One of the most difficult qualities of being a successful trader is learning to
be a good manager of your own money. It's completely possible — and actually
pretty common — to see people turn out to be right on a high percentage of their
trades and still lose money. How is that possible? If you don't use good money
management by locking in profits, taking small losses on the picks you're wrong
about, and controlling your use of margin, eventually you'll lose it all, no
matter how good a trader you are.
Protecting your capital is your first
priority.
As a trader, the most valuable thing you have is your capital.
Without it, you can't trade at all. Bringing in no profits at all is better than
losing any part of your capital, because if your account is intact, you can
always make a profit another day. If your capital has suffered a loss, you'll be
wasting effort playing catch-up. The more you've lost, the longer it will take
to get back to where you started from — both because you've got more to make up
for, and also because with a smaller chunk of capital to work with, your profits
for any given percentage return will be proportionally smaller. Making 10
percent on a $10,000 account earns you $1,000, but if you've lost half of that
account and have only $5,000 left, making 10 percent on your money will earn you
only $500. You'd have to do that twice to make the same $1,000.
Market
corrections are inevitable, and will continue to occur from time to time.
Traders must anticipate them and take precautions before they occur. Properly
prepared, traders can even profit from corrections. Without proper money
management, though, your account balance can be destroyed.
Goals
of Good Money Management
Sound money management
has two main goals: to avoid losing money, and to avoid missing profit
opportunities by tying up capital in problem trades for long periods of time.
Failing to avoid either of these will cost you.
Avoiding loss of money is
pretty easy to understand: You want to preserve your capital and whatever
profits you've accumulated. Not only do you want to keep it, but you want to
trade with it as well, so that your capital continues to grow and makes your
returns larger and larger.
Avoiding loss of profit opportunities isn't
quite so obvious, but if you think about it, it's easy to see the point. Let's
compare the outcomes of two money-management decisions. Trader A buys a stock,
expecting it to go up, and finds that it doesn't. He's just sure it will go up
eventually, and he's incurred a small loss, so he decides to wait it out. He
ends up holding the stock for three months before finally selling
it.
Trader B buys the same stock at the same time as Trader A, but once
he sees that it isn't going up, he sells it at a small loss. He buys another
stock and makes a 15 percent profit on it. His next trade loses 1%, but after
that he makes 8 percent, 15 percent, and 30 percent on series of trades. Because
he is growing his account, he makes these percentages on a larger and larger
capital basis each time. At the end of three months, his account has grown by 48
percent.
Whose money-management decision turned out to be the best? While
Trader B made a nice profit, Trader A not only lost time but also never made his
money back. Even if he had made his money back on that stock, it's hard to see
how this was a good use of his capital over the course of three months.
Keys to Sound Money Management
There are six important things you must do to manage your account safely and
effectively:
1)Lock in profits.
2)Take small losses and make big
gains.
3)Use margin with caution.
4)Go to cash when the market nears its
top.
5)Diversify your portfolio.
6)Hedge risk.
You must do these
six things consistently and without exception. The most important difference by
far between successful and unsuccessful traders is money
management.
Exercising good money management is the single most important
thing you can do to improve your trading performance.
Lock in
Profits
Lock them in or lose them. We can’t say it more simply than that.
One of the most common and frustrating mistakes traders make is failing to
lock in profits. It's great to be up 35 percent on a trade, but it's only
“virtual” money until you do something to ensure that it's yours to keep.
Remember one of our examples from the last chapter? A trader watched his
stocks go up initially, failed to take profits, and then watched them go back
down — and down, until he'd actually lost money on what had been profitable
positions. There's no reason this has to happen. It will happen, though, if you
have no plan and no strategy for locking in profits.
How should you lock in profits? Since price targets are guidelines, we
recommend making a habit of selling half our shares at a more conservative
target than the one you actually think the stock has a good chance of reaching.
That way, you lock in a good chunk of profits, and whatever happens after that
there's no way those profits can disappear. Sometimes, if you think the stock
could travel a long way, plan several levels where you’ll take profits — first
selling half your position, then half of what's left, then half of what's left
of that. Often these selling points are near psychological barriers you expect
the stock to encounter — round numbers like 10, 20, and 50, or percentage
barriers like a 25% gain for the day.
Another way to lock in profits is to use trailing stops. By continuously
raising these stops as the stock price moves up, you’ll lock in the profits
you’ve made below the stops. You can also protect the entire position in case of
a sudden downturn.
These strategies must be part of the plan you have before you ever buy the
stock. After you're in the position, it's too easy to get either panicked or
carried away by high expectations. Locking in profits is part of your exit
strategy and as such is part of the whole plan for the trade.
Let's look at a shorting example. You short a position at 38 after it runs up
100% in a day on modest news. You calculate it could lose around half of its new
gain in a day or two. You decide that you'll take half your profits when it gets
down to about 35, another half when it reaches 32 and the rest when it reaches
29. You place a stop buy-to-cover order at 40.21 and wait.
The position moves as you’ve predicted, and within an hour is approaching 35.
You adjust your trailing stop to cover half your position at a lower price and
place a limit buy-to-cover order on the other half at 35.10, which
executes.
Late in the day, the position takes a dip down to 32.70, then
32.30. You know that a lot of people put in orders right at round numbers, so
you always try to get in a little ahead of them. You buy to cover half of the
shares you have left at 32.10. You reset your stop for a lower price on the
position that is left but let it expire at the end of the day because you think
it might temporarily gap up in the morning as the last gasp of its big run. The
position closes at 32.60.
The next morning, it gaps up as you thought it
might, reaching 33.40. It then starts to fall, slowly making its way toward your
expected final selling point of just above 29. You reset your trailing stop at
33.60.
To your surprise, though, it picks up steam later in the morning
and runs up to 33.90, triggering the stop on your remaining shares. It seems to
have the legs to run for another day. You don't care, though — you're happy,
because you took profits at a much better price yesterday and no one can take
them away from you. On top of that, you're now free to short the position again
once it reaches the top of its second-day run.
If you'd held your entire
position, you'd have no profits and would have to wait for the position to go
down in order to see them — plus you'd run the risk of it rising higher than the
point where you shorted it.
Accept Small Losses and Make Bigger
Gains
If you don't take small losses, you’ll
eventually lose. If you're unwilling to take a loss on any trade, we guarantee
that you'll lose money.
Most people have trouble taking small losses.
They don't want to lose anything on a trade because it makes them feel like they
failed somehow. But taking small losses means you succeeded. Focus on the fact
that you should take small losses, not that you should take losses. Taking small
losses is a way to limit losses when they occur and to make sure they never turn
into big ones. Taking small losses and big gains is the way successful traders
trade. It's the only way to be a successful trader.
The best way to
enforce the discipline of taking small losses is to use protective stops on
every trade. If you decide how much you're willing to lose on a trade before you
enter the position, as part of your plan, you can set your stop right after you
enter the position and you won't have a chance to second-guess
yourself.
If you think about how much you're willing to lose as part of
your plan, it also helps you determine about whether the trade is one you really
want to make in the first place. Taking a good look at your downside should help
to keep you away from questionable trades.
Use Margin
Carefully
Margin is a powerful tool that can
really increase your profit, but must always be used with care. The fact that
using margin lets you make much more on successful trades but lose much more on
unsuccessful trades should make you even more carefully evaluate the
risk-to-reward ratio every time you look at a potential trade.
What's the
proper way to use margin?
First of all, don't use all of it. Always leave
yourself a generous cushion. Every change in the price of a stock in your
portfolio changes the value of the collateral you have available for your margin
loan. If the value of your holdings goes down, it will go down faster due to
margin than if you weren't using margin, and this means that the size of your
margin cushion will decrease at the same faster rate. We suggest that you never
use more than two-thirds of your total margin capacity. This leaves at least
one-third as a cushion. If declining values bring your cushion to below
one-third of your capacity, it may be time to sell some positions to keep you
out of trouble.
Second, when deciding how great a loss you can tolerate on any one trade,
remember to take margin into account. If you're using half your margin capacity,
a 2% loss on the value of a stock position will equal a 3 percent loss to your
actual capital.
Learn how your broker calculates account equity. This can
be very confusing, but it's really helpful to be able to anticipate how much
margin capacity you'll be left with after you make a trade. Always keep track of
your margin status. Check it every morning and at the end of every trading
day.
Don't worry about margin interest. Your broker will charge interest
on the borrowed amount, but the interest rate is low and the cost is extremely
small if you're trading profitably.
In general, use margin only in
markets with a strong bullish direction. You can't use margin capacity to
increase the sizes of short positions in a bear market, anyway (though you must
have a margin account to short.) Whenever the market seems overbought, unsteady,
or unclear in its direction, get completely out of margin before a downturn can
take place.
Shift to Cash When a Market Nears its
Top
Besides getting out of margin when a market
seems unsteady or overbought, you should also lighten up on positions and go
mostly to cash. When the market is about to turn, cash is always safest. Staying
away from unpredictable and difficult to trade volatility will save your account
from potentially devastating losses.
Diversify your
Portfolio
Diversification is very important in
trading. Putting all of your money into positions that carry the same types of
risk is not good money management. Instead, find trades with different risks so
that if one sector experiences a sudden downturn, only a portion of your account
will be affected.
Hedge
Risk
Learn about strategies for hedging risk.
For example, if you're playing a stock that you believe will go up but could
instead go down, try to find a weaker stock that should generally go in the same
direction and short it. That way, if the primary stock goes down, you'll profit
from your short, which is likely to fall faster because it's weaker. If it
doesn't fall, it's not likely to rise as fast for the same reason.
Many
common hedging strategies involve options. Two examples are straddles and
strangles. A straddle is an options play where both a call and a put are
purchased. The call and put have the same strike price, the same expiration
month, and the same underlying stock or index.
A strangle is an options
play where both a call and a put are purchased. The call and put have different
strike prices (usually both out of the money), but have the same expiration
month and the same underlying stock or index.
Hedging is a form of
insurance, so it will cost you a bit by decreasing the profits you make on a
play. But there are times when insurance is well worth the
cost.
Risk Taking
Traders who
routinely fail to use safe trading and money-management practices should ask
themselves why they're engaging in dangerous and self-defeating behavior.
There's always a psychological motivation for something that doesn't otherwise
make sense. What are they getting out of it, since it's clear that they're not
getting better financial results?
Risky behavior is often a form of
escapism or a substitute for something more meaningful in a person's life. If
you seem to resist using proper money management or often "forget" to make a
plan or set stops, take a look at your own motivations. Better to figure it out
now, deal with it, and prosper than to lose all your money because you didn't
know what you were really trying to do.
If you find yourself taking
unnecessary risks or engaging in other self-injurious behavior, try to figure
out your motivations and deal with them.
"What Takes Some Successful Traders A Lifetime To Achieve Could
Take You Just A Few Days... Or Less!"
HOME
Advertorial 1 - Introduction
Advertorial 2 - The Basics of Analysis and Rational Trading
Advertorial 3 - Basic Principles
Advertorial 4 - Characteristics of Successful Traders
Advertorial 5 - Playing to Your Strenghts, Overcoming Your Weaknesses
Advertorial 6 - Winning Psychology
Advertorial 7 - Avoiding Common Pitfalls
Advertorial 8 - Sound Money Management
Advertorial 9 - Trading Systems
Advertorial 10 - Final Words
