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Money Management

Money Management: There are only two rules in online trading. The firstonline stock trading rule is preserve your trading capital at all costs, and the second rule is don't forget rule one. If you read nothing else on this web site, please take time to learn the lessons from this page. A few minutes of reading, will save you an awful lot of money later. It is not complicated believe me. Most people view risk and money management as rather boring, compared to the excitement of real trading. Most of these people no longer trade as they have lost all their money. One major point before we move on is this - any trading capital should not be more than 10% of your total net worth. In other words, if all your assets are worth 500,000, then your maximum exposure should be no more than 50,000.

Very few online traders implement disciplined, professional money management or risk management strategies. During the stock market bubble in the late 90's, limiting risk was an afterthought. After all what could possibly go wrong. Everyone was making lots of money very fast, and virtually any high tech stock you cared to pick seemed a winner. What could possibly go wrong ? The rest is history ( and if you don't know I suggest you find out ).

Professional risk and money management are the foundations on which success is built, and before I go on, let me define the difference between the two, since this is fundamental to your understanding and implementation of simple controls. Both strategies are essentially defensive, and both will keep you in the game to fight another day. Ignore the following methodology and you will lose a lot of money fast -   I absolutely guarantee it  - You will find very few books or articles written on the subject and even fewer web sites - this is one of them.

Money Management: Introduction

Why is money management so important? - put simply it is the ability to determine your trade size in relation to your overall portfolio position, and takes into account open positions and cash in hand. Imagine you are just starting out and have your cash ready and waiting, and lets suppose it's £ 10,000. How much are you going to put on your first trade 5%, 10%, 20%, all of it? Do you consult your partner, your friends, or just see how you feel when you place the trade. Many traders ( probably most ) have no idea about trade size, how to work it out logically or even whether it is important. The problem of course ( as ever ) is that it is rather a dull subject, and one which requires discipline and attention to detail ( not good news for the more testosterone fuelled amongst us !) One other point, before we move on, is that everything is based on percentages for the simple reason that they can be applied to any amount of money irrespectively. If you lose 100% of your money you are out of the game. If you lose £100, how much does this represent of your starting capital? From now on we work in percentages which can be applied to any amount in any currency.

Let’s start with a very simple assumption that you are just starting, and therefore have 100% trading capital. If we are prepared to risk 50% of our capital per trade, how many trades could we get wrong before we were out of the game ? - CORRECT 2 !! not very sensible. Most articles written on the subject suggest that this is 2%. I suggest that you start with a maximum of 1% This means that you can get 100 trades wrong before you are out of the game. I know this seems unlikely but anything can happen, and bear in mind that even with the best trading system in the world you're probably not going to do better than 60% success rate, or 6 in 10 trades going in your favour.

OK, so now we have established that to start we are only going to risk a maximum of 1% of our online trading capital on each trade. The next question is how much of our trading capital do we want to risk in total at any one time. Imagine if you had converted all your trading capital into open positions on the market and there was a world event which sent prices tumbling. How much of your capital could you afford to lose in one such event and still recover? If we lost 5%, we could recover as this only requires a recovery of 5.2%, similarly a 10% loss only requires a recovery of 11.1%. Both of these are achievable but anything more is going to be difficult. Some commentators suggest risking between 6% and 15% of our trading capital at any one time. I suggest that you start with a maximum of 10%. This means that if the worst happens and there is a collapse in prices the most you would lose is 10% of your working capital.

Please note that both the figures suggested so far are maximum percentages. If you want to keep it to less this is fine, as long as you remember where the maximum level is set. OK let's look at risk management and then we can put the two together with some examples which will make it all clear.

Money Management: Risk Management

In case you hadn't guessed it before, the key tool for risk management is a STOP LOSS. This order does exactly what it says and that is, it stops your loss form getting any worse, where hope and prayer become the watchword!!! I refer you to rule three - YOU WILL NEVER EVER TRADE WITHOUT A STOP LOSS. The stop loss has three functions. Firstly it creates a mechanical exit point with no emotion, secondly it is placed in position when you enter the trade and all is calmness and logic, and thirdly it stops any more loss.

The next question then is how do we decide where to put the stop loss ( beneath our share if we are going long, or above if we are going short ) in relation to our share. For simplicity and so that you remember all these figures, I am going to suggest that you work on 10% - set your stops approx. 10% below the share price ( you can tighten this up once you become more experienced to nearer 5% if you wish ). This is an approximate figure as stops are always placed in position according to the chart ( i.e. below the last low which offers some protection to prices coming back down - and never use whole numbers, or round numbers etc. ).

One final point on risk management which we will cover later, concerns sectors. It is an obvious point but you wouldn't buy all your shares in the same sector - i.e. all technology or all utility - you would spread your risk!! ( I hope ) OK, lets put it all together with some number and you'll see how it all works in practice. Remember these percentages will work with whatever your trading capital amount:

Assumed Online Trading Capital of 10,000 Risk
Maximum amount of capital risked per trade = 1% Risk per trade = 100.00
Maximum capital at risk at any one time = 10% Total at risk = 1,000.00
Maximum number of open trades Total = 10
Maximum trade size or number of shares per trade Number
Assumed share price 5.00
Stop loss at 10% ( 0.50) 4.50
Maximum risk per trade from the above 100.00
Therefore we can buy a maximum of 100.00/0.50 - this is the maximum risk per trade of 100.00 divided by the maximum loss allowable per trade of 0.50 200 shares

Remember we can always buy less. The 1% per trade is a maximum. We could have decided to start with only buying 100 shares. Our risk on the trade would then have only been 50 ( 100 x 0.50) Now you will have to study the above to get the hang of it, and if you have any questions by all means send me an email and I will do my best to answer. In the above example, had we decided to buy only 100 shares which would meant we were only risking £50 on this trade ( i.e. 0.5% of our capital as opposed to 1% ) THIS DOES NOT MEAN WE THEN INCREASE OUR RISK ON THE NEXT TRADE TO 1.5% - YOU STILL KEEP TO YOUR MAXIMUM 1% RISK PER TRADE. Remember I have not included commissions, stamp duty, or tax in the above

As you become more experienced you may want to tinker with some of the percentages, but I feel that the above will give you a conservative base to work from as a starting point. Do not feel when you are starting that you have to open all ten ( or more ) trades at once. Start slowly with one or two and get used to the charts, brokerage, the ups and downs of the market etc - don't rush!

Money Management: Risk And Reward

Now, from the above we have a sensible strategy in place for the management of our capital and downside risk. We have a mechanical system in place with the stop loss which will take us out of a losing trade. Now the hardest thing in trading is to let your profits run! ( trust me - you will find it almost impossible to contain your emotions as trades move into a profitable position) - but you must. The whole rationale is based on your winners outweighing your losers, and on the premise of keeping your losses small ( with stop losses ) and letting your profits run. To use a gardening analogy, you don't go and chop down all the young plants. You kill off all the weeds and let the young plants grow. Remember with the best trading systems yielding 4 losses for every ten trades, then if you are prepared to risk 100.00 per trade, you must be looking to achieve a reward of at least 100.00 on the winning trades. ( if you are only running at 50% success then at 100.00 you would be standing still at breakeven! ).

Unfortunately in taking profits it is impossible to set % figures. However, when you open a trade you must have some idea of the profit target for that particular trade. Therefore, if you are looking to risk 100, you should be looking for a reward of 150 if possible ( or more ). Now in the example above you would be looking for the share to rise to 575 approx. Naturally where and when you close the trade will depend on many factors. You may see a resistance point in the charts and feel that higher prices may not be likely. The main index could be showing signs of weakness etc. It is a judgement that only you can make at the time - no-one else - and if you close a trade early and prices keep going up, just be grateful that you have taken a profit off the table ! ( its easy with hindsight)

Now, one final technique which will help you lock in profits and reduce the pressure a little. Let's go back to the stop loss again. When trading the long side of the market, you NEVER move a stop loss down. ( when short selling you NEVER move it up).

However, once prices have started to move up on a buy order, we can start to move it up gradually to reduce our exposure on the trade, and eventually ( with luck ) to lock in some profit at which point this becomes a 'free' trade for us with no risk. This type of stop is called a 'trailing stop' . Some brokers will provide this as an option. I do not recommend this as it takes control away from you - you should be in control of what you are doing and know why you are doing it. The stop should be moved up by you, when you are ready and not by your broker or an automated system. (they don't like them anyway so it's best you do everything yourself )

Taking the example above, suppose prices have now moved to 540, you might decide to move your stop loss to 487 say - this would reduce your capital risk on this trade to : 500 - 487 ( original purchase price - new stop loss ) 13 x 200 ( no of shares ) = (-26.00)

This is a much more comfortable position, and hopefully if the trend continues you could then move it higher to lock in real profit. But remember, think very carefully about moving stops up as you cannot move them down again as it breaks the above rule !!! Don't rush to lock in profit, lock in reduced risk first ( boring but more rewarding ) OK - you will be pleased to know that's the end of this topic of risk and money management. It is the most important technique you will learn. Whatever else you do, or however you invest or trade in stock, options, currency or futures, please follow these simple rules - they will get you out of more trouble than you can ever realise - trust me. Risk and money management will stop you losing all your online trading capital. Now the next topic is related to money - its called margin and you need to understand how dangerous it can be.

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