Competitive Malaysia: Sound Money Management (Advertorial 8)

One of the most difficult qualities of being a successful trader is learning to be a good manager of your own money. It's completely possible — and actually pretty common — to see people turn out to be right on a high percentage of their trades and still lose money. How is that possible? If you don't use good money management by locking in profits, taking small losses on the picks you're wrong about, and controlling your use of margin, eventually you'll lose it all, no matter how good a trader you are.

Protecting your capital is your first priority.

As a trader, the most valuable thing you have is your capital. Without it, you can't trade at all. Bringing in no profits at all is better than losing any part of your capital, because if your account is intact, you can always make a profit another day. If your capital has suffered a loss, you'll be wasting effort playing catch-up. The more you've lost, the longer it will take to get back to where you started from — both because you've got more to make up for, and also because with a smaller chunk of capital to work with, your profits for any given percentage return will be proportionally smaller. Making 10 percent on a $10,000 account earns you $1,000, but if you've lost half of that account and have only $5,000 left, making 10 percent on your money will earn you only $500. You'd have to do that twice to make the same $1,000.

Market corrections are inevitable, and will continue to occur from time to time. Traders must anticipate them and take precautions before they occur. Properly prepared, traders can even profit from corrections. Without proper money management, though, your account balance can be destroyed.

Goals of Good Money Management

Sound money management has two main goals: to avoid losing money, and to avoid missing profit opportunities by tying up capital in problem trades for long periods of time. Failing to avoid either of these will cost you.

Avoiding loss of money is pretty easy to understand: You want to preserve your capital and whatever profits you've accumulated. Not only do you want to keep it, but you want to trade with it as well, so that your capital continues to grow and makes your returns larger and larger.

Avoiding loss of profit opportunities isn't quite so obvious, but if you think about it, it's easy to see the point. Let's compare the outcomes of two money-management decisions. Trader A buys a stock, expecting it to go up, and finds that it doesn't. He's just sure it will go up eventually, and he's incurred a small loss, so he decides to wait it out. He ends up holding the stock for three months before finally selling it.

Trader B buys the same stock at the same time as Trader A, but once he sees that it isn't going up, he sells it at a small loss. He buys another stock and makes a 15 percent profit on it. His next trade loses 1%, but after that he makes 8 percent, 15 percent, and 30 percent on series of trades. Because he is growing his account, he makes these percentages on a larger and larger capital basis each time. At the end of three months, his account has grown by 48 percent.

Whose money-management decision turned out to be the best? While Trader B made a nice profit, Trader A not only lost time but also never made his money back. Even if he had made his money back on that stock, it's hard to see how this was a good use of his capital over the course of three months.

Keys to Sound Money Management

There are six important things you must do to manage your account safely and effectively:

1)Lock in profits.
2)Take small losses and make big gains.
3)Use margin with caution.
4)Go to cash when the market nears its top.
5)Diversify your portfolio.
6)Hedge risk.

You must do these six things consistently and without exception. The most important difference by far between successful and unsuccessful traders is money management.

Exercising good money management is the single most important thing you can do to improve your trading performance.

Lock in Profits

Lock them in or lose them. We can’t say it more simply than that.

One of the most common and frustrating mistakes traders make is failing to lock in profits. It's great to be up 35 percent on a trade, but it's only “virtual” money until you do something to ensure that it's yours to keep.

Remember one of our examples from the last chapter? A trader watched his stocks go up initially, failed to take profits, and then watched them go back down — and down, until he'd actually lost money on what had been profitable positions. There's no reason this has to happen. It will happen, though, if you have no plan and no strategy for locking in profits.

How should you lock in profits? Since price targets are guidelines, we recommend making a habit of selling half our shares at a more conservative target than the one you actually think the stock has a good chance of reaching. That way, you lock in a good chunk of profits, and whatever happens after that there's no way those profits can disappear. Sometimes, if you think the stock could travel a long way, plan several levels where you’ll take profits — first selling half your position, then half of what's left, then half of what's left of that. Often these selling points are near psychological barriers you expect the stock to encounter — round numbers like 10, 20, and 50, or percentage barriers like a 25% gain for the day.

Another way to lock in profits is to use trailing stops. By continuously raising these stops as the stock price moves up, you’ll lock in the profits you’ve made below the stops. You can also protect the entire position in case of a sudden downturn.

These strategies must be part of the plan you have before you ever buy the stock. After you're in the position, it's too easy to get either panicked or carried away by high expectations. Locking in profits is part of your exit strategy and as such is part of the whole plan for the trade.

Let's look at a shorting example. You short a position at 38 after it runs up 100% in a day on modest news. You calculate it could lose around half of its new gain in a day or two. You decide that you'll take half your profits when it gets down to about 35, another half when it reaches 32 and the rest when it reaches 29. You place a stop buy-to-cover order at 40.21 and wait.

The position moves as you’ve predicted, and within an hour is approaching 35. You adjust your trailing stop to cover half your position at a lower price and place a limit buy-to-cover order on the other half at 35.10, which executes.

Late in the day, the position takes a dip down to 32.70, then 32.30. You know that a lot of people put in orders right at round numbers, so you always try to get in a little ahead of them. You buy to cover half of the shares you have left at 32.10. You reset your stop for a lower price on the position that is left but let it expire at the end of the day because you think it might temporarily gap up in the morning as the last gasp of its big run. The position closes at 32.60.

The next morning, it gaps up as you thought it might, reaching 33.40. It then starts to fall, slowly making its way toward your expected final selling point of just above 29. You reset your trailing stop at 33.60.

To your surprise, though, it picks up steam later in the morning and runs up to 33.90, triggering the stop on your remaining shares. It seems to have the legs to run for another day. You don't care, though — you're happy, because you took profits at a much better price yesterday and no one can take them away from you. On top of that, you're now free to short the position again once it reaches the top of its second-day run.

If you'd held your entire position, you'd have no profits and would have to wait for the position to go down in order to see them — plus you'd run the risk of it rising higher than the point where you shorted it.

Accept Small Losses and Make Bigger Gains

If you don't take small losses, you’ll eventually lose. If you're unwilling to take a loss on any trade, we guarantee that you'll lose money.

Most people have trouble taking small losses. They don't want to lose anything on a trade because it makes them feel like they failed somehow. But taking small losses means you succeeded. Focus on the fact that you should take small losses, not that you should take losses. Taking small losses is a way to limit losses when they occur and to make sure they never turn into big ones. Taking small losses and big gains is the way successful traders trade. It's the only way to be a successful trader.

The best way to enforce the discipline of taking small losses is to use protective stops on every trade. If you decide how much you're willing to lose on a trade before you enter the position, as part of your plan, you can set your stop right after you enter the position and you won't have a chance to second-guess yourself.

If you think about how much you're willing to lose as part of your plan, it also helps you determine about whether the trade is one you really want to make in the first place. Taking a good look at your downside should help to keep you away from questionable trades.

Use Margin Carefully

Margin is a powerful tool that can really increase your profit, but must always be used with care. The fact that using margin lets you make much more on successful trades but lose much more on unsuccessful trades should make you even more carefully evaluate the risk-to-reward ratio every time you look at a potential trade.

What's the proper way to use margin?

First of all, don't use all of it. Always leave yourself a generous cushion. Every change in the price of a stock in your portfolio changes the value of the collateral you have available for your margin loan. If the value of your holdings goes down, it will go down faster due to margin than if you weren't using margin, and this means that the size of your margin cushion will decrease at the same faster rate. We suggest that you never use more than two-thirds of your total margin capacity. This leaves at least one-third as a cushion. If declining values bring your cushion to below one-third of your capacity, it may be time to sell some positions to keep you out of trouble.

Second, when deciding how great a loss you can tolerate on any one trade, remember to take margin into account. If you're using half your margin capacity, a 2% loss on the value of a stock position will equal a 3 percent loss to your actual capital.

Learn how your broker calculates account equity. This can be very confusing, but it's really helpful to be able to anticipate how much margin capacity you'll be left with after you make a trade. Always keep track of your margin status. Check it every morning and at the end of every trading day.

Don't worry about margin interest. Your broker will charge interest on the borrowed amount, but the interest rate is low and the cost is extremely small if you're trading profitably.

In general, use margin only in markets with a strong bullish direction. You can't use margin capacity to increase the sizes of short positions in a bear market, anyway (though you must have a margin account to short.) Whenever the market seems overbought, unsteady, or unclear in its direction, get completely out of margin before a downturn can take place.

Shift to Cash When a Market Nears its Top

Besides getting out of margin when a market seems unsteady or overbought, you should also lighten up on positions and go mostly to cash. When the market is about to turn, cash is always safest. Staying away from unpredictable and difficult to trade volatility will save your account from potentially devastating losses.

Diversify your Portfolio

Diversification is very important in trading. Putting all of your money into positions that carry the same types of risk is not good money management. Instead, find trades with different risks so that if one sector experiences a sudden downturn, only a portion of your account will be affected.

Hedge Risk

Learn about strategies for hedging risk. For example, if you're playing a stock that you believe will go up but could instead go down, try to find a weaker stock that should generally go in the same direction and short it. That way, if the primary stock goes down, you'll profit from your short, which is likely to fall faster because it's weaker. If it doesn't fall, it's not likely to rise as fast for the same reason.

Many common hedging strategies involve options. Two examples are straddles and strangles. A straddle is an options play where both a call and a put are purchased. The call and put have the same strike price, the same expiration month, and the same underlying stock or index.

A strangle is an options play where both a call and a put are purchased. The call and put have different strike prices (usually both out of the money), but have the same expiration month and the same underlying stock or index.

Hedging is a form of insurance, so it will cost you a bit by decreasing the profits you make on a play. But there are times when insurance is well worth the cost.

Risk Taking

Traders who routinely fail to use safe trading and money-management practices should ask themselves why they're engaging in dangerous and self-defeating behavior. There's always a psychological motivation for something that doesn't otherwise make sense. What are they getting out of it, since it's clear that they're not getting better financial results?

Risky behavior is often a form of escapism or a substitute for something more meaningful in a person's life. If you seem to resist using proper money management or often "forget" to make a plan or set stops, take a look at your own motivations. Better to figure it out now, deal with it, and prosper than to lose all your money because you didn't know what you were really trying to do.

If you find yourself taking unnecessary risks or engaging in other self-injurious behavior, try to figure out your motivations and deal with them.