Trading Lesson: Critical Money Management Skills for Traders
07/28/2017 2:55 am EST
There is no Holy Grail for successful trading, asserts Dave Landry, in this second of a three-part series. He’s Founder and President of DaveLandry.com, a trading and consulting firm.
There are only three things that you'll need to become a successful trader: A viable methodology, a solid money & position management plan, and the proper mindset to follow it. That’s it. In this second part of this series, I’m going to lay out a very simple, yet robust, money and position management plan. But first, I’m going to stay true to Random Thoughts and tell some amusing anecdotes.
Betting on the trader who seeks money management knowledge
As I’ve said before, one day I’m going to do a comprehensive course on money management. It’ll probably sell just two copies but that’s okay. At least two people will “get it.” Whenever I speak, several people will usually approach the stage afterward. Nearly all have setup questions. And, that’s understandable-we’re all setup junkies.
Occasionally, there’s one with a money management question. If I had to bet on who’s going to make it as a trader, I’d bet on that one. That’s the trader who knows that ALL methodologies are imperfect and there is no Holy Grail. That’s the person that knows in order to make-and keep!-money, you must first not lose too much.
I was a guest panelist recently...In the host’s introduction, he talked about the traders out there who are selling their rags-to-riches-and-so-can-you! Stories, going from being homeless to multi-millionaires or parlaying their bar mitzvah money over 3,000%. Even if the stories are 100% legit, is it repeatable? Returns like this mean that excessive risks were taken. Could you really repeat what they did? Or, a better question to ask would be, could even they do it again?
I was up close and personal with someone who turned $5,000, which I would later find out was of questionable origin (2 drink minimum on that story, and it’s a good one!), into roughly $1-million. As he neared the million dollar mark, I encouraged him to cash out, put the majority of the money into a secure annuity so that he would have a lifetime of income. And, if he truly was that great, then take the remainder and rinse & repeat. Show me. Do it again! He said, “I’m not going to take financial advice from you!” His voice still haunts me to this day, especially when the market humbles me or quite simply, I screw up on a trade.
Unfortunately, this all ended badly. He showed up on my doorstep when he was on the downside of this round trip. As his account was nearing zero, the broker sent a letter notifying him that they were suspending his trading because he obviously didn’t know what he was doing. I guess this CMA disguised as paternalism was just a tad bit late. It sure would have been nicer of them to do this a few hundred K ago. Anyway, he’s no longer on this earth due to his own demise (part of the aforementioned 2-drink minimum story, unfortunately, for him, it was more than just 2 drinks).
Having money and losing it is much worse than never having it
We all read about these famous traders who amass fortunes but the Paul Harvey “rest of the story” is that many subsequently blow up. In Wall Street Darien-the high maintenance girlfriend explains quite frankly to Bud—the young punk seeking Wall Street riches-that: “When you’ve had money and lost it, it can be much worse than never having it at all.” Darien’s right, psychologically that can be tough.
You don’t want to be able to buy anything and then end up only buying the farm. Ridiculous returns can be had provided that you don’t blow up in the meantime—and eventually, you will. And, that comes with another cost. Your psychological well-being.
Money management, methodology, and trading psychology
I’m working on a trading course that starts with the basics and builds. Every time I begin talking about the methodology, I find myself mentioning psychology. And, every time I mention psychology I find myself talking about money management, and so on, and so forth. Case and point: This article is supposed to be about money management but so far, it’s been mostly about psychology. The three are intertwined and cannot be separated. The good news is, as you get better at one, you get better at all. “A cord of three strands is not easily broken” --Ecclesiastes 4:12
Proper money management will cure a multitude of sins
I was once working on an old car that I’m restoring and thanks to my manly sized hands, broke off a part. Long story endless, unless I wanted to go dig through a junkyard in Arizona, the part no longer exists. Well, being an expert in jury rigging, I decided to mix up a little JB Weld and glue it back on. To my surprise, it actually worked. When the ex-mechanic in the auto parts store inquired about how I fixed it, I embarrassingly admitted that I simply whipped out some JB Weld. He began to laugh. I assumed that he was laughing at me but it was actually with me. He then said “Dave, JB Weld will cure a multitude of sins.” This got me to thinking. Money management is the JB Weld of the trading world. We’ll come back to this.
Trading is unfair that’s why money management is key
Trading is unfair. It’s unfair because no matter how much you make on your rise from being homeless on a park bench to Park Avenue if you lose 100% along the way the game is over. Yeah, you might get lucky and parlay a 3,000% return on some found money, but all it takes is a 100% loss to obliterate that. Let’s say you lose 10% and then make back 10%. You’re whole, right?
Well, not exactly, a 10% loss requires a 11.1% return just to get back to breakeven. And, obviously, once you’re down 50%, you’ll need to earn 100% to scratch out. It grows even more geometrically from there—e.g. a 90% loss requires a 1,000% gain. This is illustrated in the graphic below which I have put into all of my books. If you’re new to trading or ever find yourself swinging for the fence, then print this off and tape it to your monitor right next to the back of my business card with the up/down/sideways arrows. Someday you’ll thank me. You’re welcome in advance!
Get your money management right
Since trading is unfair, your money and position management plan must control losses while still allowing for unlimited gains. So called “income-producing” systems do just the opposite. They take small gains and huge losses. Legally, I can’t promise you much but the one thing I can promise is that’ll work until it don’t.
The trader’s dilemma
I often talk about the trader’s dilemma between short-term and longer-term trading. You can only predict the short-term but you don’t make enough short-term trading. And worse, even though risks are less something bad can—and will—eventually happen. You can’t predict the long term but that’s where the money is. Unfortunately, so are the risks. We all read about famous traders who make all this money longer-term trading but the Paul Harvey “rest of the story” is that many subsequently blow up. Some readily admit this publicly. Kudos to them for keeping it real!
Money & position management: have your cake and eat it too
My solution to this trader’s dilemma is to trade the short-term but stick around if the trend materializes. You can only predict so far but you can follow forever. Since the odds are stacked against me longer-term, I take a short-term partial profit just in case that’s all I get. True, more often than not, the mother-of-all trends does not materialize but we’re there when they do. If you keep your losses small, then “one big winner pays for them all.” (Seykota) Making a little on a swing trade here and there helps to keep the lights on in the meantime.
You need money management because all trades eventually end badly
Before we get into the nitty gritty, just know that bastardizing a line from George Carlin, “ALL trades will eventually end badly. You’ll either stop out at a loss, make a little then stop out, or catch a great trend but give up a big hunk in the end.”
Money and position management rules in a nutshell
1. Risk 2% of an account value on each trade if stopped out.
2. The initial stop will be set based on the volatility of the stock.
3. Take partial profits (half) when reward equals the initial risk and bump your stop to breakeven (intra-day).
a. If the trend then materializes, you’re still in.
b. If it doesn’t materialize, at least you made something (barring overnight gaps).
4. Trail your stop roughly on a one-to-one basis before the initial profit target is hit and then let it gradually open up on the remainder to make the transition to longer-term trader.
Let’s break down the money & position management
Risk 2%: First, know this, you’ll always feel that your position is too small when you have a winner and too big when you have a loser. Get over it. You’ll just have to learn to accept this or find something else to do. Notice I used the word “feel”—there’s the trader’s psychology rearing its ugly head. Again, you see, you can’t talk about one of these things without the two others. 2% risk seems to be the sweet spot. Any less and you don’t make enough and any more you’re risking too much.
Money management is a good defense but never forget that your best defense is a good offense to begin with.
Even at just 2%, you can spiral an account down pretty darn fast if you’re not taking the best opportunities to begin with. As we used to say way back in my computer science days, “garbage in, garbage out.”
If you made it this far, then you know that money management is crucial.
Just never forget that your best defense is a good offense. I know it’s cliché but you must pick the best and leave the rest. If you’re taking the best trades to begin with, the money management and the psychological issues of trading will take care of themselves. Again, notice how all three things are intertwined? I’ve received calls and emails from people throughout the years who have had 10, 15, and even 20 or more losing trades in a row. Either their stock picking can use a little work or their stops are too tight. The too tight of a stop problem is easily fixed (keep reading). And, with a little work we can fix the stock picking part too. Start with my Trading Full Circle course (free to get started) and stay tuned for Part 3 of this series.
BTW, if you are new are newer to trading, ease up to the 2% maximum but be consistent. For instance, say you’re at 1/4% per trade and start becoming successful.
Don’t instantly jump to 2% and then drop back to ¼% if you get hit. As Murphy would have it, chances are you will get whacked for a full 2% and then have to claw your way back. Instead, bump to 1/2% and stay there for a while, at least until you prove that you can stay consistent. Then, continue to slowly but consistently ease your way higher. If you’re not first making money risking a little, then you certainly won’t make money risking a lot. Yeah, I know, a Captain Obvious statement but I see mistakes exactly like this all the time.
Setting your initial protective stop
Tight stops are universally preached. Ironically, by trying not to lose money you end up doing just that. Stops must be set based on the volatility of the underlying instrument for the period that you tend to hold the position. There’s a popular method that says you should use an 8% stop on all stocks. That’s like saying we all should wear a medium sized shirt. Case and point: on the date that this article was originally published, we had a stock in the portfolio move over 20%.
So, where exactly do you place the initial protective stop? Well, it’s as much an art as it is a science. Statistics are worthless, 73.4% of all people know that. Seriously, statistics (the science) can help but you can’t rely on them exclusively since markets aren’t normally distributed—if they were, statisticians and/or those with the fastest computers would own the markets. The art is simply “eyeballing” the chart to see how much the stock bounces around and making sure your stop will withstand that normal volatility. Otherwise, you’ll get stopped out on noise alone—one of the few things that I can guarantee. The other part of the art is asking yourself where would you be wrong as a trend follower? If you’re long and the stock is making new lows, then, ah, you’re wrong.
Take partial profits when the reward is equal to the initial risk
For your initial profit target, take partial profits on a one-for-one basis. For instance, suppose you determine that your stop should be 5 points away from your entry then take partial profits when you have a 5 point gain. Wait, Big Dave, shouldn’t you make more than you risk? Yep. Good point. Taking a one-for-one risk to reward raises a so called “negative expectancy” concern. We beat the perceived negative expectancy by allowing for the potential of virtually unlimited gains on the second portion of the trade-something that I address often on my YouTube Channel.
Trailing your stop
Trail your stop roughly on a one-for-one basis before the initial profit target is hit. So, if the stock goes up 1 point, then bump your stop up 1 point (on the full position). Don’t split hairs. If the stock only goes up a few cents, then don’t bother adjusting. Note: In more recent times I have been somewhat more liberal in the initial trailing of the stop. In other words, I have been trailing on a slightly less than a one-for-one basis. This is me making a slight tweak to the more choppy conditions that we’ve seen in more recent times. In trading, there’s always a trade-off. (Hey, is that why they call it trading?). The more liberal you are with your stops the more winners you will catch. Unfortunately, the more you will lose when the trend doesn’t materialize.
As soon as the initial profit target is hit, immediately take half of the position off and then bump your stop to breakeven. This happens intra-day. You don’t have to watch a screen all day. And, don’t. That’ll make you crazy. Use alarms to alert you when you are near and action needs to be taken. I’m not a huge fan of limit orders but this is one case when they can be used to help ensure that you get the initial profit out of a trade when you’re not around.
Now’s the fun part. Sit back and relax (I know, ha ha!). Seriously, these are the ones that we have been waiting for. We’ve taken the risk off and now are making the transition to longer-term trend follower. Barring overnight gaps, the worst we can do is break even for a “better-than-a-poke-in-the-eye” trade.
Below is all of the above in action. Again, see the aforementioned Dave Landry's The Week In Charts for a walk through.
In summary, money management IS crucial. It will cure a multitude of sins. If you’re trading at the right size, then it’s much easier to follow your methodology from a psychological standpoint. Ya see, there’s all three again.
May the trend be with you!