Welcome to the first in a refreshed series of educational articles for modern traders!
As we embark on our journey to create the ultimate guide to stock and options trading, we aim to enhance your knowledge and sharpen your trading skills through practical, real-world examples. Each week, we will highlight strategies, dissect trades, and track their outcomes. This isn’t just theory—it’s a hands-on approach to mastering the markets.
In this inaugural post, we’ll discuss two cornerstone principles of investing: The Golden Rule and The Cardinal Sin of Investing. These concepts are foundational and will guide every strategy we discuss moving forward.
The Golden Rule of Investing
“The more uncertain you are about a position, the more you should hedge it.”
Uncertainty is part of trading—especially during high-volatility events like earnings season. The Golden Rule reminds us that mitigating risk through hedging can be the difference between surviving a volatile market and getting wiped out.
Practical Application: Hedging During Earnings
Earnings season is a perfect example of peak uncertainty. Let’s consider some companies reporting earnings soon, like Microsoft (MSFT), Tesla (TSLA), Amazon (AMZN), or Coca-Cola (KO). Even if you believe you’ve analyzed the financials thoroughly, there’s no guarantee the stock will react as expected. A strong earnings report might lead to a drop due to weak guidance, while a poor report could see shares rally if expectations were even lower.
Hedging Examples:
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If you own long call options, consider buying short-term puts to protect against a sudden drop.
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If you hold stock, you might sell covered calls to generate premium and offset potential losses.
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Use a straddle or strangle strategy to profit from significant movement in either direction.
Real-World Example:
Recently, traders hedged positions in Apple (AAPL) leading up to an anticipated earnings release. By combining long calls with short calls at a higher strike, they created a vertical spread that reduced exposure to unexpected outcomes. The result? A trade that limited downside risk while preserving upside potential.
Hedging is not just a defensive move; it’s a strategy for ensuring your portfolio survives to trade another day.
The Cardinal Sin of Investing
“Ignoring risk management is the fastest way to ruin.”
This principle—“Don’t put all your eggs in one basket”—is timeless for a reason. Concentrating too much of your portfolio in a single position can lead to catastrophic losses.
Why Risk Management Matters:
Warren Buffett famously said, “Rule No. 1: Don’t lose money. Rule No. 2: Don’t forget Rule No. 1.” Here’s why:
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A 10% loss requires an 11% gain to recover.
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A 20% loss requires a 25% gain.
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A 50% loss requires a 100% gain just to break even.
Large losses are exponentially harder to recover from, which is why spreading risk across multiple positions and asset classes is crucial.
Practical Steps to Avoid the Cardinal Sin:
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Diversify Your Portfolio: Spread your investments across sectors and asset classes. For example, pair growth stocks like NVIDIA (NVDA) with defensive stocks like Johnson & Johnson (JNJ).
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Position Sizing: Never risk more than 2-5% of your portfolio on a single trade.
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Use Stop Losses and Alerts: Automate your risk management with stop-loss orders or alert systems to minimize emotional decision-making.
Lessons from History:
The 2006 collapse of the hedge fund Amaranth Advisors serves as a cautionary tale. By betting heavily on natural gas futures, the fund lost $6 billion in a single month. The lesson? Overconcentration is a recipe for disaster, no matter how confident you feel about a trade.
Key Takeaways:
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The Golden Rule: Hedge your positions when uncertainty is high.
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The Cardinal Sin: Always prioritize risk management by diversifying and limiting your exposure.
The market is full of opportunities, and tomorrow will bring new trades. There is no need to “go all in” on any single idea. Discipline and consistency will serve you far better than bravado.
In future posts, we’ll build on these principles with detailed strategies and examples. Next week, we’ll explore the mechanics of spread trades, including how to use vertical spreads to limit risk while maximizing potential returns.
Let’s make 2025 the year of smarter, more disciplined trading.
All the best,
— Phil
