stock, further diluting the company and lowering the share price in accordance with the now higher amount of shares outstanding. In other words, when I began the journey this company only had about 25 million shares outstanding, now it had about 40 million. I should have cut the chord and never looked back right then.
After one private placement to ‘keep the lights on’ and sustain the business, the market capitalization of the business at $0.40 was about $16 million. Prior to the raise, the market cap of the business at $0.40 would have been only about $10 million.
So you can see and understand the effect these dilutive share offerings have on the value of the price-per-share relative to the market cap of the business. Aways watch these penny stocks incredibly closely, since loose exchange regulations allow for very liberal issuances to management as well as things like options and warrants for the bankers and investors who keep the party alive. All the while the little investor at home on his online brokerage account is often completely ignorant to the fact that the share count is increasing quarter-by-quarter in some cases quite drastically, and in this case it was a dramatic increase in shares that was a continued theme throughout 2009. A good opportunity to stress the importance of good independent directors; governance is the only insurance against bad or inexperienced management.
Further, CEO .ca and Twitter .com should not be where you do your due diligence. Yes, I’m talking to us all with that statement.
Often times you will see a share price slowly deteriorate over time and assume that the business is getting cheaper, when in reality the market cap is actually staying the same or in some cases increasing despite the decreasing share price because they are adding more shares to the issued and outstanding amount while the share price is coming down. An Incredibly important checkbox in your due diligence process. It is a trap and is something that needs to be addressed by regulators as it relates to specific disclosure around dilution in between reporting periods.
Less than five months after my initial purchase and once the private placement four-month unlock allowed the private placement sellers to offer their shares, I was now looking at a $0.25 price per share and a business that now had a total market market cap near where it was many months before, above $0.60 per share.
Needless to say I had blown myself up with my own naivety, greed, people-pleasing of the ever optimistic CEO, and ego as my share count increased and I told others of my ‘big position’ which was now worth far less than half of what I paid for it when I started the ill-planned trade. It was all avoidable had I created and stuck to a plan.
Rollbacks
I give you this example of the solar trade because it carries an equally as important lesson about becoming an involuntary shareholder who is then strapped in (trapped) for a potential fractional rollback of micro cap companies.
As bad as it was that I bought a company near a dollar and didn’t even sell it when it went below a quarter, I hung on through a rollback of the shares. Nearing the end of 2009 the share price had come down so low that the company was no longer able to attract new investment so it did something in the business known as a rollback. Management had made a series of bad decisions, the biggest being a cannibalistic process known as check swaps with promoters which is something I will also discuss in a later post.
When a company has 100 million shares outstanding, and it’s price per share falls to 5 cents, it will often reverse-split that cap table say 10 for 1, which would mean that it reverse-splits it’s 100 million shares into only 10 million shares, and it’s price per share is now comfortably at 50 cents instead of 5. The reason is mostly optics, and it is almost always a sign of bad management and fiscal responsibility resulting in a sort of reset of the capitalization table of a failed or fledgling business. I also view it as deceiving with the recent $TSLA and $AAPL splits. Young people are easily tricked into thinking that the stock is now “cheaper”, all the while the market cap keeps cranking up unjustifiably. Tesla is more expensive today at $375 than it was at $1,450 per share 30 days ago, pre-split. Sadly, there are still people trading who think the price is ‘more attractive’ than it was a month ago. Very concerning.
Much like a pizza you can cut it into four pieces and each of you get a quarter, or you can cut it into eight pieces and everyone gets two. The pizza is the same size and weight, but the ratio in which it is split up is different. It’s the same thing with a share rollback. I have seen many share rollbacks take place where naive investors aren’t even aware of what it means and they fail to look at the market cap and instead focus solely on the price per share which is an extremely dangerous oversight that is sadly far more common than one would think. Often a share is steeply sold off after a roll back has taken place, with naive investors who didn’t see the roll-back news, seeing the increased price-per-share on the stock in their accounts and selling it at market, driving down the price, not realizing that the fractional change had just occurred, and that they’re still at yesterdays price, albeit displaying a much higher price per share.
If Mr. CEO is going around town trying to sell a private placement at $0.50 with 10 million shares outstanding, the optics of that offering are far more attractive than if he were offering it at $0.05 with 100 million shares outstanding. In both cases he is selling shares at the exact same price; the market cap of the business, or the “pre money valuation” is still $5 million pre and post roll-back. A dirty little tool in the penny stock market.
Back to my promising solar venture, once I had acquired over a million and a half shares the company underwent exactly that; a 5 for 1 reverse-split leaving me with only 300,000 shares, at a new cost basis of around $1.25 in a company that now has a share price, post rollback, of only $0.20. I had invested over a half-million dollars and my “investment”, only a few quarters later, was worth less than $60,000 showing no signs or reasons to ever return to the levels I first started buying it at. Worse yet, it was busy trying to find new versions of me, to do this all over again since the CEO’s primary job title was selling stock, not solar panels.
Despite all of this, the CEO continued after the rollback to tell me to “buy more cheap shares” because it was “undervalued” and that it would “definitely come back when people figure out how cheap they are”. The standard script of the penny stock pusher.
I eventually took the tax-loss and never looked at the chart or price of the stock again. The peace of mind once you finally exit your losers is often worth every penny of the loss and it was a loss I should have taken a week after the trade went against me. Ego, greed, fear and people pleasing all played a part in this loss and more important; it was a monumental waste of time and energy. Time – hundreds of hours spent only because I hung onto a trade when I knew right away I made a mistake. I hope that my real-world example helps others to see just how easily emotions can get in the way of making sound business decisions; even when you know better. Trading stocks and investing in businesses are not even in the same ball-park.
Plan your trade and trade your plan and never let bad trades turn you into an involuntary investor.