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Money and Risk management

Good money and risk management is more important than the correct application of technical analysis! With good money management you survive much longer in the stock market, even with a number of trading failures in a row. With good risk management you also make sure that the risk/reward ratio is in your favor at least with a ratio 1 to 3.

Good money and risk management limits as much as possible losses in losing trades and makes as much as possible profit in the winning trades. Assume you are trading based on daily charts, you buy a stock and sell it when the stock drops more than 3% below the buying price. Unfortunately limiting losses is not that easy! In this example, the result will most probably be too many losing trades and losing all of your money at the end.

 

How much loss you need to accept will be proportional to how much profit you want to make in a certain period of time. Only accepting 2% loss and a 5% profit target could be possible when using hourly charts. Looking at the medium term and using daily charts however, loss will be more in the range of 10% with a profit target in the order of 25%.

Also do not forget that behind every stock there is a company that can go broke! So, you may lose all your money investing it in one stock only.

Good money management means:

  • Only use money you do not need for living expenses.
  • Do not put more money at risk than what you have.
  • Investing and using a credit line or a leverage (Futures, Options) should only be done with money you can afford to lose in full.
  • Depending of the starting capital you must spread the money among more stocks.
  • You must limit the loss in a single trade from 1% to maximum 2% of your total portfolio value.
  • You must limit the loss in one trade to about 15% maximum of the trade value.
  • If your starting capital is too low to invest in more stocks, you can use an ETF tracker (Exchange Traded Fund) of a stock index. The index than takes care of the necessary stock risk spread.

 

Good risk management means:
Keep an initial stop based on:

  • The maximum allowed loss in a trade.
  • The maximum allowed loss in relation to the total portfolio value.
  • The use of an initial stop based on technical analysis.
  • A risk/reward ratio of minimum 1 to 3.

Keep a trailing stop for maximum profit based on:

  • Use a trailing stop based on the volatility of the stock.
  • Apply a method for distributing profits or losses between stocks in your portfolio.

Money management and buying power

Arbitrary number of stocks

A first money management method would be to trade in a limited number of stocks out of an unlimited list of stocks. A second method, we will discuss later on, would be to trade a fixed, limited number of stocks.

A $25,000 starting capital, could be used to invest in 10 stocks any moment in time, limiting the capital per stock to $2,500.

Keeping an average loss per stock of 10% or $250 would only be a 1% loss in relation to the total capital.

Special offer: "Capturing Profit with technical Analysis"

Of course you would have to calculate your buying power with each purchase in relation to your cash value and the value of the stocks in the portfolio. You could use the following spread sheet for this:

Look in the "Capturing Profit with Technical Analysis" book for this spread sheet...


Is this setup sufficiently crash resistant?

Let’s apply this system and calculate each time the maximum allowed buying value for each contract. Next, we assume the most negative scenario. Each of the 10 contracts ends up as a losing trade with a 10% loss. This even happens 10 times in a row. A total of 100 consecutive losing trades

Crash resistant?

10 contracts investment

10 contracts losing trades

Remaining amount

Starting value

25000

 

 

Trade_1

23904

2390

22610

Trade_2

21618

2162

20448

Trade_3

19552

1955

18493

Trade_4

17682

1768

16725

Trade_5

15994

1599

15126

Trade_6

14464

1446

13680

Trade_7

13080

1308

12372

Trade_8

11830

1183

11189

Trade_9

10699

1070

10119

Trade_10

9676

968

9151


Still there is a remaining capital of $9,151. It looks like good money management, you are surviving quite long and maybe the following trades will make up for all the losses! In the table you can see the remaining capital after each 10-stocks trade.

 

Money and Risk management Next --Part 1 -Part 2 -Part 3

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