Money Management
Wise investment necessarily involves money management. Money management involves spreading your risk appropriately across your portfolio. If you capably manage your money, you can trade successfully for years, but ineptitude in the long or short term could wipe out any fortune you have.
Trading in stocks and CFDs is invariably compared with poker, and clearly some of the skills are transferable. Both require astute money management to be successful in the long term. Both are activities in which an ability to collate, retain and use information will increase the odds of a win. But, of course, poker is very much about the perceptions of opponents-while in trading, you will find yourself unable to bluff the market.
The investors who tend to enjoy the greatest sustained success are those who stick to predetermined, clearly defined rules. These rules help them to avoid major crises.
We will look at three money management rules you need to incorporate in your trading:
- Live to trade another day
- Know what you are willing to risk
- Know how to determine trade size
You will also learn about one of the stock and CFD market's most important trading tools: the so-called 'stop-loss.'
Living to trade another day is perhaps the most important goal. Regardless of whether you make bad decisions during any trading period, if you live to trade another day, you will have a chance to recoup losses and ultimately achieve success. The common-sense rules we suggest that you impose on your trading will enable you to survive everything that the stock and CFD market throws at you. If you understand and observe these rules, you will already have an advantage over most investors. That advantage means you should, of course, not only survive but outperform the market.
The single factor that causes most investors to overextend themselves and suffer catastrophic losses is greed. Greedy investors take unnecessary risks. Typically they will fool themselves that a single indicator is the absolute key to success. You could draw a parallel with those who bet on horses using the formula that the next stake has to be sufficient to potentially wipe out any previous losses. Clearly such a strategy can only work if the gambler is wise enough to quit whilst he is ahead and does not run out of the necessary funds, the amount he needs to wipe out previous losses, first. Of course, such a gambler, when he is left with a reduced stake, can only recoup all of his losses by gambling at longer odds. Those longer odds reflect the likely chances of success. So the risks become increasingly acute, and the apparent necessity to gamble all that is left means ever-increasing risk. This is the kind of desperation which traders need to avoid.
Unfortunately, there is no secret to sure-fire gains in the markets-just like there is that a race-goer will beat the turf accountants. Most traders have confidence in specific indicators. Many focus on particular markets and hope that this focus, and the quantitative or qualitative data they collect, will prove to be the key to investment success. But markets are dynamic and essentially volatile. In such an environment there are no cast-iron certainties. To help you avoid a roller-coaster ride, we are going to show you how to live to trade another day so that, no matter what changes take place in the market, you can enjoy at least modest and worthwhile success.
Know what you are willing to risk before you ever enter a trade is the basic tenet of living to trade another day. If you do not risk too high a proportion of your funds in any one trade, or in a handful of trades, then you will be able to continue trading whatever the outcome of your trades. In other words, it is not sound investment practice to put too many eggs in one basket.
You will have to decide what percentage of your account you are willing to lose in any one trade. Once you have decided that, the rest is simple math. Most investors feel comfortable risking approximately 2 percent of their total account balance in any one trade. This is a general rule of thumb, but it is up to you to decide how aggressive or conservative you want to be. If you want to be more aggressive, you could risk a larger percentage of your account in any one trade. If you want to be more conservative, you could risk a smaller percentage of your account in any one trade. It is up to you to determine how much you are willing to risk.
Once you have decided what percentage of your account you are happy to risk, all you have to do is enter that value into the following equation:
Account balance × risk percentage = amount at risk
The math is simple. Imagine that you have an account balance of $50,000 and would like to risk 2 percent of your account in any one trade. If you drop these numbers into the equation, you will see you should not risk more than $1,000 in any one trade.
$50,000 × 0.02 = $1,000
Clearly, the same math works even if you want to invest in pounds or euros.
Remember that this is the maximum amount to risk in any single trade. You may have much more at risk if you are simultaneously involved in other investments. If you were in five trades at once, for example, you would risk only $1,000 per trade but have a total amount at risk of $5,000. Once you decide how much you are willing to risk, you are ready to determine your trade size.
What we should emphasize at this point is that you ought to consider every penny of your investment to be at risk of a total loss-unless you have a 'stop-loss' (something we are going to explain, but essentially it means a limit at which you would definitely sell an investment that was losing money and cut your losses).
You need to know how to determine trade size to prevent unnecessary exposure to risk. Trade size is the volume of stocks or CFDs you buy or sell in any individual transaction. Once you know how much you are willing to risk, you need to know how to set up your trades so that you do not risk more than you are comfortable with. It is pointless deciding what risks you will tolerate but then, for whatever reason, entering a transaction that exposes you to too much risk.
To determine your trade size, you must first decide where you are going to set your stop-loss. Once you have decided where to place the stop-loss, you have to calculate the difference between that price point and the point where you enter the trade. Then all you have to do is enter that difference into another simple equation.
Amount at risk ÷ distance between entry price and stop-loss price = size of your trade
e.g. $1,000 ÷ ($1,000 - $700) = $300
The size of your trade is now, in effect, not the whole amount invested but the part of it which is at risk between your entry point and the stop-loss.
Knowing exactly how to size your trade will help you eliminate the nightmare scenario-one where you could lose more than you are comfortable losing, and perhaps even lose everything in that stock or CFD. Using a stop loss you will make investing much less stressful, and the presence of such boundaries will increase the likelihood of you making an overall profit on your trading rather than a loss.
A stop-loss order is an order you place with your dealer to sell if the stock or CFD reaches a predetermined price point. Stop-loss orders allow you to automatically protect your trading account even in your absence-i.e. when you are not in front of your computer. This is essential since most traders cannot watch their investments 24/7.
If you buy a stock or CFD, you should always place a stop-loss order somewhere below the current price. This will protect you if the stock or CFD loses value.
If you sell a stock or CFD to enter your trade, you should always place a stop-loss order somewhere above the current price. This will protect you if the stock or CFD uexpectedly increases in value.
We will give you an example. Imagine you buy 50 shares of General Electric (GE:xnys) stock at $35. You know that there is strong support approximately $5 below this price level at $30. You therefore decide that if GE falls below this $30 level, it may continue lower. To protect your investment, you set a stop-loss order with your dealer at $30. If the price of GE drops to $30, even momentarily, at any time during the trading day, your dealer will automatically sell your stock for you.
Stop-loss orders provide safety and security when you are trading, and they ought to play a critical role in all of your money-management decisions. You should never place a trade without one.
Lastly, we ought to explain a more sophisticated type of stop-loss order. When you have a little confidence in the use of ordinary stop-loss orders, you could experiment with trailing stop-losses. These move as the price of the stock or CFD moves. You can set a trailing stop-loss to trail the price of the stock or CFD by $5, for instance.
You might buy at $35 and initially set your trailing stop-loss at $30. Then, if the price rose to $40, your trailing stop-loss would automatically rise to $35 (i.e. $5 below the highest price the stock or CFD reached). If the stock or CFD then suffered a reversal and fell back to $35, your stop-loss level of $35 would trigger the stock's sale.
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