Money management in the field of stock trading is almost as important as stock selection. Without proper money management it is very hard to make money while trading stocks. And in fact poor money management can send your balance spiraling down faster than poor stock selection. Because if you hit a rough patch, where you are losing money, which always seems to come in faster torrents than winning streaks, than without proper money management, you will lose huge chunks of dough while floundering around for a plan.
If you have been reading articles by yours truly, and/or following our blog at http://livingonlargecaps.blogspot.com, then you know, we trade exclusively in large cap stocks. And as I if I haven't hounded on this point enough, one very nice thing about large cap stocks is their predictability, and frankly lack of volatility. Predictability is nice for trading and making profits. Lack of volatility is great for helping in money management. It is this lack of volatility that rarely will put you in the situation mentioned above, where, huge chunks of dough are being shredded, in the blink of an eye. But it can and does happen, and that is what you need money management for.
Because I trade in only large caps, I am extremely aggressive in money management. I was in the 90's too, when I traded hi-techs, dot-coms, and bio techs too, and frankly that is what sunk me. Constant margin calls, forced me to sell or cover stocks that went against my position, and when trades did open up and looked like that 'can't miss', I had to liquidate some other trade to open the 'can't miss' one. All of this led me to becoming broke, and leaving stock trading for several years. But the reflection has paid off more handsomely than I could have ever guessed. So back to money management. I will tell you what I do, this is not a recommendation, just a presentation of ideas. But as we have earned over 50% per year for three years trading large caps, this money managemnt system actually increases that yield to close to 75%, and that is after commissions.
We generally have eight to nine open positions. Sometimes less, sometimes more. And we always use a margin account, which automatically will increase your returns, or frankly losses. To avoid margin calls, we use only half of the available margin in any one direction. So for example if we have a $10,000 stock account. Go ahead and figure eight positions for the time being, if you follow our blog trades and we go higher than 8, you might have to skip a couple of trades, until you liquidate, do not get in the happen of closing out one trade just to jump into a new one. As you know if you use margin you actually have $20,000 available to you, keeping half of your margin out of the market leaves you with $15,000 for trading. If you figure 8 trades, that leaves you investing about $1,875 per trade. Now most people think one cannot make money trading large caps, let alone only holding them for about a month. And only trading $1875 per trade. But our average trade through 2005 at the time of I am writing this has been just over 4%, per trade. At $1875 that is $75 profit per trade. Commissions now run as low as $7 per trade, I have actually seen some advertised that are lower, but we will use $7 (available at Scott Trade), so if you subtract the $14 to buy and sell from your $75 profit that leaves you with $59 in your pocket. And more money to trade with, you take your new balance and divide by 8 and viola your next trade will be $1886. And so it goes, on and on, you average trade earns you $59, you average trade lasts a month, your average monthly gain will be $640. But as your balance grows so do the size of your trades.
Two nice, very nice things happen as your average trade grows. One is the commission as a percentage of your trade drops, and two your account size grows exponentially.
Besides commissions, there is also margin interest, which runs currently at about 8% annually. Which on a $10,000 account will cost you about $66. So your $640 profit actually becomes about $575. On the plus side, since we are trading large caps, you will find dividends rolling into your account which offset your margin cost, but as those are random, and I don't trade with them in mind, just call them a nice little bonus. Lastly there is the tax thing, which can hurt depending on your level of income. The Feds don't give you a break on short-term profits, so expect to give some of this money back. But it is still better than digging ditches.
So that is how I decide how much to invest per trade. I actually divide by 10, and as aggressive as I am, I don't leave 50% of my margin in reserve IF I am both long and short the market at the same time. If I am only long I do heed the 50% reserve, as a cushion. It also gives me money to short when it becomes likely there will be a short pull back, or to hedge against a pull back, but I don't want to yet sell my longs.
As for losses, you can institute a stop-loss system on your positions, only wanting risk say a 5% pull back. I have tried that in the past, and most traders will swear you have to do it. But again since we are trading large caps, I no longer put in a stop loss. If a trade is obviously not going to make money, the last place I want to get out, is when I have had enough and can't take it anymore. I will wait until the price rebounds a bit and then dump it. It is amazing how not panicking, can save you thousands in losses per year. Again this is where it pays to keep 50% of your margin off the table so you can temporarily absorb moves against your positions, without having to heed a margin call.
When a stock is moving in my favor I do lock in profits, however with moving stop-limit orders. On long positions I find I do almost as well locking 3.5% profit once a stock's intra-day high is 5% above my entry price. I then keep moving up the stop-loss as the stocks highs become higher. Sometimes I use technical analysis to pinpoint where I think a stock's rally will be over. But many times I find the stock hits that point and then re-rallies, so a pure percatnatge stop-limit system of exiting profitbale positions works very well. On shorts, I usually keep the stop-limits very tight, especially if the market is not in a downtrend. When a short moves against me, I tend to exit at the first sign of it's next down ward move is ending. I don't usually find shorts as profitable as longs, but I do use them. In other words I again wait for my short to move somewhat in my favor limiting the loss and then I cover.
Trade without fear and greed and you will trade better. A clear money management plan, will help you eliminate fear and greed.
About the Author
CT Larsen has been trading stocks since 1990. Now trading large cap stocks exclusively. He has recorded three straight years of greater than 50% annual returns. You can read his blog at http://livingonlargecaps.blogspot.com. |
