Money management is an extremely important, but often ignored, aspect of trading. It involves the use of stop losses and allocation of capital in order to both maximise the profitability of your trading strategy but to also preserve capital during losing periods.
Stop losses are essential be they mental or physically placed with your broker. Before I even place a trade I will decide where my stop loss is going to be, as this will entail the size of my position. The maximum I will risk of my trading capital on any one trade is NEVER greater than between 2% and 4%. That means if I have £100,000 in my account and I choose to buy the S&P at 800 and place my stop loss at 780 if my stop loss is triggered there will be between £96,000 and £98,000 left in my account.
Another important thing to remember which never fails to surprise people when I mention it during seminars is that roughly 6 out of 10 of my trades lose money. Yes lose money. I take my losses quickly but run profitable positions as I am looking to get on the back of major trends. My profits are anywhere between 3 and 20 times the size of my losses.
Preservation of capital and risk reduction is the key to successful trading. If an equity or commodity is said to have a high correlation with another it means that they will generally move in tandem. For an example if I own Barclays and HSBC they will move in the same direction 98% of the time and therefore have a high correlation. However if I owned both BP and British Airways these are said to have a low correlation as they often move in different directions. This is because high oil prices are good for BP but not for BA as they are big buyers of fuel.
If I wish to therefore buy Barclays and HSBC I will have to change the amount of money I would normally risk per trade as if one falls the other will almost certainly do the same. I would therefore perhaps only risk between 1% and 2% on each of these trades.
Quite often you will see me write that I am looking to " balance my book" or make it more "symmetrical". Say I have the following positions: Long the S&P, Long of the FTSE 100 and Long Cable and Wireless. There is a high probability that they will all move in the same direction. To balance this book I might choose to sell a particular stock, sell dollars or to buy Gold. This is because in a falling equity market these would partly hedge my book. Please note that I do not always want a balanced or hedged book as my job is to take risk, but it is important for you to know when I am doing it and why.
I have a very simple and surprisingly obvious technique to maximise profits and minimise losses. If I start to lose money I cut down the size of my trades and conversely during winning streaks I will increase them. It is as simple as that. Do not be tempted to keep increasing your risk when losing in the hope that you must be about to get one right as this is one of the surest ways to lose the lot.