Although the idea of money management to me is one of the most important aspects of trading, it is surprisingly how little it is discussed in many trading forums. My idea of money management is being able to keep losses small no matter how much money is being placed into the trade. Some traders tend to think in terms of lot size per trade, while others tend to think more in percentage terms. Let’s look at each issue separately, as I feel both have their merits depending on what style of trading you have.
First, let’s discuss the share lot size. Many traders, as they become efficient with their trading executions, look to increase their size position into the trade. This share size tends to not change with respect to stock price, meaning that traders will trade 1,000 shares whether the stock is $2 a share or $100 a share. Obviously, the comfort level of trading 1,000 shares will come in time to newer traders, while an experienced trader will think nothing of it. Notice that in this scenario, a trader will risk either $2,000 or $100,000. Although the share lot is the same, the percentage of the portfolio has obviously changed dramatically. For purposes of this discussion on money management, I will assume that trading 1,000 shares from an execution standpoint is relatively easy and does not pose a problem to take a wider than expected loss. However, assuming that a trader sees a trading opportunity in a more moderate to high-risk scenario, they will simply drop their share allotment to the trade.
In this case, instead of trading 1,000 shares, they may only trade 500 shares, capitalizing on the move but not opening them to more portfolio risk, should the trade provide too much difficulty in the execution phase. This change in thinking towards each trade can only be assessed from a personal viewpoint in the trader’s willingness to add this extra risk and playing smaller shares. Many times I see this scenario in my own trading. However, times occur when I see this in other’s trading and I would not employ this strategy. There is no right or wrong as traders are different and each decision is made on their own merits as a trader. The market will ultimately decide if the trade was right or wrong, but it will be the responsibility of the trader to execute the exit strategy.
Each trader must determine how tight to keep his stops and how much of a percentage of his portfolio he is willing to risk on any one trade. One trader may feel comfortable with keeping a .15-point stop loss, while another feels comfortable with .40 of a point. This is all determined by portfolio size and a willingness to lose a certain percentage of your portfolio on any one trade.
For instance, if your portfolio size is $50K, you are in a trade with 1,000 shares at $50 per share, and your stop is .25 of a point, then your loss potential is $250 plus commissions. If your portfolio size is only $25K, then your loss potential is still $250 but twice the percentage loss of your total portfolio. Market conditions may require you to loosen up your stops at times, but the number of shares should be adjusted to fit the total amount of loss you are willing to accept from your entire portfolio. You may want to only purchase 500 shares instead of 1,000 if your portfolio size is 25K on a $50 stock to keep the total percentages in line with your percentage loss program.
However, that being said, I am a firm believer in keeping your stops tight. After all, if the momentum has shifted against you, then the reason you originally entered the trade is no longer valid. This ensures that a good stop loss regiment will keep your total losses small. This assumes that you have the character and strength in your own trading plan to execute the stop loss when it needs to be stopped out, not changing the plan in midstream. Money management is a beautiful thing when employed in the right fashion for momentum traders. It helps to alleviate taking huge chunks out of your portfolio.
The learning curve can be fierce and your greatest resources include time and money. Fortunately, sometimes these are mutually exclusive, but often they are not. Give yourself enough time to let the trading plan work. Taking huge chunks out of your trading portfolio early in the learning process will not allow for this learning period to be long enough to catch on to the gist of the trading strategy. Obviously, if you are trading a small portfolio under $10,000, you have a harder road ahead of you in terms of share size and different price levels of stocks. However, whether you have $10,000 or $1,000,000, the principles of stop loss and money management must still be adhered to.
Be strong enough to accept the loss as a matter of safety, not personal negativity and disgust. If you can’t get rid of the ego or the inability to execute stop losses when you know they should be taken, you may want to reconsider your choice to continue trading. You will save a lot of time,frustration, and money by doing so. Give yourself a chance and employ the described discipline in this chapter that best fits your abilities.