Your “Inner Voice” of Trading

10/11/2011 8:00 am EST

Focus: STRATEGIES

Michael Bellafiore

Author, One Good Trade: Inside the Highly Competitive World of Proprietary Trading

Learning from every trade—both good and bad—helps build an understanding and an “inner voice” that enables us to continually improve and become the most successful trader possible.

Steve Spencer and I at SMB Trading have both read (and are in) the excellent new book from Michael Martin,The Inner Voice of Trading. Below is an excerpt that FT Press was gracious enough to share with our readers. 

The Inner Voice of Trading has started with terrific reviews. Last week, it cracked the top 1,000 on Amazon’s best sellers list, which for a trading book is outstanding.

My Tuition – Part 1, by Michael Martin

I paid a great deal of tuition to develop my inner voice, mostly in the form of trading losses. You learn the most from your losses. Winning trades do nothing for you in this regard except boost your ego. If you are ever asked, “How would describe your level of intelligence?”, you might answer, “Above average.” This is probably emotionally gratifying to say, despite not having a single, measurable heuristic as proof. I’d probably say the same thing, although nowadays I have what’s called “Social Proof”—recommendations on LinkedIn, letters from deans, and positive reviews from students. I’m smart enough to know that I can still vaporize cash very quickly, and I own the fact that I am not immune from becoming a bonehead. As a trader, my profit and loss statement is the best reflection of my inner voice.

When I began my career, I made several errors in my own trading that certainly didn’t look “above average.” In fact, the mistakes I made were the same rookie mistakes that I teach everyone else to avoid. Looking back, most of them were downright hilarious, although they didn’t seem so at the time.

You can avoid two easy errors:

  1. Don’t overtrade.
  2. Don’t over-leverage your account.

If you can avoid these two errors, you will go a long way toward avoiding total ruin. Out of the game. Done. No equity. No margin. No career. And lots of excuses. When I first began trading, there were no exchange traded notes (ETNs), exchange traded funds (ETFs), or Internet stocks. I had blue chips, tech stocks, and commodity futures. Most of these also traded options.

Then, like now, Intel (INTC) and Microsoft (MSFT) had great influence on the Nasdaq Composite Index. Yet they were nowhere near becoming Dow components, as they are today. Naturally, with few great names in tech to trade, many of us focused on the theme of the day, known as W-Intel, the marriage of Microsoft’s operating system Windows and Intel’s newest chips.

Earnings season was up, and INTC was about to announce its earnings per share number. I had a hunch that if that number was positive, the stock would see a sizable move because the trading range (the near-term high and low prices) had been tight for the past few weeks. Traders had a few ways to play the potential upside for INTC, which at the time was trading around $70 per share. I used an options position because I didn’t want to tie up a large portion of my equity in a long position in the stock. I could benefit on the upside by spending $4,000 of my equity on options, whereas the same position in the stock would tie up $70,000.

I read all the research from my firm and every other firm on the Street, thinking that was going to give me an edge.

No other Internet source at the time was available for traders to get the line on earnings, nor were there online communities for sharing advice—no StockTwits, for example. I had to rely on my research and the evil, false, and manipulative whispered number.

I owned the 70 calls (call options that give the owner the right to buy INTC at $70 per share) in my portfolio at a cost basis of $1.50 per contract about ten days before the earnings announcement date. Lucky for me, the stock began trading higher over that time. On the day before the earnings announcement, my calls were just over $3 per contract. I was up 100% on this trade based on the premium paid, and I hadn’t even gotten to the announcement yet.

When earnings day came, the market closed and I sat in utter stillness to await the news. I had interpreted the paper gains of 100% as a foreshadowing of more profits to follow. Based on that, I’d inferred that I’d make many times my money. Keep in mind, there was no aftermarket, save for what was known as InstiNet (institutional network)—no electronic communication networks (ECNs) or anything. The number reported was significantly higher than the Street guidance. While my colleagues hit the phones looking for a quote from one of their buddies on a desk, I had an “in” with an analyst I’d caddied for and was listening to the earnings conference call. The analysts on the conference call mentioned that the stock was trading up $7 on InstiNet in the aftermarket and that the firm, Intel, had, in fact, announced a two-for-one stock split.

I had all night to fantasize about how the stock would rage at the open the next day: a better-than-expected earnings number, stock up significantly on InstiNet, and a split. What a dream! “Who knows how high this thing can go?” I remember telling all my friends and clients on the phone that night. I was up, on paper, almost ten times my original investment while the rest of the world was liquidating its shares overnight on the InstiNet system. I got to the office much earlier than usual the next day. I needed to celebrate my big win and enjoy how the morning would unfold. I wanted to experience it all—smell the smells and watch all the folks roll in and wonder how their days would go. I had a built-in good day: I had a built-in profit and limited emotional downside, given all the positives for Intel that the Western world was going to wake up to. 

By Mike Bellafiore of SMB Trading

Michael Martin can be found at MartinKronicle.com and is the author of The Inner Voice of Trading. This excerpt first appeared on SMBTraining.com.

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