Friday, 26 October 2018

Manage your money

Money management tasks

You need to perform the following important money management chores to do the job properly:
• Determine how much you are willing to risk on each trade.
• Understand the risk of the trade you are about to take and size the trade appropriately.
• Track the trade going forward.
• Pay attention to your risk points; take small losses before they become big losses.
• Review your performance.

Determining per-trade risk

The most important decision you need to make is how much you are willing to risk on each trade relative to your entire portfolio. For example, many of the top traders said they limited this amount to less than 2 percent of their stake.

The reason to keep this number small is to protect yourself from a series of losses that could bring you to the point of ruin. Losing trades are a fact of life when trading — you will have them. The key is to limit those losses so that you can endure a string of them and have enough capital to place trades that will be big winners.

Expectancy along with position sizing is probably the two most important factors in trading/investing success. Sadly most people have never even heard of the concept. In simple terms, expectancy is the average amount you can expect to win (or lose) per Rand at risk. Here’s the formula for expectancy:

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)

As an example let’s say that a trader has a system that produces winning trades 30% of the time. That trader’s average winning trade nets 10% while losing trades lose 3%. So if he were trading R10,000 positions his expectancy would be:

(0.3 * R1,000) – (0.7 * R300) = R90

So even though that system produces losing trades 70% of the time the expectancy is still positive and thus the trader can make money over time. You can also see how you could have a system that produces winning trades the majority of the time but would have a negative expectancy if the average loss was larger than the average win:

(0.6 * R400) – (0.4 * R650) = -R20

In fact, you could come up with any number of scenarios that would give you a positive, or negative, expectancy. The interesting thing is that most of us would feel better with a system that produced more winning trades than losers. The vast majority of people would have a lot of trouble with the first system above because of our natural tendency to want to be right all of the time. Yet we can see just by those two examples that the percentage of winning trades is not the most important factor in building a system.

Understanding trading risk

It’s easy to determine how much risk there is in a particular trade. The first step is to decide — before you put the trade on — at what price you will exit the trade if it goes against you. There are two ways to determine this price level. The first is to use a trading method based on technical analysis that will provide a reversal signal or a stop-loss price for you.

The second is to let money management determine the exit when you don’t have a technical or fundamental opinion about where the “I was wrong” price point is. This is where you draw a line in the sand and tell the market that it cannot take any more money out of your wallet.

The point is that no matter what your approach — whether technical, fundamental, astrological or even a random dartboard pick — you should not trade or invest in anything without knowing, at all times, what your exit price will be. You need to know this price ahead of time so that you don’t have to worry about the decision when that price is reached — the action at that point should be automatic. You won’t have time to muddle it out when the market is screaming in the opposite direction you thought it would go!

If you are using the first method, you can use this formula to determine how many shares of stock to buy:

s = size of the trade
e = portfolio equity (cash and holdings)
r = maximum risk percentage per trade
p = entry price on the trade
x = pre-determined stop loss or exit price

For example, Belinda has a trading account with a total value (cash and holdings) of R100,000 and is willing to risk 2 percent of that capital on any one trade. Her trading system gives her a signal to buy XYZ stock trading at R100 per share and the system says that the reversal point on that trade is R95.Plugging this into the formula tells Belinda that she can buy 400 shares of XYZ. The cost of this investment is R40,000, but she is only risking 2 percent of her capital, or R2,000, on the idea.

Belinda then gets a tip from her brother-in-law that ABC is about to take a nose dive from its lofty perch at R40 because he heard from his barber that earnings of ABC will be well below expectations. She’s willing to go short another R10,000 of her stake on this idea. She studies a ABC chart and can’t see any logical technical points that would be a good place to put in a stop, so she uses the money management method to determine the stop according to this formula:

x = pre-determined stop loss or exit price
p = entry price on the trade
i = investment amount
e = portfolio equity (cash and holdings)
r = maximum risk percentage per trade

Since she’s shorting ABC, the value for i, R10,000, should be negative.

Plugging these values into the formula above would tell Belinda that her stop price on the short sale of ABC should be R48. If she didn’t want to assign a high confidence on this trade she could reduce the max risk to 1 percent (r=0.01), which would bring the stop down to R44.

Tracking the trades

It is important to watch your positions as they progress and adjust your stop prices as the market moves in your direction.

In the first example, if XYZ moves from R100 to R120 and the stop is left at R95, what started as R2,000 or 2 percent at risk is now R10,000 (9 percent of the total equity) at risk.

The mistake most people make is to consider trade winnings on open “house money” — that somehow this money is less painful to lose than the money in your back pocket.

This is a bad mental habit. If losing 2 percent of equity on a trade would be painful to Belinda when her account was at R100,000, losing 9 percent after the stock has moved to R120 should be several times more so.

Moving your stop loss up with the price on a winning trade does several good things: It locks in your profits and if you are using core equity to size new positions, it will allow you to take more risk on new trades.

Never move a stop backwards from its initial price — stops should always be moved to reduce, never increase, the amount of risk on a trade.

Past the initial risk you are willing to take, stops should be a one-way valve for the flow of money from the market to your account.

Terminating with prejudice

A money management plan will only be useful if you do what it tells you. This means planning your trades as outlined above and trading your plan. If a stop price is hit you must take that hit.

If you find that your system is giving you stops that are constantly getting hit, then perhaps you should re-examine the rules of the system — but don’t mess with your money! Second-guessing the approach will cause you to take on more risk than you planned, increasing the chances that a bad trading system will ruin you. Once your stop is gone, how will you know when to get out next?

Take your losses when they are small because if you don’t they are sure to get large. In this regard, discipline is of the highest importance. It is a cardinal mistake not to take a stop if it is hit. It’s even worse if the stock comes back and turns the trade into a winner because now you have been psychologically rewarded for making the mistake.

Get out quickly and re-assess the situation. If you think it will come back, put on a new trade with a new stop.

Faith, hope and prayer should be reserved for God — the markets are false and fickle idols.

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