|First, take a deep breath and say this out loud: "I am calm and strong, and I will never take a large loss!" Now, believe it. |
The politics of money management is a multipart puzzle that must be approached analytically. While the first part is common sense, the remainder consists of a plan that must be kept in place — at all costs.
While you may have read many complicated money management plans in the past, this article serves to do something a little different. My goal is to give you — the investor, whether you are a novice or a professional — a fresh outlook on money management from a crisp, clear standpoint, without the cloud of complicated numbers. Think of it as taking a psychological bath in an effort to rejuvenate your money management skills.
When it comes to money management, keep in mind the following:
Five tenets of money management
1. Believe in yourself and your money management skills. You must believe in your ability to exit the trade, rather than simply choosing good entries. After all, the best traders in the world are not those who pick incredible entry positions; they are those who exit a trade profitably, or with little loss. Have you ever been in a losing position waiting for it to come back, because one time in the past, one of your losing positions turned into a big winner? The problem is, if you've ever stuck around waiting for a loser to turn into a winner, you've begun forming a very destructive habit. For every loser that comes back into profitability, two or three other positions will most likely go against you.
By this point, you may be saying to yourself, "I thought you were going to teach me something about money management!" But that's just it. That common-sense nugget of knowledge is almost impossible for most investors to follow. Dig deep and ask yourself if you have ever fallen into this category.
2. Know your stop before you enter the trade. By making sure you know exactly where your stop is before you ever enter the trade, you are doing several very positive things. First, you are taking a deep look at the position just in case the worst-case possibility occurs. Second, by knowing your stop, you can calculate your risk to reward ratio and eliminate potentially bad trades.
For example, say you see a breakout chart that looks promising. You are ready to jump into the stock. However, with closer analysis, you discover that a reasonable technical stop is one point below your desired entry, while your resistance is sitting one and a half points over. Again, this sounds like common sense — but how often do you ever calculate risk to reward? In this case, your risk to reward would be 1:1.5 — clearly not a good trade, even though the breakout chart looks like a sure winner. The point here is that if you always look for risk to reward of 1:3, you will eliminate more potentially bad trades.
The best traders in the world live by a simple motto: Never take a large loss. Calculating your risk to reward ratio will act as a screening tool that will also help you avoid a large loss. In addition, by knowing your stop before you enter a trade, you will keep yourself from foundering on exit if the trade does go against you.
3. Know your exit for two parts of the trade. Once the trade begins to work for you, have a clear point where you will take half of your money off the table. By doing this, you will not only book a small profit and cover your commissions, but you will also cleanse your mind to not trade in fear. This simple strategy may enable you to hold remaining winners longer, and take a larger profit upon exit. Again, this seems like a simple strategy, but it is one that many investors have trouble adhering to.
4. Never average down. While averaging down seems like a great strategy to lower your cost basis, you must remember that you are hanging onto a losing position. If you adhere to your original stop and exit the position, you can then move on to find a winning trade. Think of it as: small loser, small loser, big winner.
5. Never risk more than 5% of your total account in any one trade. Make sure your stop does not risk more than 5% of your total capital. By ensuring that your stop will not cause a loss of more than 5% — and your risk to reward is 1:3 — you will eliminate more bad trades. Your filter for finding excellent setups will become much more difficult, but effective. You may find fewer trades, but missed money is always better than lost money.
Finally, repeat after me one more time: "I am calm and strong, and I will never take a large loss!" Remember that your trades are only effective as your mental acuity. If you ever feel uneasy about a trade, take a step back and clear your head. Then approach the trade again and make sure you adhere to your original projected stop. You are the most incredible trader in the world — as long as you stick to your plan.
Mark Whistler is a licensed securities trader and broker and leading arbitrage expert. He writes a daily newsletter for ETG Securities (catering to retail investors) in Denver, Colorado, and has been a guest on several nationally syndicated radio shows. He gives seminars on trading techniques, technical analysis, pairs trading, and deciphering economic news. He is the author of Trading Pairs: Using Statistical Arbitrage To Increase Profits And Hedge Risks, available at www.pairstrader.com.
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