Chapter 3-1 Money Management
Formulate a Plan
“Good fortune is what happens when opportunity meets with planning.”
Thomas Alva Edison
The money management plan you will develop for yourself will no doubt be tailored to fit your personality. Consequently, there will be as many plans for individual success as there are individuals. What is your plan? Where should you start?
One example of a solid (conservative) plan: Maximum of 600 share lot size. Only give a trade $0.05 against before you exit. Once you are $0.25 in the money, scale out of half of your position. Hold the remaining shares against cost. Move your stop exit up only when up over $0.50. If you lose $200 in your account by 11:00 am, trade half size the balance of the day or until your account is back to even. Stop trading completely for the day if down $400. If you go up quickly ($500 as an example) trade half size if you give back 20%. Simple, right?
Wrong! Stocks gap, liquidity dries up, and exits disappear. It’s a market after all, and it’s dynamic and at times violent. What is important to note is that although the plan may at times go out the window, the planning itself is indispensable. Without it you’re just guessing.
The above is a good example of the type of money management plan a young trader who is learning his/her craft is apt to adopt. However, it may or may not be suitable for one who has developed into a successful trader and is a student of market dynamics. For as your skill set evolves your money management plan will evolve accordingly. But you have to start somewhere.
“In baseball, my theory is to strive for consistency, not to worry about the numbers. If you dwell on statistics you get shortsighted, if you aim for consistency, the numbers will be there in the end.”
A well thought out plan is useless if not implemented properly. The only way one will succeed as a trader over the long haul is to develop consistency by following his/her own rules. A young trader will quite commonly delineate from their own money management plan with horrific results. They make money on the trade. What?
Although making money is the ultimate goal of any trader, developing good habits that will make money consistently is the foundation upon which your ultimate success will be built. Don’t fall into the trap of outthinking the market. If the money management plan you had developed is solid and the impetus behind your entry and exit decisions is sound than your career path will be defined by your discipline. Remember, anyone can learn to make money as a trader. Not everyone will learn how not to lose it.
A way in which a trader practices sound money management skills is by paper trading when new and unfamiliar with a particular trading strategy or market.
Paper trading is simply trading without putting any money at risk; in other words, on “paper.” When paper trading, a trader should try to simulate real life trading as much as possible. This is what will determine if you will be successful when you start day trading with real money. For this reason, you do not want to take any unnecessary risk in paper trading that you would not take in real life. Unfortunately, many people fail to do this. It is common to see people reckless and overconfident when paper trading stocks; often being far too speculative, rather than being careful and disciplined. They wind up do anything and everything possible to create a profit in their paper trading account, regardless of how unrealistic it may be. The reason why so many people fall into this trap is that there is no true recourse or penalty when paper trading. It’s simply paper. As a result, people can gain a false sense of hope that trading is easy and that they have developed a successful skill set. However, once they begin trading with real money at stake, they quickly come to the realization that the wild things that they were doing when they were paper trading is actually destroying their capital. Therefore, use the time you spend paper trading practicing the fundamentals and abiding by a set of rules you create. That way when you begin to trade with real money, you are not caught unprepared.
There are many websites out there that allow you to follow a mock portfolio of stocks. Doing this is dangerous and is not the way paper trading should be done. True paper trading should be carried out with the same system that you plan on using when you start trading live. Since those portfolio-tracking websites don’t allow you to see everything that is going on in the market when you buy and sell your stocks, you become shielded from reality and, if you are lucky, start believing that trading is very easy to do. What you don’t see is that you are taking more risk than is really prudent because the stocks may be fluctuating more than you know. Thus, you might be holding on to your stocks longer than you should and letting your losses accumulate beyond what you would allow in reality. This is not replicating actual trading; when you place an order you should know almost exactly what price you would have obtained in the open market, and just how much risk you are really taking. This can only be accomplished using a real time simulator.
Moreover, when paper trading, it is important to practice both buying and shorting stocks. Most traders have a strong bias towards buying a stock rather than for selling it short. They want to buy a stock low and sell it high, even when the market is telling them that they should be selling short. If from the start of paper trading, a trader searches for stocks that are good candidates regardless of direction, he will lose the emotional preference to buy stocks and will realize money can be made whether the stock market rises or falls. Besides, haven’t you noticed that stocks go down faster than they go up?