By Justice Litle Markets diving... gold putting in the biggest one-day move in history... Goldman Sachs and Morgan Stanley on the edge of the vortex... It’s almost a cliché to say we’re living in historic times, but this time it’s true. We haven’t seen anything like this since the panic of 1907. Time is needed to sort this all out.
Money management is often dismissed as a dull subject. New traders especially can’t be bothered with it. They’re too full of vim and vigor -- anxious to get to the “good stuff” and not concerned about risk.
Eventually, the new trader takes a hit from Mr. Market: Whoa! You mean I can actually get hurt in this game?
After the first real setback, many would-be traders lose their nerve. But those who tough it out find a resolve to become stronger and smarter. Their hunger for knowledge increases along with their determination.
This is when the light bulb clicks on: Hmm. Maybe there’s something to that “money management” stuff after all...
I’ve been studying money management (MM) ideas for more than a decade. In my three years as a commodity broker, I saw clearly how MM helped turn some clients into consistent winners... and how neglect of it pushed others to the brink. The topic has fascinated me ever since. (I’m one of those weirdos who thinks this stuff is fun...)
I don’t want to spend too much time on MM in these pages (lest we bore the newbies to tears). But it’s a truly important topic, so we’ll revisit the subject from time to time. I’ll collect your questions and answer them as best I can. Here are a few for starters.
...I would like to see more about money management. Most of what I have seen says to only put 2% of your account on any one trade. This is fine if you are running a billion or even a few million but if you are running a few thousand it is meaningless. I suggest that the next time you are making a recommendation you go into this in detail for people with different account sizes. - TD reader David H.
I understand your frustration. The traditional advice assumes every trader or investor starts out with a large pool of capital. We know this isn’t true. In fact, the opposite is probably true. We also know that it’s possible to turn thousands into millions, because real traders have done it. It’s happened plenty of times before, and will happen plenty of times again in future.
If you have a large starting base of capital, Job One is to keep what you’ve got. That means sizing positions conservatively -- keeping planned risk per trade in the single-digit percent range. Things can work differently, though, if (a) you are starting out very small, and (b) you have an ongoing stream of capital that constantly replenishes the portfolio.
Say, for example, that Trader X has only a few thousand dollars in his trading account. But now give Trader X the ability to add $300 per month to his account balance. What is the total available capital for the trading account? It’s not helpful to take a static snapshot. You can’t just quote the balance, because it goes up every four weeks or so with the new capital infusion.
Point being, “risk capital” can be a very fluid concept. Future cash flows are as important to consider as available cash here and now.
A basic MM rule of thumb I use is that, with a very small pool of capital (like a few thousand bucks), you want to be either very conservative or very aggressive, depending on your risk profile and your ability to replenish the account. The middle ground doesn’t do much good; it’s better to go for the gusto or stay cautious, depending on what’s right for you.
If I were starting out with, say, $1,500 worth of capital, and I had the ability to set aside an additional $300 for the trading account each month, I would use a max planned risk of $300 per trade. Then I would maintain a small number of concentrated positions -- limited margin power would demand it -- and focus on building the account to a larger size as quickly and efficiently as possible.
At first, the $300 planned risk per trade would represent a very large chunk of capital -- a whopping 20% of the starting balance. But by keeping the risk amount static (unchanged) even as the account size grows, volatility falls over time.
A $300 trade represents 20% of a $1,500 account, but only 10% of a $3,000 account. Once the account reaches 10K, that same $300 would only be a 3% risk per trade
And then, once the account surpassed 15K, I would have enough dollars to go back to a 2% sizing rule if I chose. By the time the account reached $25,000, the 2% threshold could bump the risk up to $500 per trade, and so on.
The challenge with this type of plan is handling the initial swings. Because risk and volatility are both much higher in the beginning, that small opening balance would move around quite a bit. It might take a few pulls of the lawnmower cord to really get things going.
That’s why the “aggressive” plan assumes a high initial tolerance for risk. If I had to go the more conservative route with a small account balance, I wouldn’t trade. I would invest instead. I would look for high-quality, high-yield dividend stocks that I could sit with for long periods of time, and steadily build my cash flow that way.
Would be very interested in your money management thoughts. I deal mostly in options but find it difficult to come up with a money management plan that will work all the time. I’ve read so many different ideas on this that I’m totally confused as to what is best. Seem to either get out too early or not early enough and end up with a loss. My account is down to, well, not much left. - TD reader M.W.
If you have an unacceptable rate of losses, the problem might not be MM. It might be a “hole” or a “leak” in your trading methodology. If your trades don’t have a positive expectation over time -- that is to say, if the method is not a winning method over a statistically meaningful period -- then money management won’t be a magic bullet. It will only slow the rate of bleeding. Tolstoy said, “Happy families are all alike, but unhappy families are unhappy in their own way.” Unhappy traders are unhappy in their own way, too. It’s impossible to give a one-size-fits-all type diagnosis, because there are so many different things to consider: trading frequency, entry and exit methodology, consistency of execution, and so on.
If you’re willing to do a self diagnosis, I’d recommend a copy of Trader Vic: Methods of a Wall Street Master by Victor Sperandeo. The book is old now and a little dated, but it’s still one of my top 10 trading books of all time.
“Trader Vic” will give you lots of food for thought on money management, trading methodology, personal psychology and other worthwhile topics. (If you check it out, be sure to e-mail me and share your thoughts and questions: email@example.com.)
One simple and powerful concept Trader Vic teaches is his three-step approach to MM. Sperandeo focuses on three things in his trading:
Preservation of Capital
The key is to always keep the priorities straight. Preservation of capital is paramount. Once you’ve made sure to keep the money you have, consistent profitablity is the next thing on the list. And then, when 1 and 2 are taken care of, that’s when you give yourself permission to go for the gusto and seek out the big returns. (Note, too, that this formula assumes an account of meaningful size. For building up a small account from scratch, see my earlier response.)
Probably all of us know to cut your losers short and let your winners run. But if the industry even has a term for not doing it as you say, “Picking your flowers and watering your weeds,” then I must not be the only one getting it wrong. Why do we do this, and how do we stop doing it and let our winners ride, especially if you are trading options and a 25% trailing stop would get you stopped out all the time unless you hit the timing perfect? I would love to hear your response.
Building a trading plan is a bit like building a car engine. All the elements need to be in place: psychology, methodology, risk control, and so on. The book I mentioned above can help a lot with this; Trader Vic covers all the basics in a thoroughly impressive way.
To address one other thing: I never use option stops. That is to say, I never plan my trading risk around the fluctuating price of a put or a call.
I know that some other traders do this, but the practice never made sense to me. After 10 years of heavy involvement with stocks, futures and options on both, I feel that I know more than a little about how markets work, and I feel very strongly that option stops don’t work. There are better ways to trade.
I prefer to use chart stops and time stops on all my directional trades. Even if I’m buying a put or a call, I will not plan my risk around the fluctuating price of the option. I will plan it around the price action on the chart.
The use of chart and time stops allows me to incorporate support and resistance levels into my decision making. If, say, a crude oil futures contract moves through a key price level, that is telling you something... and in fact might be telling you to get out of the trade.
If the price of a put or call option moves 30%, however, that might not be telling you anything meaningful at all... except that the bid/ask spread is thin and the market maker is feeling grumpy today!
The bottom line is this: When the market conveys information through price action, it does so via the underlying stock movement or futures contract movement -- not individual option movement.
Furthermore, if you find your options positions getting stopped out too frequently -- or any type of trading position getting stopped out too frequently, for that matter -- then the market is trying to tell you something. Your stops are too close!
A trader who gets stopped out too much is like the skinny defender on a basketball court, taking sharp elbows in the chest from a mean point guard. The thing to do is give the point guard, and the trading position, a little more room.
When selecting a risk point, volatility considerations come first; money management concerns come second. If the trade requires more “elbow room” for your stop, you can adjust accordingly on the MM side by simply taking a smaller position.
There’s more to be said here, but hopefully you get the gist. I encourage you to use chart and time stops, not option stops. The other nice thing about options is that risk is limited from the start (provided you are buying puts and calls as opposed to selling them).
If I put 3% of my trading capital into an options position, I know my max risk is 3% -- even if the option goes to zero. And by using the right combination of chart and time stops, chances are my risk will be a good deal less than 3%... even if the trade doesn’t work out.
We’re only scratching the surface. I could talk about MM for a very long time, which is why I’ll stop here.
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