General
In an age where it has
become fashionable to manage one's own investments,
very few traders have implemented disciplined, professional
money management strategies. During the stock market
bubble, limiting risk was an afterthought, but given
the price action over the past year, the time to get
serious is here.The need for professional risk and
money management techniques is a foundation for success.
Money management tells you how many shares or contracts
to trade. This is the most crucial concern a trader
faces; it determines your risk and profit. It is a
defensive concept that keeps you in the game to play
another day.
For example, money management
would tell you whether you have enough new money to
trade additional positions. However, money management
would not focus on stop placement as some mistakenly
believe. Stop placement does not address the "how
much question".
The risk management formulas
and philosophy are key to increasing profits while
also controlling risk. Many avoid or don't understand
proper risk management. However, risk management is
the difference between success or failure in trading.
Trading is 90% money and portfolio management.
Few, if any, have the
ability to view their portfolios as a whole and even
fewer are able to optimize capital usage. Traders
and investors must move from a defensive or reactive
view of risk in which they measure risk to avoid losses,
to an offensive or proactive posture in which risks
are actively managed for a more efficient use of capital.
Special Questions
What is money and
portfolio management in the context of risk management?
The following list of issues encompass money and portfolio
management:
- Capital preservation
v. capital appreciation. How to handle in trading.
- Expectation of success.
- How much capital do
you place on each trade?
- When should you take
a loss to avoid larger losses?
- If you on a losing streak
do you trade the same? What do you do?
- How should you prepare
if trading both long and short positions?
- Is trading affected
by commodities that move at different times?
- How is correlation handled
in practical trading sense?
- Does a portfolio of
long and short allow one to trade more positions?
- How is your trading
adjusted with accumulated new profits?
- How are stops handled
when volatility is a concern?
- Is there a method to
limit entry risk with options?
- How does one prepare
for unforeseen large scale trends?
- Psychologically, money
must be viewed as a means of keeping score.
Should one trade
the same number of contracts in all markets?
No. Money and portfolio management dictate contract
number. Precise formulas set forth size. A trader who
uses constant trading size gives up an important edge
much the same way a blackjack player does who always
bets the same regardless of the cards on the table.
Common single contract/share measures of trading system
performance such as win/loss ratio, percent winning
trades, etc. are of little value to analysis. Often
the best trading approach, when tested on a single contract/share
basis, will not be the best approach when money management
is incorporated. This is a crucial advantage to trading.
What about short
term trading? Isn't shorter term less risky?
Short term trading is not by definition less risky.
Some might say I don't want a "large loss"
thinking a long term strategy involves only large loss.
But they forget profit and loss is proportional. A short
term system will never allow you to be into the trend
long enough to achieve large profits. You end up with
small losses and small profits. Numerous small losses
added together equal big losses. When you trade for
the big picture you have more positive expectation in
terms of the move. The larger the move, the larger the
validation of the move. If you were trading some short
term pattern predictive system you would never be able
to participate fully in the big trends. And big trends
make the big profits.
What about drawdowns?
All systems have drawdowns. You can't have a profitable
methodology, without having some risk and taking some
losses. Drawdowns are a function of risk level desired.
Risk level varies depending upon the reward sought.
For example, if you sought 100%+ a year gains you must
be prepared for the possibility of a 30% drawdown. Anyone
that states you can make 100%+ with only the possibility
of a 5% drawdown is not truthful.
Margin issues?
Required margin has little to do with money management
considerations. If for example margin was dropped from
$5000 to $2500 on a particular stock or commodity, should
you trade twice as many shares or contracts? Of course
not. Margin issues are not money management.
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