Chapter 7 - Money Management

Previous < Chapter 6 - Using Stock Trends systematically

 

So you think you can pick stocks? That may not be enough. Whether you’re managing $10,000 in a self-directed RRSP or a $2-billion pension fund, the returns you produce will have more to do with your money management abilities than your knack for identifying stock trends. Unless a trading system is 100-per-cent accurate in all cases, a sound system of risk management and damage control has to be part of it.

 

How many stocks do you take positions in? How do you decide how much to invest in each position? Suppose a stock doesn’t do what you hoped — what then? Do you sell or hold on a bit longer? These are the issues that investors must address before risking capital, just as every professional money manager must. In general, the money management rules are:

 

1. Trade with the trend;
2. Let profits run, and;
3. Cut losses short.

 

Stock Trends helps with the first part and the second part seems self-evident. But learning how to take a loss is one of the most difficult lessons to learn in the stock market. An investor’s psychological makeup has a hand in his or her expectations of where a stock "should" go, rather than where the market is taking it.

 

This is where a lesson in trading psychology is worthwhile. Ask yourself some hard questions about your trading record to date. How have you dealt with trading losses? Did you exacerbate a situation by inaction? Were you too quick to pull the plug, only to be dejected about the momentary volatility in a stock? Do you become attached to stocks – do you go on and on convincing yourself that “it’s a solid company”, that the market has got it all wrong? Are you sleeping well? Does the market make you miserable? Is it your friend or your foe? Do you have a plan? Do you follow it?

 

Surely the greatest battle every trader faces in the market is within the walls of his or her head. Seasoned traders will know that they have fooled themselves out of more money than the market has. We are slaves of our emotions – in life, in love, in money. It doesn’t take long to figure that out. Unfortunately, success in the market demands that we abandon this human frailty and put on the armor of the automaton. The sooner you abandon your emotions, the sooner the market becomes your ally – not your enemy. This is the wisdom imparted by successful traders who take the time to share this revelation.

 

What does this mean in practical terms? How can we not be emotional about our money? We have more money - we feel happy. We have less and feel fear. Not much sense in denying these emotions. Few of us have the luxury, the religion, or perhaps the youth to be so carefree about our economic well-being. Besides, why would one possibly want to risk assets in hand (both time and money) if we did not have in mind the rather excellent feelings of having even more of the same? But if happiness is our motivation, fear is its ugly twin. One way or the other these emotions propel us. No, the trader cannot abandon emotion in his motivation.

 

What the sage trader’s advice really refers to is our execution. Like the lawyer who enters the profession for altruistic reasons, the trader plunges into his career. But success as a lawyer comes not from the compassion to protect abused victims, but rather from the sustained rigid application of the law. No heartstrings pulled, no tearful emotions muddling the ultimate objective – just determined legal tactics delivered to win a verdict in any manner possible. So too, it must be with the trader. No attachments to stocks – whether astoundingly profitable or disastrous money pits. Just a dogged application of a trading system. BUSINESS! The job at hand is to buy and sell stocks. The result we want is simple: profits!

 

So far this sounds easy. But the problem with most novice traders is that they lack a proper business plan. They enter the market with unrealistic expectations and little or no thought about preparing themselves for the execution of a game plan. Their ships desire the riches of the East, but they have no compass, no fortitude to make it around The Cape. They are doomed.

 

What is this game plan? How does one develop a trading system? How can one have faith in it? The answer to these questions lies no further than a pen and a piece of paper. Putting your trading plan on paper (some of us probably would prefer using the computer instead) is the best way to steer yourself in the stormy waters of the stock market. Write out your plan, your strategy to buy and sell stocks. That is what you are doing: buying and selling stocks. What “must be” before you buy? What “must be” when you sell? How much will you trade? How much will you trade per position? The answers to these questions should be written down so that you know the reasons for your action, the reasons for your inaction, and the reasons for your result. If you don’t know the reasons, you have no idea how to repeat the result - or change it. There is a science to trading - use this laboratory to your advantage and record your plan and your actions thoroughly.

 

Stock Trends has a plan. It is born out of the basic tenet that stocks trend, and that we can identify when these trend changes occur. It devises to categorize stocks by trend and narrow down a search for stocks to trade with certain trend and momentum criteria. You may choose to incorporate a particular, perhaps unique, strategy in employing the Stock Trends indicator – but it should be documented as well as it is devised. Use the Stock Trends reports to isolate stocks based on your selection criteria. Ask questions like which stocks advance more - stocks with established momentum (high RSI) or stocks suffering decline (low RSI)? Follow results. Find patterns of volume. Learn to watch the market in a clinical manner. Learn to recognize the tension of supply and demand. You will find that you will begin to see stocks, not companies. You will develop no attachments to stories, to analyst reports, to tips and rumours. You will trade stocks clinically. Only then will you be able to remove your emotions from your trading. And you will gain confidence in the doing.

 

How much to invest?

There is a rigorous science behind portfolio risk management. Perhaps you will demand more knowledge for yourself and study the daunting literature on this topic. Ralph Vince, is a major contributor to this field – his books The Mathematics of Money Management, Portfolio Management Formulas, and The New Money Management give traders firm guidance in their trading plans. Nevertheless, an overriding calm and common sense will steer most small traders in an effective fashion.

Portfolio management theory merely quantifies the elements of risk management we instinctually employ in many parts of our lives. We know that “having all our eggs in one basket” is a bad idea. Our survival instincts often provide us with this wisdom, if our parents don’t. Unfortunately, many new traders take unnecessary and costly risks in the market because they have not quantified their risk and learned to spread the impact of risk across an entire trading strategy. It is imperative that every new trader evaluates his/her capacity to meet the capital requirements necessary to trade with adequate risk management principles at work. In short, you need money to make money. The alternative is to enter the stock market arena, dice in hand, ready to be delivered the fortune you deserve. Most of us just aren’t that lucky.

 

Stock Trends offers investors a variety of buy signals every week. Some are more valid than others and a few are not valid at all. Nevertheless, it is a trader’s tool. It interprets the movements of a stock and gives timing signals. Traders should be prepared to enter the market when these signals are given. Different trading systems may generate more entry signals, and consequently require a portfolio to handle more positions. The systems I have tested with Stock Trends all seem to require that a portfolio hold at least five positions at a time.

 

These guidelines make it sensible to limit net investment per initial position to 20 percent of total trading capital. For example, $25,000 trading capital would permit $5,000 to be invested in five positions. It is important to remember that this is trading capital, not total investment capital. A good financial planner would not want all of your capital at risk in trading stocks – you should have a complete financial plan that diversifies your wealth between assets. Trading capital should only be one component – probably the most risk-tolerant component of your portfolio of assets.

 

Can you begin trading without $25,000 or even $50,000? Suppose you have little savings, say $10,000 socked away and you are convinced that the market is going to be your ticket to financial security. What is the danger in trading stocks with limited capital? The answer is simple: limited capital equals maximum risk. It would be nearly impossible to manage your exposure to risk with insufficient trading capital. A trader would be unable to develop sound trading practices if the necessary funds to execute a trading system are not in place. It is impossible to be a clinical and systematic trader if holdings are limited to one or two stocks. The emotional pull of every trade would be a recipe for disaster. Yes, there are those that will defy the odds and leave the rest of the house wondering how such good fortune was had, but these are few and far between – they are merely a part of the folklore that draws new traders to the market.

 

How much to risk? 

 

Most professional money managers limit risk to one percent of available trading capital when taking an initial position. Smaller traders might find two percent more realistic — meaning that on an account with total capital of $25,000, a limit of $500 would be at risk in each position. That is, for every trade you are prepared to lose $500. If the stock goes against you, you would sell as soon as you lose $500.

 

For example, suppose you buy 573 shares of Precision Drilling Corp. at $17.25 each. The total cost, including commissions, is $9,983. If the stock price drops to $16.38, the value of the investment drops $500 to $9,384.25. You sell the stock at a loss as soon as the price drops 88 cents — hardly much room for early volatility in the trade. Obviously, investing more capital will improve the system’s ability to weather a trade with bad beginnings. An account with $100,000 trading capital would accommodate a $20,000 position (20% of trading capital) and a $2,000 loss per trade (2% of trading capital) – and in this example would have allowed the stock to drop $1.75 to $15.50 before the position was stopped out or closed. In some trades, this extra leeway will allow a trader to stick with a trade even with early volatility. Other times it merely delays inevitable losses. But the purpose of a stop-loss order is to remove the trader’s emotions from the decision. It is unforgiving but salvages precious capital when a timing signal is off.

 

 

SUMMARY

 

Money management skills are learned, both through the application of specific risk management principles and the hard-knock education of self-evaluation (otherwise known as the painful lessons of experience). The essential components of money management are derived from basic principles, some of which include:

 

• Before you trade, know why you are buying a stock. Just as importantly, know why you will sell a stock. Determine your rules of engagement before the battle begins. Successful trading demands a well-defined trading plan.
• Determine the amount of trading capital to be employed. Remember the necessity of good financial planning and take care of your wealth management with proper consideration of tax implications and conservative asset allocation. For most investors, it is prudent to allocate only a certain percentage of total capital toward an active trading account.
• Once a trading account is funded it is critical that a trading plan be implemented – diversifying risk on active trades. One way of doing this is limiting capital per position to a certain percentage of total trading capital. Never put all your eggs in one basket!
• Limit allowable losses on each position. Risk per position should be quantified. Determine the dollar amount at risk per trade, and implement an exit strategy that attempts to cap losses at the defined level.

 

Next > Chapter 8 - Trade Execution

 

 Stock Trends Handbook - Contents