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The Most Violated Rule in Trading

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What is the 1st rule of trading, whether stocks, bonds, futures or options? Always be able to trade the next day. Its rule #1 and it is the most violated rule. Just yesterday I was on the phone with a trader who was in the middle of a margin call crisis in relation to a short position. He did not want to close out his position because he thought eventually he would be right. The problem was he could only see his 'realized loss' and not the potential. I explained to the trader he could do one of the following: 

- Cover the trade now wait and sell when the his or her trade looks like its ready to work 
- Sit here and watch the margin calls come, race around to buy hedges to avoid margin calls, and  potentially blow out.

Despite how simple the answer is: Take the trade off and look for a better chance to get into the market. All this trader could see was his 'realized loss' and he was ignoring his potential loss, and even more so his potential to make more money by being in cash. He is not the first person to have this type of mentality. Its happened to me, and probably just about every trader out there, sans maybe two or three traders in the history of mankind.

When a trader takes a 'realized loss' its a lot like an amputation of a limb: painful and permanent. However, if a limb isn't removed, the person attached to the limb might die with an leg that is going to go anyway. Once the limb is removed and the health of the patient is no longer in doubt, recovery can begin. However, unlike a limb (and this is the part traders forget) a trading account can grow the loss back, and if the trader is in cash at an opportune time, the he or she can grow the account back quickly. The key is that the trader needs to be willing to 'slice the limb out' to save his or her account allowing him or her to trade.

In the last two weeks we saw the CBOE Volatility Index (VIX) rallying over 50% in about two days. Needless to say there are a lot of traders that took some heat. Some are sitting looking at a position that they put on in a different market, slowly eat their account. Others cut the limb off and are in a position to trade.

If the VIX makes another move higher, the first group will likely be done trading. The second group will likely take their lumps and look for opportunity to find edge in a trade. The second group is I like to call traders. The first group I like to call 'failed and closed'.

So on a day like today that has started out slow, take a minute to review the account. Are you in trade that actually makes sense or are you holding onto a limb that is going to need to be removed, that is going to put you out of business?

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At the time of publication, Mark Sebastian held positions in VIX.

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