Money Management is Key in Stock and Options Trading
Okay, so today I’m going to talk a little bit about money management. One of the key factors in managing your money is just to make sure that you don’t go broke. So you don’t want to lose all your capital; you don’t even want to lose a large portion your capital, although intermediate fluctuations are impossible to avoid. You can’t really make much money without having some sort of fluctuation. So, another aspect about money management most people don’t mention is that you do want to make sure that you are using your capital efficiently; so you want to make sure that your size is large enough that you are making the type of money that you’d like to be making but that usually won’t usually won’t be a factor until you are really sure what you are doing and you are sure you have a good edge.
So here’s an example of how you could manage your money. You can divide your total capital into units and so in order to decide what an appropriate unit is you would first of all be aware of how volatile what you’re trading is; you’d want to look at the average true range, the daily fluctuation, and get a good idea of what an appropriate unit size was. Then you have to figure out what amount of units is appropriate to allot to each trade. So you want to allot not so many that you risk going broke but not so few that you don’t make adequate gains. Then you decide how much of your capital is appropriate to risk for each trade. So divide your capital into say four hundred units and allocate up to four units for each trade. Then allow one re-buy for up to four units if you absolutely feel that it’s a good thing to do. Most of the time if you’re in a losing trade it’s better to cut it off then to re-buy but you want to be able to re-buy if you need to, but only one time and then if you lose eight units you should be done for the day.
And it’s okay to add to winners but never lose more than eight units in one day. If you do add to a winner you have to recognize that now the retrace will get you back to even in half the time if you double your unit. So, for instance, if you’re up to $0.50 on a trade and you buy four more units, if it retraces $0.25 you’re now going to be even instead of if it retraces $0.50 before you double the trade value. So when you’re adding it’s okay to add when you’re ahead but recognize that if it starts to fall back you’re going to be breaking even a lot more soon. And then if you go in the red it’s going to happen a lot more quickly too. Once you go in the red you’re going to be losing more quickly than you would have been. And you can increase and decrease your size by re-dividing your capital by four hundred units whenever you have some significant change in the capital size. So if you have a big win you’d want to re-divide and your unit size would be higher. If you have a big loss you re-divide and your unit size would be smaller. That’s an additional way to manage your capital.
So if you do it that way you would have to have multiple losing days in a row in order to suffer any short-term large drawdown. You could still have a large draw down over time without having multiple losing days in a row by losing some days and breaking even for a bunch of days then winning a couple days and losing more days then breaking even. Over time that could result in a large capital loss but you won’t have a very quick severe down streak using this method unless you have multiple losing days in a row. And then when you do it this way if you do start to have any sort of severe down swing it gives you time to adjust what you’re doing. You can think about it overnight because every night you’re only going to be losing a maximum of eight units which is only 2% of your total capital. So even if you had five maximum loss days in a row you’d only down 10% of your capital. Now, there a lot of other ways to manage your money. This is just a simple way to do it and I’ll go into other more involved scenarios at another time