Money Management

Trading Course (Get Started In Trading) Money Management

Money management and risk management are some of the absolutely most important concepts in trading. Your main tool as a trader to make money, is your trading capital. As such, it’s paramount that you work to conserve your capital. If you lose your capital, you obviously can’t continue trading.

This is what we are going to have a closer look at in this lesson:

Risk Management in Trading: What Is It?

One of the most important parts of risk management is to have a plan. It might sound like a cliche, but it’s really not. If you want to succeed as a trader, it’s extremely important to consider all the scenarios that might occur, and ensure that you know what to do would they turn into reality.

In finance, risk often alludes to the probability of your investment getting an unwanted outcome. It may just be that your investment gets a lower return than what you anticipated, but could also mean that you lose parts of or all of your investments, and in some cases even more!

The Size of your Trade: Position Sizing

Position sizing is the part of your trading plan that dictates how many shares or contracts you should buy in each trade. Reckless or “bad” position sizing is the reason behind nearly all occurrences of big capital losses, provided that you trade a profitable trading strategy from the beginning. As we mentioned earlier, managing and preserving your capital is the most important aspect of trading, for those who want to stay in the game in the long run.

When it comes to swing trading, rule number 1 is to always begin trading without money, or paper trade, as it’s also called.

By paper trading, you make sure that your strategy is profitable before you risk real money. Then, as you start trading live with real money, it’s crucial that you start off with a small amount, and then size up your trades as you feel comfortable with the process, and see that you’re profitable.

We recommend that you use a model where you increase the position size after regular intervals, such as a month or two weeks. For example, you could decide to step up your position size by a small amount each month you discover that you were profitable, until you find the right balance!

Another sensible approach

To start your swing trading career in a responsible and conservative fashion, we recommend that you start trading with small positions, and divide your capital into 10 parts, or even smaller parts, if you want to risk less.

So if you have $10,000 on your trading account, you could divide it into ten parts of $1000 each. Then, you allot one share worth $1000, to each signal you get.

For instance, if you get two signals one day, you use one share of your capital for each signal, which means that you, in total, have $2000 in your market positions.

Using this model, you’ll have a maximum of 10 open positions at the same time.

Of course, you may vary the size of each lot, depending on your risk tolerance.

Know Your Buy an Sell Levels BEFORE sending away any orders!

Successful traders put heavy emphasis on their risk management strategy, which to a great extent is concerned with the amount of money they are willing to lose on any given trade. This means, that before you buy any stock or security, you have to know what you are risking.

Depending on your strategy, this could mean that you have a specific level where you are going to exit the trade, or that you have some sort of criteria that dictate when the time has come to get out of the trade. However, backtests should take care of your exit levels.

By determining beforehand when to get out of the trade, you minimize the risk of making mistakes, and acting on a whim. It’s hard to stay objective and faithful to your strategy in the heat of the moment, when you are affected by all sorts of psychological stresses!

Many beginners make the mistake of not knowing when they should get out of their positions. They buy a stock, and decide to postpone the decision to sell to a later time. In case the market starts to go down, they may very well find themselves sticking to losing trades, in hopes of waiting for a reversal of the trend.

The opposite scenario is common as well. Many people become greedy as they see their positions appreciate. As such, they look to exit profitable positions rather quickly, which means that they often miss out on the following upswing.

Stop Losses

A stop loss is a stop sell order, meaning that it’s activated as soon as the market reaches a specific level.

Stop losses are used as protection against trades that develop into big losing trades.

It’s important to recognize that stop-loss orders aren’t bulletproof. For instance, the market may gap beyond your stop loss level, rendering the order useless. Then, as the market opens up at a much worse price than your stop level, you’ll get stopped out at the current market price, given the nature of stop orders.

Another issue with stop-loss orders, is that they don’t work that well with the types of trading strategies that tend to work best in swing trading, namely mean reversion strategies. In the lesson on trading strategy types, we covered this trading strategy type, and also concluded that the edge tends to get stronger the more a stock has fallen.

Given that stop-loss cut off a trade when it has gone against us, this means that we’ll be exiting at the moment when the edge is at its strongest.

Thus, you might look at alternatives to stop losses.

Drawdowns

Drawdown is a really important concept to understand as a trader.

In short, a drawdown is the peak to trough decline for your trading account, and thus shows the amount of money you’ve lost from the time when you were at equity high.

For instance, if you once were at an equity high of $10,000 and then experienced losses so that your account got down to $8,000, you would have had a drawdown of 20%.

Of course, as swing traders, our objective is to minimize drawdowns, and it should be noted that larger drawdowns are hard to cope with psychologically. As such, it shouldn’t come as a surprise that most traders believe they can stand a bigger drawdown than they actually do!

Diversification – Spreading Your Risk

Another way of reducing risk is by making use of diversification across markets and strategies.

In the type of swing trading that we’re going to work with, it can be hard to reap all the benefits that come with diversification, as we don’t have that many uncorrelated markets to work with. Most stocks simply are highly correlated, even across different market sectors, although spreading your positions across different market sectors can be of some help.

Still, it should be remembered that putting your capital into several stocks, instead of just one of two, will make wonders with regards to decreasing your risk level. If you perform portfolio simulations, you’ll find that the portfolio stability and stability with regards to the evenness of the equity curve, benefits from trading at least a couple of stocks. Then as you reach perhaps 7 stocks, the slight benefits of adding even more stocks generally aren’t worth the added complexity of trading more positions.

Risk Management Tips!

Here follow some tips that we believe are really useful!

Focus on the losses!

Most traders who trade full time focus more on the losses than the profits. By ensuring that you are using sound risk management rules, you’ll minimize losses, and give profits a chance to amass at a quicker rate.

As we have covered earlier, the most important thing you can do as a trader, is to preserve your trading capital!

Don’t Trade If You’re Out of Shape!

One choice you have as a trader, which is forgotten by many, is to not trade at all! In times of stress, technical issues, long travel, hardships, or anything else that will make you a worse trader, you always have the option of limiting your own risk by taking a break! By taking a break you decrease risk, as you don’t have to take and manage trades in a manner that might make you have to, or force you to, not follow your strategy and set risk management rules.

Perhaps you’re going to travel, and don’t have the time to keep yourself updated with what’s happening in the market at the moment. Then you might decide to stay out of the market, not to expose yourself to unnecessary risks!

Remember that deciding not to trade, is as much a decision as deciding to trade! It’s just as important knowing when NOT to trade.

Don’t Listen to Media or Other People’s Trading Tips!

You should always strive to make all trading decisions on your own, and not listen to the statements of experts or other boisterous commentators! Most of them don’t know a jot, but are paid to speculate freely in financial matters. And in case you would listen to some of the few who actually know what they talking about, you don’t know their trading plan or what their specific edge looks like. Thus, it will be very unlikely that you’ll be able to take advantage of it yourself!

As a trader, you should always follow your trading plan, regardless of what experts and commentators are saying in the media. In some cases, you might have made it clear that you’ll listen to some particular experts, in some particular topics. If that’s the case, then it’s already part of your trading plan, and you could take in the opinions of your trusted experts, without deviating from it. However, if you choose to do so, it’s important that you know what the edge looks like beforehand!

The Market Is Random

Try to always remember that the outcome of your next trade is random, regardless of whether the trading strategy you trade has 70-80% winning trades, or even more. This is an insight that hopefully will make you remain humble before every new trade, and keep you from taking on a reckless position size!

Final Words

In this lesson, we have presented different ways of managing risk in trading. Risk management is paramount and should be kept as first priority by everyone who wants to become a successful trader long term.

We’ll end this lesson with a simplification of risk management we like to throw around:

There are four possible outcomes of a trade: