Sunday, July 30, 2006

Money Management and Reward to Risk

Unless you're a pure gambler, "betting it all on black" or putting all your trading money into one position definitely isn't the way to go. Money management can be critical to long term success in stock and option trading and investing. "Diversify." "Don't put all your eggs in one basket." Who hasn't heard those words of wisdom? Yet, time and time again, people forget that wisdom. They put all their savings into one stock -- often the company where they work. Apparently they believe the company can't fail so they don't perceive the risk until it is too late. Talk to people who owned Worldcom, Enron, United Airlines, Qwest, GM over the last 5 or 6 years, and see how they feel that strategy worked. Clearly, many stayed until the all too bitter end in some of those stocks and suffered the life changing results. For companies like GM where the stock topped out around 94 in the year 2000 and as of mid March 2006 trades around $21 or $22, the old "it'll come back" refrain will require over a 400% move. Suppose you owned 5000 shares of GM since the year 2000; your asset value has gone from about $470,000 to $107,500. Suppose today was the day you planned to retire and those shares of GM and Social Security were it! First, you can see how important it would have been to have used an exit (see our Trend Trading materials on our website), but also quite importantly you can see how leaving all the eggs in that one basket worked out. I don't mean to pick on GM. Stock in many companies have suffered a similar fate. I just want to illustrate the dangers of failing to manage money.

What do I mean by "money management"? How is it done? When someone trades stock (or options) he should set aside a specific amount to trade. The money set aside should be risk money; money that isn't needed to pay the bills, the mortgage, the car payment, groceries, etc. Since all trading involves risk, the amount set aside should definitely be considered to be at risk. Once the amount is identified, the trader has the option of making equal dollar amount trades or trading a fixed percentage of the risk money on each trade. Someone with a relatively small stake may initially make equal dollar amount trades. So, for example, if the trader has $10,000 in risk money, he may make each trade $500 (or $750 or maybe even $1,000) thus if everything is lost in one trade, there is still $9,500 (or $9,250 or $9,000) left to trade. He is still in the game. Even better, in my view, is making equal percentage trades. I prefer something in the 3% to 5% of risk money in any given trade. Let's say our hypothetical trader starts with $100,000 and trades 3% per trade. The first trade is for about $3,000. Let's say that all is lost on that trade, now the trader has $97,000 and the next trade would be only $2,910. Again, the $2,910 is lost, now there is $94,090 in risk money and the next trade would be about $2,800. Finally, that trade makes a nice gain of $2000. Now, there is $96,090 and the next trade would be for $2,900. Again, there is a gain, and this time a big one for $6,000. Now the risk money is $102,090 and the following trade would be for about $3,060. You get the point. As the fund diminishes, the trades are getting smaller and as it gains, the trades get larger. Several wins in a row will result in more money traded so dollar gains should be greater. If there are several losses in a row, less and less money is traded so potential losses are smaller and smaller. The chances of staying in the game are greater with this method of money management, and you can't make money trading unless you are able to trade. Of course, there is the old bridge players story of the Duke of Yarborough who purportedly went years without having a single point in a hand of bridge. If you are the stock trader's equivalent of the Duke of Yarborough, I guess nothing will help, but proper money management could give you a better chance.

While many people who trade are aware of money management principles, they fail to use them. Though money management makes sense, greed sometimes takes over. I once had a trading student who was doing very well. He'd call me and say "I made "x" today." The next day he'd tell me he made twice as much as the day before and the following day he did well again. The calls went on for some time, each one more excited, and then they stopped. I was concerned so I called him and asked how he was doing. He was crestfallen. He had five winning trades in a row on a particular stock and then guess what he did. He put all his money on the next trade. As fate would have it, the stock gapped down hugely the following morning and my friend not only lost all the profits he had claimed, he was out of the trading business. The market is a stern teacher and "Murphy" is always near at hand. Knowing that every trade involves risk, do everything you can in your trades to try to put the odds in your favor. Proper money management is one of those things that could help.

Another thing I believe a trader should analyze is the reward to risk ratio of a trade. I am a firm believer that I should know my initial exit before I ever enter a trade. I should also have a "first target" for the move I am trying to play. That does not mean that I will exit just because my position hits the first target. I'll see what the stock is doing if it gets there. If I'm bullish, I won't sell automatically if it hits that first target -- it may keep going, you know. If I sold just because it hit the target I may cut my profits by getting right out. I'll have my stop close, but unless the stock turns back at that point, I'll stay in the position.

My "first target" is important in determining the reward to risk ratio I am looking at when I buy the stock. Suppose the stock is trading at $50 and my initial exit is $1 below that at $49. My risk, for the purposes of this calculation only (the real risk is $50) is $1.00. Further suppose that my initial target is $53. My reward to risk ratio in this scenario is $3 to $1 ($3 potential profit to $1 potential loss) or 3:1.

Let's say, for purposes of this Article, that my reward to risk criteria for entry into a position is 2:1 and that I do 10 trades. Here is the hypothetical Trade Table:

Trade 1 +2
Trade 2 +2
Trade 3 +2
Trade 4 +2
Trade 5 -1
Trade 6 -1
Trade 7 -1
Trade 8 -1
Trade 9 -1
Trade 10 -1
Total +2
In that example, I could have lost 6 out of 10 trades and still come out ahead if I lost my anticipated risk in 6 and gained my initial target in the other 4 trades. So I can theoretically lose 60% of the time and still make money if I am trading positions with a 2:1 reward to risk. In actuality, I try to find trades that have a 2.5:1 reward to risk ratio.

Money management and reward to risk awareness can make all of us better traders and help try to enhance our trading.

Bill Kraft, Editor
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Bill Kraft is the editor of the Trend Trader Service at

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