Is Your Investment Account a Ticking Time Bomb?

Bomb

Is your investment or trading account a ticking time bomb waiting to blow up? Hopefully not. Big losses that decimate portfolios usually come without warning and are difficult to recover from. It can take many years to grow an account and only a couple months or weeks to give up hard earned gains. As an old Wall Street saying goes the bull marches up the stairs and the bear jumps out the window. Knowing what NOT to do and avoiding unnecessary risks is the key to long term success in the markets.

 

There are many different factors that contribute to destroying equity in an account. Throughout my 13 years of trading and investing I've learned some crucial lessons on how to avoid disaster. These lessons aren't cheap so I suggest you try and avoid the following...

 

Over use of leverage/margin: Leverage is a double edged sword and If used correctly in the right situation it can be a valuable asset. However, using leverage or margin without the proper knowledge can be dangerous to your financial well being. Just ask currency traders who were short the Swiss Franc back in January of this year. An unexpected event can cause a position to move drastically against you and your account could end up going to zero (in some cases beyond) very quickly. Using margin to trade leveraged Exchange Traded Funds (2x and 3x Long or inverse funds) or ETFs that rely on the price of a specific futures contract can add another layer of risk to your all ready leveraged position. Do your homework and understand the risks involved before using margin or leverage in your portfolio.

 

Buying Penny Stocks: A Penny stock can be defined many different ways but it's usually a low priced stock that has a small market capitalization, a large bid-ask spread and lacks liquidity. These securities usually trade for "pennies" for a reason. They're not proven companies and the vast majority will never turn a profit. Most listed penny stocks will inevitably go to ZERO. Extra caution should be paid to penny stocks that trade Over the Counter (OTC or Pink Sheets). This market has very little regulation and is a favorite place for "pump and dump" schemes.

 

Buying deep out of the money Options: Out of the money options are similar to a lottery ticket. There are many good uses for options such as hedging a portfolio or generating income on existing positions. However, buying long out of the money calls or puts is a losing game. Every once in a while you may catch a winner and watch the option you purchased double or triple in value but you'll eventually lose over time. The probability of these options increasing in value is extremely low and most go to zero. It can be a lot of fun buying a lottery ticket or playing roulette at the casino but the reality is the odds favor the house or in this case the option seller.

 

Investing or Trading without a plan: Mr. Market is a horrible teacher. You could open up a trading account place your first trade without knowing anything at all and make money. If this happens to you. Quit. Take the money and buy yourself something nice or save it and don't buy another stock or option until you have spent some time educating yourself. If you continue to go back in to the market over and over again with no plan you'll most likely watch your account balance dwindle. At the minimum a plan should include: reasons for taking the position, how much money are you willing to risk, when you will get out for a loss, when you will take profits and your time horizon for the position. Plan the trade and trade the plan.

 

There are many ways to lose money in the markets and the above are some of the more common temptations you face as an investor or trader. It may sound appealing to use leverage to enhance your potential return or buy that cheap option or penny stock in hopes of a 10 bagger. Unfortunately these actions will more than likely contribute to the detonation of that ticking time bomb which is your portfolio. Investing and trading is a journey and like most endeavors there are few if any short cuts that lead to long term success.


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