In this post I will continue on the series IÂ started last week relating to developing a strong, solid trading plan. Now we get into the meat of the subject, with the Personal Assessment. As in the earlier posts, this material is primarily excerpted from my book, The Essentials of Trading.
The backbone of a good Trading Plan is in its reflection of the trader who is applying it. Plans, systems, and methods which do not mesh with those who attempt to trade them are often doomed to fail. For that reason, it is imperative that the first step in building a system is assessing the trader.
 Trading is not something one does on a whim or in some willy-nilly fashion. It takes a thorough understanding of several things, not the least of which is your own personality and situation. To that end, the first step in the process is assessment. The topics related to methods and system building will be addressed soon, but not before laying the ground work which will help in guiding the trader to pick those most suitable to her or his individual situation.
In progressing through the steps which follow, make sure to include the questions and answers in your System Research journal.
Step 1: First things first—Why?
Can you state clearly what motivates you to be a trader? Is it the potential for large profits? Is it the excitement? Is it the challenge of puzzle-solving? Maybe it’s something else.
Do you know what your trading goals are? This doesn’t necessarily have anything to do with money, by the way. It is just a question of what you hope to get out of being a financial market participant.
Motivation is a very serious consideration. At the top level, it can help you decide whether trading is even something you should be doing. The markets very quickly weed out those trading for the wrong reasons. For example, excitement and consistent profitability do not go hand in hand for many people. Although some do well operating in highly emotional states, most do not. It is quite often a good idea to find other sources for that “rushâ€.
At the same time, motivation can be directly applicable to the way one trades. For example, if you want to trade for a living, you are going to take a different approach than if you just want to handle your retirement account. This is a topic which will come up repeatedly in the sections ahead, and it is something which must be reassessed from time to time.
Step 2: Financial Assessment
Before one should even start to think about trading, it is imperative to determine whether it is reasonable to do so in the first place. Trading should only be done with risk capital. Risk capital comprises funds which, if lost, would not negatively impact the trader’s financial well-being. In simple terms, one should not put at risk what one cannot afford to lose. This is a hugely important point. A trader who is playing with money he or she needs to live on does not operate from a solid footing in so many regards, not the least of which is the stress it creates and the impact that can have on decision-making.
Once the question of how much money you can afford to lose is addressed, another similar question must be asked. How much are you willing to lose? At first glance, one might think this is the same question. There is an important difference, though. While some folks are risk takers who would answer the same to both questions, many people would not. An example would be the trader with $10,000 in available risk capital only willing to lose $5,000.
This second question moves us from the realm of the practical to the world of the emotional in that it addresses the individual’s specific feelings toward money. Different people will place value on different sums in varying ways. In the just mentioned example, the risk capital was $10,000. One trader might be fine losing 100% of that amount, while another would consider a 50% loss devastating. It may be hard to look at it in that manner with such a relatively small sum, but what if the risk capital was raised to $10 million? That changes things, doesn’t it? That first trader might not be so willing to lose 100% now. That’s an awful lot of money!
The point being made here is that before one begins trading, it should be clear from both the objective sense and the emotional one what is at stake. This is Step #1 in the trader’s on-going process of risk evaluation and management, and it needs to be re-evaluated periodically.
One other financial consideration is account or portfolio size. One can start trading stocks with relatively little money, and it is possible to open an FXTrade account with an initial deposit of less than $100. This is not the case in all markets with all brokers or trading platforms, though. Many have minimums of $3000 and higher, and there can be baseline account sizes for the use of margin.
Regardless of what the minimum requirement is, however, one needs to keep transaction costs in mind. A small account is impacted more significantly in terms of performance by transaction costs like commissions than is a larger one. Consider a trade with a $20 commission. That would be a 2% hit 0n a $1000 account, but only a 0.4% impact on a $5000 account. What’s more, non-flat rate commissions (which still exist) tend to operate on a sliding scale where larger trades incur smaller commissions on a percentage basis. For example, in options trading there is often a fixed base fee, then a small per option fee.
Also, if one trades the futures market the account size becomes an issue in regards to margin requirements. If one is to trade E-mini S&P 500 contracts, the account must have at least enough to cover the initial margin requirement (approx $2500). It’s also a good idea to have some cushion so one small loss does not mean having insufficient funds for future trades.
All of this is somewhat irrelevant when trading demo accounts, but it is very important when shifting in to live action.
In the next post we will go deeper into the personal assessments with some more stuff you need to think about.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
** See John’s full bio.
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