It does not matter if you know all there is to know about stock selection. Strategy mastery is not the most important skill to possess. You will be out of the game in short order if you can't control your money.
Money management is probably the most important skill a trader can have yet it is the most overlooked. Last week we talked about The Power of Diversification and the benefits of getting broader market exposure by not placing all of your eggs in one basket. This week we're talking about money management, the importance of position sizing and strategy diversification.
The size of your account is a factor that will dictate how you will allocate funds. It may sound counter intuitive, but it may be necessary to take more risk with a smaller account. A $5000 account that is diversified and invests in a minimum of ten stocks at $500 a position will find it difficult to minimize the effect of the bid/ask spread and commissions. This is known as "slippage".
Although one needs to always be aware of slippage, it has less of an impact on larger accounts as a percentage of the portfolio. Smaller accounts will return smaller absolute dollars even though the percentage return may be reasonable. If you are generating a reasonable percentage return you must not be tempted to implement riskier strategies in order to achieve larger absolute dollar returns with a smaller amount of capital. That type of thinking will lead to ruin. Larger accounts have the luxury of more flexibility in strategy choices, position size and diversification.
Your risk tolerance will also play a role in the amount that you allocate to each trade as well as the strategy that is applied. It is necessary to master and implement strategies that you are comfortable with. You should have strategies that can be applied to an up, down or sideways market. The next important step is to define the goals for your account(s). Your goals will dictate how you will trade the account. You may be trading for monthly income in one account and capital appreciation in another. A qualified account may be traded differently that a non-qualified account (IRA vs. regular account). Retirement investing in an IRA may be approached more conservatively that a non retirement account and tax considerations may come into play.
OK, with all of that said, what about money management. The following are guidelines to keep in mind:
Diversify with multiple positions
Don't load up on one stock
Keep some powder dry/ cash reserve
Strategy diversification is important in my trading system. The reason is that strategies have varying degrees of aggressiveness and not all are appropriate to apply based upon market conditions, risk tolerance and position sizing considerations.
I always keep 20-25% of my portfolio in cash for contingencies. The remaining 75% is usually allocated as follows:
40% Collar trades
20% credit Spreads
10% Debit spreads
5% directional plays
Collars are very conservative as are credit spreads (the way that I do them). Debit spreads are more aggressive and directional plays are high risk.
If you use stops, you should factor your maximum risk for each trade. I personally rarely use stops but rather, I hedge my positions with options. I will risk no more that 2.5% of my entire portfolio on any one trade. It's important to understand that the amount of money traded per position is not the same as the risk amount. If I had a $100,000 account and I bought 1000 shares of a $21 stock and in addition bought a strike 20 put for $1.50, my risk is $2.50. (the difference between the $21 stock and the 20 put plus the cost of the put at $1.50 equals a $2.50 risk).
That would represent my maximum risk for this trade which is 2.5% of $100,000. The risk in this example works but I have applied too much of my capital to this one trade which will not allow me to properly diversify. My cost basis in this trade is $22,500 which is too over-weighted on this one play leaving only a balance of $77,500 in my account to invest in other positions. I hope you are grasping this concept because it will be the difference between success and failure.
About the Author:
Mark Espy (aka RobinHood Trader)is a full time trader and professional educator. Mark loves to help others master trading skills and is co-founder of a rapidly growing trading education company. Receive a free lesson and learn more about how to improve your trading skills.
25 November 2008 Business