Money and Risk management

Maintaining good money and risk-management habits is more important than correctly applying technical analysis! Good money-management habits ensure that you’ll survive much longer in the stock market, even with a number of trading failures in a row. Good risk-management habits ensure that the risk-to-reward ratio is in your favor, with at least a ratio of one to three.

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Practicing good money- and risk-management habits helps limit losses in losing trades and helps create profit in winning trades. Let’s assume that you are trading based on daily charts; you would buy a stock and then sell it when the stock drops more than 3% below the buying price. Unfortunately, however, limiting losses is not that easy. In this example, the outcome most likely will be too many losing trades that result in losing all of your money at the end.

How much loss you’re willing to accept will be proportional to how much profit you want to make in a certain period of time. While it’s likely that you’ll only suffer a 2% loss when using hourly charts, your profit target will be in the order of 5%. Using daily charts will result in losses in the range of 10%, but with a profit target in the order of 25%.

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

Good Money Management Practices

• Only use money that 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 leverage (e.g., futures, options) should only be done with money you can afford to lose in full.
• Depending on the amount of starting capital, you must spread the money among several stocks.
• You must limit the loss in a single trade to 1% up to a maximum of 2% of your portfolio’s total value.
• You must limit the loss in one trade to no more than a 15% maximum of the trade value.
• If your starting capital is too low to invest in more stocks, you can use an Exchange Traded Fund (ETF) tracker of a stock index. The index takes care of the necessary stock risk spread.

Good Risk-management Practices

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-to-reward ratio of a minimum of one to three.

Keep a trailing stop for maximum profit based on:

• The volatility of the stock.
• Applying 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, which 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 at any moment in time, limiting the capital per stock to $2,500.
Keeping an average loss per stock of 10%, or $250, would only constitute a 1% loss in relation to the total capital.
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:

Calculation of the Maximum Buying Power for a Single Stock
		Available cash
Total buying power	25000	=RC[-1]-(SUM(R[1]C[-1]:R[10]C[-1]))
Buying value_1	0	=RC[-1]-(RC[-1]*0.1)
Buying value_2	0	=RC[-1]-(RC[-1]*0.1)
Buying value_3	0	=RC[-1]-(RC[-1]*0.1)
Buying value_4	0	=RC[-1]-(RC[-1]*0.1)
Buying value_5	0	=RC[-1]-(RC[-1]*0.1)
Buying value_6	0	=RC[-1]-(RC[-1]*0.1)
Buying value_7	0	=RC[-1]-(RC[-1]*0.1)
Buying value_8	0	=RC[-1]-(RC[-1]*0.1)
Buying value_9	0	=RC[-1]-(RC[-1]*0.1)
Buying value_10	0	=RC[-1]-(RC[-1]*0.1)
Allowed buying value		=IF(R[-12]C<R[-2]C,0, SUM(R[-12]C:R[-2]C)/10)
	=SUM(R[-12]C:R[-3]C)	=SUM(R[-12]C:R[-3]C)
	Total investment	Remainder

One-hundred percent of the cash value above $25,000 will be available for new investments.

The actual value of the 10 contracts in the portfolio will be reduced by 10% (the average stop value) as an extra precaution when calculating the new contract value.

The maximum buying value for one new contract will then be the available cash and the value of the open contracts divided by 10 (10% of the total capital).

 

Calculation of the Maximum Buying Power for a Single Stock
		Available cash
Total buying power	25000	25000
Buying value_1	0	0
Buying value_2	0	0
Buying value_3	0	0
Buying value_4	0	0
Buying value_5	0	0
Buying value_6	0	0
Buying value_7	0	0
Buying value_8	0	0
Buying value_9	0	0
Buying value_10	0	0
Allowed buying value		2500
	0	0
	Total investment	Remainder

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We will get the following result with $25,000 starting capital and consecutively buying 10 stocks:

Calculation of the Maximum Buying Power for a Single Stock
		Available cash
Total buying power	25000	1096
Buying value_1	2500	2250
Buying value_2	2475	2228
Buying value_3	2450	2205
Buying value_4	2426	2183
Buying value_5	2401	2161
Buying value_6	2377	2139
Buying value_7	2354	2119
Buying value_8	2330	2097
Buying value_9	2307	2076
Buying value_10	2284	2056
Allowed buying value		0
	23904	21514
	Total investment	Remainder

As an example, let’s close trades 1 and 4 with a 30% profit, while all of the other contracts remain open. Adding this profit to the capital gives a new allowed buying value of $2,458.

Calculation of the Maximum Buying Power for a Single Stock
		Available cash
Total buying power	26477	7499
Buying value_1	0	0
Buying value_2	2475	2228
Buying value_3	2450	2205
Buying value_4	0	0
Buying value_5	2401	2161
Buying value_6	2377	2139
Buying value_7	2354	2119
Buying value_8	2330	2097
Buying value_9	2307	2076
Buying value_10	2284	2056
Allowed buying value		2458
	18978	17080
	Total investment	Remainder

You can always see the total invested value and the remaining value when all trades would suffer a 10% loss.

Is this Setup Sufficiently Crash Resistant?

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

There still is a remaining capital of $9,151. It looks like good money management; you survive for quite a while, and it’s possible that the following trades will make up for all of the losses!
In the table, you can see the remaining capital after each 10-stock trade.

 

Money & Risk management next -Part 1 -Part 2 -Part 3 -Part 4 -Part 5 -Part 6

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