|
|
|
|
|
|
|
|
| MONEY MANAGEMENT |
|
|
Money management is probably the most overlooked and neglected aspect of trading, and ironically it is the single most important. Most traders are more concerned with finding the perfect technical indicator, or the perfect setup or the perfect trade calling guru and all the while experiencing information overload. While using technical indicators and various set-ups is important, without a proper money management approach, these factors will be rendered useless. Trading is a game of statistics and probabilities. You must understand that. It is not a game of luck. It is not a game where your emotions should be involved. It is not a game where intelligence is the main factor. As a trader, you are operating in an environment of uncertainty. You can never possibly be sure which way the market will go. Its too big and too chaotic for anybody to figure out. It is out of your control. The one thing that is in your control is risk. You can control your risk and you can control which trades you enter. You must enter trades with a high probability of winning, and you must cut your losses short, let your winners go, and not be too quick to take a profit. The old saying, "You can never go broke taking a profit", is just not true. You can certainly go broke taking profits as soon as you realize them while hanging on to your losers, "hoping" that things will turn around for you. Most novice day traders get into day trading with a gambling attitude. Its kind of like playing a slot machine right on their desktop. As in any casino, the gamblers eventually end up losing. Oh, sure, gamblers will have their big win days, of which you will surely hear about, but they end up losing over the long haul. You will never hear of all of their losing days. Its kind of like fishermen. When a guy goes out fishing and catches all kinds of big fish and limits out, what does he do? He takes as many pictures as he can and makes sure as many people know about it as possible. This makes one think that he is a great fisherman. He could be, but probably isn't....he just got lucky and needed to tell the world to make him feel good about himself. You'll never hear about all the times he went out and didn't even get a bite! Its just too humiliating. The first thing you must do when considering a trade is to determine the amount of loss you are willing to take on the trade in case it goes against you. Lets face it, no one is perfect. You cannot possibly make all winning trades. The sooner you accept that fact the better off you will be. Accept the fact that you will be wrong many times, maybe as much as 50%. So you need to be prepared to deal with those losses. If you aren't, you will be eaten alive and out of the game sooner or later. So you must be willing to accept and deal with losses. Next, before entering a trade, you must ask yourself this question: "Does this trade have a high probability of success". If it does, then you must next determine how much money you are willing to risk on the trade. Many traders will advise not to risk more than 2% of your portfolio on any one trade. This is a general guideline, but I personally I think this is too high, and prefer to risk 1% or less. So in this case, lets assume you will risk 1% on the trade. You must then assess the risk/reward ratio of the trade. Risk/Reward Ratio is simply the amount of risk you are willing to assume divided by the amount of profit you can reasonably expect from the trade. I prefer a risk/reward ratio of .33 or less. So this means that I am willing to lose $100 to make $300. So, for example, lets say you are trading a $30K portfolio. You are interested in making a trade in a stock. You must first determine where your initial protective stop must be placed. This is usually placed under a swing low or over a swing high for a short play. Lets say that you are going long, and you are going to place a stop just under the last swing low, which is 3/4 pt under your planned entry point. You have also determined from your charts and technical analysis that you can reasonably expect 2 1/4 points profit if the trade goes in your favor. Knowing this, you can determine the number of shares you can safely play. You know that you can only risk a maximum amount of 1% of your portfolio. .01 x 30,000 = 300 So the maximum you can safely risk is $300. Now you must determine the number of shares you can play. So we setup a simple equation. .75x = 300, where x is the no. of shares, .75 is the amount of point loss you will accept and 300 is the dollar amount you will accept to lose. So in this case "x" equals 400. So you can safely play up to 400 shares on this trade. This is based upon a "perfect world". I personally would cut this down to 300 shares to account for any slippage that may occur in case the stock tanked real fast making it hard for me to get out at my stop point. Yes, call me paranoid, because I am. In this game, "conservative" is your best friend. I have made several charts to graphically illustrate the above dissertation. I think that you will see how important this concept is. All of the charts have been created assuming 550 trades will be made during the year. The round trip commission cost is $32. The net profits shown are after commissions have been deducted. No compounding was included. Click the below links to view them and I think you will gain an understanding of how important money management is.
|