A Primer on
V. Money Management
No literature on technical analysis
would be complete, if there is no mention of some type of money
management technique. Some traders believe that money management is the
most important ingredient in a trading program, even more crucial than
the trading approach itself. I'm not sure I'd go that far, but I don't
think its possible to survive for long without it. Money management
covers the allocation of funds. It includes such areas as portfolio
makeup, diversification, how much money to invest or risk in any one
market, the use of stops, reward-to-risk ratios, what to do after
periods of success or adversity, and whether to trade conservatively or
Admittedly, the question of portfolio
management can get very complicated, requiring the use of advanced
statistical measures. The following are some general guidelines that can
be helpful in allocating one's funds and in determining the size of
one's trading commitments:
1. Total invested
funds should be limited to 50% of total capital.
2. Total commitment in
any one sector should be limited to 10-15% of total equity.
3. The total amount
risked in any one stock should be limited to 5% of total equity.
These guidelines are fairly standard in the industry,
but can be modified to the trader's needs. Some traders are more
aggressive than others and take bigger positions. Others are more
conservative. The important consideration is that some form of
diversification be employed that allows for preservation of capital and
some measure of protection during losing periods.
Using Protective Stops
I strongly recommend the use of
protective stops. Stop placement, however, is an art. The trader must
combine technical factors on the price chart with money management
considerations. The trader must consider the volatility of the market.
The more volatile the market is, the more loose the stop that must be
employed. Here, a tradeoff exists. The trader wants the protective stop
to be close enough so that losing trades are as small as possible.
Protective stops placed too close, however, may result in unwanted
liquidation on short term market swings (or "noise").
Protective stops placed too far away may avoid the noise factor, but
will result in larger losses. The trick is to find the right middle
Reward to Risk Ratios
The best traders make money on only
40% of their trades. That's right. Most trades wind up being losers. How
then do traders make money if they're wrong most of the time? Since
markets can be quite chaotic at times, even a slight move in the wrong
direction results in forced liquidation. Therefore, it may be necessary
for a trader to probe a market several times before catching the move he
or she is looking for. Because most traders are losers, the only way to
come out ahead is to ensure that the dollar amount of winning trades is
greater than that of the losing trades. To accomplish this, most traders
use a reward-to-risk ratio. For each potential trade, a profit objective
is determined. The profit objective (the reward) is then balanced
against the potential loss if the trade goes wrong (the risk). A
commonly used yardstick is a 3 to 1 reward-to-risk. The profit potential
must be at least three times the possible loss if a trade is to be
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