Proper Use of Trading Money Management
Money management is one of, if not the most critical components of any successful trading plan. Yet, it's something that many traders overlook. If you fail to properly manage your risk, your odds of making money over the long term are greatly diminished.
Depending upon what type of security your trading, and what trading style you have, proper money management techniques can vary quite a bit. Money management techniques can include asset allocation, stops and trailing stops, protective puts and spread option strategies, position sizing, profit taking strategies, etc. Whatever techniques you employ, the first step you need to take is to create an overall trading plan, and an exit strategy for each trade.
This is probably one of the most debated subjects among traders. Some traders will argue that you shouldn't use stop loss orders when trading. There are some negatives to stop orders, such as exposing yourself to being "run." (If you've ever set a stop order and had the stock drop, stop you out, and then rebound in a short period of time, your were "run".) Another argument against stops is that by placing the stop you are guaranteeing that, should your trade move in the wrong direction, you will end up selling at lower prices, not higher. If you are unsure about the position, then why not just bite the bullet and sell instead of waiting for a decline to take you out of the trade? Both are valid arguments, but we still feel that most traders are better off using stop loss orders to protect themselves.
In spite of the negatives, a stop loss is important because it can prevent a small loss from becoming a disastrously large one. What's more, by diligently setting stop losses whenever you enter a trade, you end up making this important decision at the point in time when you are most objective about what is really happening with the stock.
Some traders set their stops at a given percentage of capital that they're willing to lose. Legendary trader, William O'Neil, the publisher of Investor's Business Daily, recommends never losing more than 8% on a trade. Other traders don't want to tag a loss at some arbitrary percentage, but prefer to use technical analysis to set stops around technical support levels. One thing both sides agree on is that you never want to set your stop so close that you can get stopped out of your trade just from normal market fluctuations. Another thing most traders can agree on is that you shouldn't second guess your stops and change them due to market fluctuations. As mentioned before, your stops should have been set at a time when you are most objective about the possible outcomes of your trade. Once the stock starts moving, you can lose that objectivity, and make a change that you'll regret.
Professional traders generally won't put more than 1% of their portfolio at risk in any given trade. So, if you have a $1,000,000 account, and your trading plan includes a 10% stop loss on each trade, you would never put more than $100,000 into any one position. (A 10% loss on $100,000 is equivalent to a 1% loss on $1,000,000.)
The 1% at risk benchmark can be difficult to achieve if you are a new trader with a smaller portfolio, and/or you set tighter stops, such as 3%. What most traders will do in that situation is realize that you will need to have more than 1% of your portfolio at risk on your trades, but you still need to set a reasonable percentage so that you don't end up taking a position that's larger than necessary. Also, as your portfolio grows, you should adjust your position sizing to strive for that 1% risk ceiling.
Whatever you do, don't fall into the trap of taking a larger position due to a higher level of confidence on a given trade. No matter how clearly all the signs point to huge profits, you're going to be wrong almost as often as you're right. Having good discipline when setting position sizes and stop losses will allow you to survive a string of of consecutive losses, and still live to trade another day. Failure to employ sound money management techniques when trading will eventually lead to an empty trading account.
Too Much To Cover Here
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