The Principles of Money Management in Stock Trading

The success of stock trading online is all about money management. It is not about capital or the way you trade whether you a fundamentalist or technical, or how good your stock broker advices. The bottom line is: Money management

What is money management? It is a skill of trader to assess the risk and rewards of every trading decision or system. Investing in stocks has risk and there are also potential rewards. If there is no money management, there is no success in trading. Also trading without money management is Gambling and is not part of a trading career.

As an experienced trader, I will outline below the principles that I learn about money management:

Principle of Positive Expectancy:

Do not let me wrong, but success in trading depends on positive expectancy. What is “Positive Expectancy” ? Let me define what is “Expectancy” first.

“Expectancy” is the average amount you can expect to win (or lose) per dollar at risk. Mathematically:

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)

Examine closely the formula if you are serious as a trader, it means that to have a profitable system, you should have a positive expectancy. This can be done by having high probability of win or high average win.

MoneyManage

Principle of Stop Loss and Profit Targets

Stop Loss is the amount at which you should stop trading to avoid further loss. This is set as a percentage of your total trading capital or other conventions and you will make it sure that your stop loss reflects the way you trade and your risk level.

Profit targets is the amount at which should exit trading to grab profits. This should be higher than your stop loss to produce a meaningful trading system. Analyze the winning percentage of your trading system, your stop loss and your profit targets and you can set expectations for your trading.

Example:

%Winning= 35%
Average win per trade= $500 (profit targets)
Average loss per trade= $100 (stop loss)
%Loss= 65%

Expectancy = (Probability of Win * Average Win) – (Probability of Loss * Average Loss)

Expectancy = (0.35 x 500) – (0.65 x 100)= 175-65 = 110 dollars profit per trade

Great, if you have this trading system, even at worse %winning percentage of 35%. You can still make a lot of profits. Secret? uhmmm Money management.

In this case, your profit targets is set high at around 5 times your loss. It is high even at high losing percentage as long as we keep the loses small, it won’t affect the profitability of trading.

This principle does not apply only to trading of stocks but trading futures. In E-mini where serious losses always occur and lot of emotional traders get hurt. Trading in this type is smart.

For example per 1 point in E-mini is $50. If you set your profit targets way high (3 points for example, this is equivalent to $150). As long as you keep losses small, go and figure out the expectancy of the trading system before going further.

Principle of Paper Trading

Paper trading is simulating actual trading, the purpose is to compute the %wins and %loss of the trading system. I have made some post on how to do paper trading and it is useful for money management.

Paper trading is analogous to market test in real business or feasibility study. No business will succeed without testing it first.

Principle of Exceptional Discipline

Trading with discipline and you will eventually succeed, do not let emotions decide on your trading, it is the amateur way. Professional Traders face serious losses (even great losses such as the example above at 65%)but eventually will still succeed because of good money management skills.

The way discipline will be applied is this typical scenario, assuming your stop loss is -$100. Then trading goes to -$25, then going down further to -$50 and finally at -$95, your emotions dictate you to quit this trading because it might go down further. You quit the trade and lose $95.

But as soon as it reaches -$98 it climb high back to 5 dollars and then up and up. You miss your profit because you are not disciplined enough.

Trade with discipline, stick to your targets and stop loss plan. Implementing trading strategy takes discipline to work, it is your job.

Principle of Long term play

Long term play is profitable because it enables you trade less, hence prevent you from overtrading. Also long term play lessens that chances you will become emotional at loses and enable you to trade with focus because it is for long term.

Principle of Diversification

Do not put all your eggs in one basket. If the basket will fall to the ground, all your eggs will be lost. This is also applicable in trading, diversify your investment in other markets. Plan ahead and stick to your trading strategy.