Money Management: Do you need it?
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Money Management in Trading
The stock market is nothing more than a high-maintenance, well-oiled, but unpredictable machine. Thus, it should be treated like a machine.
Stock trading needs to be done in a routine, systematic manner. Make a plan for yourself. Every morning at the open, you check your stocks, make your plan, and place the trades. This way, it becomes not only a system, but a habit.
Utilizing this approach allows the investor the opportunity to apply effective money management techniques which will increase profitability. A system has rules that need to be followed to the letter. The very second that you decide to change the rules, profitability will begin to suffer. Strong discipline is needed.
In Van Tharp’s book, Trade Your Way To Financial Freedom, the concept of money management is explained by “position sizing”. This is essentially determining how much money you will use on a particular trade. In the process of position sizing, you are determining your overall risk on each trade. This risk needs to fit into a predetermined percentage of your portfolio. So, the size of your position in any trade is key to managing your overall portfolio.
Profitability in money management
When do you exit a trade? This question needs to be answered before even placing the trade.
Exiting a trade will be determined by your predetermined risk on the trade and the predetermined profit margin. To borrow a phrase from John Patrick, “you need to have a win goal and a loss limit.”
While I don’t want to equate trading with gambling, the gambler who uses effective money management will be more successful than the one who does not. So, your profits are predetermined, and your losses (which will occur) are limited to a particular percentage of your overall portfolio. So, taking profits becomes an automated process.
Money management helps you to sleep at night
Use of a predetermined risk when investing helps to take the emotion out of the equation. No more tossing and turning in bed, worrying about that one stock with a fickle risk margin. Know exactly what you’re getting into when you get into it. Observe, calculate, purchase. Observe, calculate, sell. The more mechanical that you make the process, the easier it is to carry out. Trading becomes simplified.
In Mark Douglas’s book, Trading In The Zone, he mentions that you need to think like a trader and in doing so learn to “properly manage your expectations”. One of the things that emotions will cause us to do is to believe that a particular trade has to be a winner. The adrenaline kicks in and a stock suddenly looks like a lottery ticket. We then begin to think that certain winning trades have to be huge gains.
This is completely false. Trades are unpredictable. You never know what the market will do. Therefore, learning to control your emotions and your corresponding expectations is paramount. Developing the balance between the amount that you are willing to lose and the amount that you want to gain is the key to profitable trading.
