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Basic rules of trading: Manage your money
One area that is rarely examined because it is very complex is money management, and the reason is probably quite simple.
Certain trades or investments appeal to different people, and who is to know what their overall financial position is before giving them the correct advice on what amount to trade or invest. Furthermore, it is very easy for an investor to confuse a trade with a portfolio investment of stocks, or make a long term purchase but with one eye on a quick buck.One of the experiences many of the great traders have in common is that they blew a fortune early on, simply because they had no conception of money management. The usual story was that they had traded well, running a sum of say $10,000 up to $15,000 in six months, and they began to think that because they had a good trading system, they would have done better by leveraging up for super fast profits. In some cases they simply doubled up trading positions, but ran into a string of losses. As they did not reduce trading size accordingly, the account equity was wiped out and they ended up actually owing money within days – it was that quick.
For sure, they didn’t follow rule two – limiting risk with stop losses – but in some cases the share or commodity gapped up or down, and just one big trading position was all it took to blow away months of hard work.
One of the more remarkable aspects of trading is the frequency of extreme events, but these are simply statistical anomalies which occur with random regularity (forgive the lapse into chaos theory, but it’s important). There have been instances of a doubling of a share price overnight – this occurred with Psion twice in 1999. At the other extreme, there was a fall of 70% in a day, with Marconi on the 21st March 2002, where they opened at 92.5p (adjusted for share consolidation), and the next day hit 27.5p. They both were FTSE 350 stocks at the time, not small companies.
These might be extreme examples, but the bottom line is that events often happen hen you least expect them. You must treat your trading account as distinct from all other investments. Once you’ve done this, there are three things you can do:
- Accept that occasionally you will have an extreme event, so if the worst that can normally happen is a 30% fall on a profit warning, or an equivalent rise on a bid overnight, work out how much that would impact your equity.
- Don’t feel that by buying five blue chips of equal amounts, you’ve diversified your risk - if they are highly correlated i.e. high beta stocks, or all tech stocks, then it’s virtually the same risk as buying five times the amount in one stock.
- If your equity is falling, and statistically you can expect a run of eight or more losses in a row more than once within a typical trading lifetime, keep reducing your size until you start winning again.
From experience, if you aim to lose an absolute maximum of 5% of your account equity on one trade, and combine a wide range of trades in different asset classes with long and short positions, then you should have at least 20 consecutive goes before it’s time to give up. Blue Index traders, including the writer, have seen it all and done it all, and what we have learned is not rocket science. We might have the edge when it comes to short term trades, but money management is crucial. So spread your risk, go long and short, and don’t be afraid to diversify to make money.
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