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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


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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