In my opinion, money management is the single most important aspect of any trading system and is badly neglected by many new (and not so new) traders. It enables traders to fully utilize and at the same time protect their capital, helps to make the trading capital to grow as fast as possible while protecting it from excessive losses and final total blowout.
Money management basically consists of 2 items, position sizing and exit strategy.
First of all, let us have a look at position sizing.
When you make a decision to buy or sell (short), you must also decide at that time how many shares to buy or sell. You have to fill in the quantity spot on your order form.
An important aspect of risk management is making a logical decision about how much to buy or sell. This decision partly determines the risk of the trade. The other part of money management is the risk we are prepared to take, determined by our exit point. We shall talk about this later. Accept too much risk and you increase the odds that you will slowly loose your capital; take too little risk and you will not be able to cover brokerage and overheads. Good money management is about finding the right balance between these undesirable extremes.
“When I make a trade, how much do I trade?”
It’s surprising that many traders and investors have no idea what money management is about. They generally entertain the idea that it has to do with setting stops, and that discipline is involved to make sure you execute the stops when they are hit, but that is as far as their understanding goes. Why is this?
Perhaps it can be explained by the extended bull run this market has had. This type of market , where making money consists of riding along with the bulls and buying the dips tends to turn the bold and possibly reckless trader into market geniuses. The perceived risk in stock market investing has been very low, so the need to manage that risk has not been a pressing concern. Why worry when it will always come back and you can make a killing if you buy more?
However I have noticed a change in our market. Have you? The market has become quite volatile and we certainly have to hone our skills to stay ahead.
Remember: Traders are different to investors.
You need to perform the following important money management chores to become a successful trader:
You have to determine how much you are willing to risk on each trade.
You must understand the risk of the trade you are about to take and size the trade appropriately.
You must take small losses before they become big losses.
You must always review your performance.
But the most important decision you need to make is how much you are willing to risk on each trade relative to your trading capital.
For example, I limit this amount to 2 percent or less of my trading capital in each portfolio. The reason I keep this number small is to protect myself from a series of losses that could bring me to the point of having no trading capital left, end of my trading. Losing trades are a fact of life, there is no way out of it. I have them. You will have them. Every trader has them. The key is to limit those losses so that you can endure a string of them and still have enough capital to place other trades that will turn into winners.
It is quite easy to find out how much risk there is in taking a particular trade. First of all, decide where your exit point will be if the trade moves against you. This is the point where you say to Mr Market, that is enough, I am out of here. Do not enter a trade without knowing where your exit point will be.
So how do we decide the size of our position. You can use the following formula:
Position size = (capital x risk percentage) divided by (entry price – stop loss)
say your capital (cash + equities) = $20000
you are prepared to risk 2% of capital per trade
your entry price = $5.80, your stop loss = $5.55.
Position size = (20000/100*2) divided by (5.80 – 5.55) = 1600.
Thus you buy 1600 shares. Now watch it – your 2% risk does NOT include brokerage and slippage. Set your percentage to your own risk tolerance.
Have a good look at your trading so far and see if this can help you.