Trading Rule #5 - Money Management
Money management is the most important component of your trading strategy. Money management defines, before you enter the trade, how much money you are willing to lose if you are wrong. Many studies have been undertaken that prove that you should not risk more than 2% of your portfolio on any one trade. Even 2% is probably much too high for the average trader. On a $100,000 portfolio, 2% risk is $2,000. As a trend following trader, you will have streaks where you will have 15 losses or greater in a row. Using 2% risk, that would represent a drawdown of 30% of your portfolio or $30,000. Could you continue to place trades after you have lost 30% of your portfolio? This is an important question you must ask yourself. Most traders or investors can handle a 20% drawdown, but with anything greater than 20% they start to panic and doubt their strategy. Remember the key to your success as a trader will be your ability to follow your system and take all the trades your system generates. After your system has lost 15 trades in a row, you must be able to take that 16th trade, as it may be the trade that makes up for the previous 15 losing trades. Most trend trading strategies rely on four or five really successful trades throughout the year to make the bulk of their profits. You must be psychologically strong enough to ensure you don’t miss those four or five really successful trades.
In order to ensure that you can stay in the game long enough to become successful, it is suggested that you trade much lower than the 2% maximum risk. It is suggested that for at least your first 100 trades you limit your maximum risk on any one trade to 0.5% of your portfolio. On a $100,000 account, that would be $500. Only after you have completed 100 trades, and your system has proven to be profitable, can you consider raising your maximum risk by an additional 0.5%.
In the previous section, we developed rules for entering the trade and setting our initial stop loss. With this information, we can determine how many shares we can buy to stay within our maximum risk tolerance of 0.5%. Let’s assume we have stock ABC in our watchlist. During our daily end-of-day review of our watch list, we notice that stock ABC has broken through a key resistance level, on higher than average volume, which is our trigger to initiate a trade. The high of the day at the close was $101.00. The 20 period ATR at the close was $2.00. Our stop loss exit rule states that we will use a 2 x ATR to calculate our stop loss price. As such, our stop price will be $97.00 ($101.00 – (2x $2.00). The difference between our proposed buy price and stop loss price is $4.00 ($101.00 - $97.00). Our defined risk on our $100,000 account is 0.5% or $500. To ensure we do not lose more than $500 on the trade, we can purchase 125 ($500.00/$4.00) shares of stock ABC. We then place an end-of-day buy stop order to purchase 125 shares of stock ABC at a buy stop price of $101.00. If on the next trading day the stock continues to trend through the $101.00 price, our order will be filled. If our trade is filled at the end of the day, we place a sell on stop order to sell the stock if our $97.00 stop price is hit. A stop loss order must be placed for every stock we own without fail. We can never adjust the price of the stop down, only up.
In the next lesson we will develop Trading Rule #6 - Profit Stop Exit.
Download our step-by-step guide - "How to Build a Systematic, Rules-Based, Trading Strategy" and start trading your way to financial freedom!